Patnaik, P. (2015), Economics Vol. 3

Title Pages
Economics: Volume 3: Macroeconomics

Prabhat Patnaik
Print publication date: 2015

Print ISBN-13: 9780199458950
Published to Oxford Scholarship Online: September 2016
DOI: 10.1093/acprof:oso/9780199458950.001.0001
Title Pages
Volume 3: Macroeconomics (p.ii)
(p.i) Economics
(p.iii) ICSSR Research Surveys and Explorations
Economics
(p.iv)
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Page 2 of 2
Tables, Figures, and Boxes

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
(p.vii) Tables, Figures, and Boxes

Tables
2.1 Balance of Payments Indicators 49
2.2 Banks’ Exposure to Sensitive Sectors 53
2.3 Asset Quality of Commercial Banks 54
2.4 Absorption of Private Capital Issues by Government Financial
Institutions and Underwriters 56
4.1 Evolving Usage of Monetary Policy Instruments in India 126
4.2 Bank Rate and CRR during 1950–68 128
4.3 Performance of the Monetary Targeting Regime 137
4.4 Monetary–Fiscal Nexus 140
4.5 India’s Balance of Payments—Capital Account 147
4.6 Actuals vis-à-vis Indicative Projections of Monetary Policy 151
4.7 Amalgamation of Commercial Banks: 1954–66 155
4.8 Evolution of Commercial Banking: 1951–69 156
4.9 Growth and Structure of Commercial Banks in India, 1969–90 159
4.10 Distribution of SCB Offices 161
4.11 Distribution of Advances of SCBs by Sectors 162
4.12 Population per Bank Office by Region and State 163
4.13 Major Sources of Industrial Finance 168
4.14 Movements in Monetary Policy Instruments and BPLRs 175
(p.viii) 4.15 Shares of Bank Groups in Banking Aggregates 176
4.16 Profitability Indicators in the Initial Reform Period 180
4.17 Select Productivity Indicators of Commercial Banks in India 181
4.18 Secondary Market Turnover in Financial and Commodities Markets
185
4.19 Average Population per Branch Office 186
4.20 Land-size-wise Distribution of Agricultural Credit Flow from SCBs
188
Page 1 of 4
4.21 Extent of Financial Exclusion amongst Farm Households: Region-

wise 190
6.1 Disparities in Per Capita Sub-national Expenditure: Summary
Statistics 254
6.2 Real Growth of Discretionary Government Expenditure: Key
Components 256
6.3 Trends in Expenditure to GDP Ratio 258
6.4 Trends in Revenue to GDP Ratio 260
6.5 Vertical Transfer of Revenues 261
6.6 Composition of Resource Flows to States 263
6.7 Real Per Capita Income: An Interstate Comparison 265
6.8 Distribution of Resources across Various Income Categories of States
268
6.9 Per Capita Tax Transfers: Select Years 270
6.10 Per Capita Transfer of Grants to the States 271
6.11 Dependent Variable: Log of Per Capita Tax and Grants Transfers to
States 273
7.1 Employment Elasticities in Various Sectors 291
7.2 Production Linkages across Sectors 292
7.3 Imports to Production Ratio for Selected Food Items 294
8.1 Labour Force Participation Rate in Rural Areas 315
8.2 Labour Force Partition Rate in Urban Areas 315
8.3 Worker–Population Ratio in Rural Areas 316
8.4 Worker–Population Ratio in Urban Areas 316
8.5 Worker–Population Ratio in Various Age Groups 318
8.6 Unemployment Rate in Rural Areas 321
8.7 Unemployment Rate in Urban Areas 321
(p.ix) 8.8 Age-group-wise Unemployment Rate (Usual Status Adjusted)
323
8.9 All India Employment Status: Composition of Workers (UPSS) by Sex
and Rural–Urban Residence 323
8.10 Percentage Share and Annual Rate of Growth of Sectors in Value
Added 326
8.11 Rate of Growth of Workers (UPSS) 327
8.12 Structure of Employment in Urban Areas 327
8.13 Industry of Employment for Rural Males 328
8.14 Industry of Employment for Rural Females 328
8.15 Industry of Employment for Urban Males 329
8.16 Industry of Employment for Urban Females 329
8.17 Sector-wise Employment 330
8.18 Size and Distribution of the Organized and Unorganized Sector
Workers by Industry and Status: 2004–5 331
8.19 Poverty Ratios among Unorganized and Organized Workers: 2004–5
332
Page 2 of 4
8.20 Poverty Ratios among Non-agricultural Workers by Nature of

Employment: 2004–5 332
8.21 Rate of Growth of GDP and Employment Elasticity 333
8.22 Labour Productivity and Growth Rate 334
8.23 Annual Trend Rates of Growth of IIP 336
8.24 IIP-based Rates of Growth of Manufacturing Production (Use-based
Classification): 1994–5 to 2004–5 338
8.25 Wage Patterns and Trends for Regular and Casual Workers 339
8.26 Trends in Real Average Daily Earnings 341
8.27 Trends in Urban Wages by Sector 342
Figures
2.1 A Diagrammatic Representation of Financial Repression 31
2.2 Investment and Loans as a Ratio of Bank Assets 46
2.3 Real Interest Rates in India 47
2.4 Savings and Investment Rate 47
2.5 Interest Payments and Developmental Expenditure of the Central
Government 50
(p.x) 2.6 Personal Loans 53
2.7 Shares and Debentures Issues 56
3.1 Expansionary Monetary Policy in IS-LM-PC Framework 86
3.2 NAIRU in the Mainstream Framework 88
3.3 Monetary Policy in the New Keynesian Framework 93
3.4a Keynes’s Downward Sloping MEI vs Kalecki’s Horizontal MEI and
Principle of Increasing Risk 97
3.4b MEI in an Oligopolistic Setup 97
3.5 Stagflationary Monetary Policy in a Heterodox Framework 109
4.1 CRR during 1968–85 133
4.2 Movement in CRR and SLR during 1985–98 141
4.3 Repo and Reverse Repo Rates 143
4.4 The Revised LAF Framework 144
4.5 CRR during 1998–2010 145
4.6 Increasing Trends in Credit and Deposits 160
4.7 Outstanding Credit of SCBs against Agriculture and Small-scale
Industries 162
4.8 Growing Financialization of the Indian Economy: 1955–6 to 1990–1
165
4.9 Growing Influence of Bank Deposits and Rising Savings 166
4.10 Nominal Interest Rates in India 173
4.11 CRAR of Scheduled Commercial Banks 177
4.12 Declining Non-performing Assets of the Indian Banking Sector 177
4.13 Banking Indicators: Credit, Deposits, and Investments 178
4.14 Credit to Agriculture and SSI Sector 187
5.1 Money Supply Endogeneity and Horizontal LM Curve 221
Page 3 of 4
5.2 Movement of Prime Lending Rate Bank/Repo Rate in India: 1993–4 to

2008–9 223
6.1a Aggregate Government Expenditure and Sub-national Income: A
Comparison 255
(p.xi) 6.1b Revenue Expenditure and Sub-national Income: A
Comparison 255
6.2 Tax Shares, Grants, and Total Transfers 262
6.3 Relative Income Divergence from High-income States 266
6.4 Real Per Capita Income: 1980–1 to 2007–8 266
6.5 Growth Rate versus Initial Per Capita State Income 267
7.1 Average Annual Growth Rates across Sectors 282
7.2 Sectoral Shares in GDP 283
7.3 Sectoral Shares in Employment 283
8.1 ASI Estimates of Registered Manufacturing Employment 336
8.2 Employment in Organized Sector Manufacturing 337
8.3 Value Added per Worker at Constant 1999–2000 Prices 343
8.4 Ratio of Wages to Value Added in Organized Sector Manufacturing
344
Boxes
4.1 Monetary Policy Analysis during the 1970s: The Debate between S.B.
Gupta and Others 132
4.2 Market Stabilization Scheme 148
4.3 Recommendations of Narasimham Committee Reports I and II 172
4.4 Evolution of Lending Rate Structure in India 174
8.1 Measures of Employment and Unemployment 304
8.2 Different Types of Employment 305
(p.xii)
Page 4 of 4
Abbreviations

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
(p.xiii) Abbreviations
AC
Average Cost
AFC
Average Fixed Cost
AFS
Available for Sale
ARF
Asset Reconstruction Fund
ASI
Annual Survey of Industries
AVC
Average Variable Cost
BC
Business Correspondent
BF
Business Facilitator
BOP
Balance of Payment
BPLR
Benchmark Prime Lending Rate
BSE
Bombay Stock Exchange
CDS
Current Daily Status
CRAR
Capital to Risk-weighted Assets Ratio
CRR
Cash Reserve Ratio
Page 1 of 4
Abbreviations
CRS
Constant Returns to Scale
CSP
Customer Service Points
CWS
Current Weekly Status
DCRF
Debt Consolidation and Relief Facility
DGET
Director General of Employment and Training
DRI
Differential Rate of Interest
ECB
External Commercial Borrowing
EFF
Extended Fund Facility
EME
Emerging Market Economy
FAQ
Frequently Asked Question
(p.xiv) FDI
Foreign Direct Investment
FII
Foreign Institutional Investor
FRBM
Fiscal Responsibility and Budget Management
FRL
Fiscal Responsibility Legislation
FYP
Five Year Plan
GAAP
Generally Accepted Accounting Principles
GDP
Gross Domestic Product
GNP
Gross National Product
HFT
Held for Trading
HTM
Held to Maturity
IDBI
Industrial Development Bank of India
IMF
International Monetary Fund
Page 2 of 4
Abbreviations
IRS
Increasing Returns to Scale
IS/MP
Investment–Savings/Monetary–Policy
LAF
Liquidity Adjustment Facility
LFPR
Labour Force Participation Rate
LHS
Left Hand Side
LIBOR
London Interbank Offered Rate
MEI
Marginal Efficiency of Investment
MGNREGA
Mahatma Gandhi National Rural Employment Guarantee Act
MGNREGS
Mahatma Gandhi National Rural Employment Guarantee Scheme
MSF
Marginal Standing Facility
MSS
Market Stabilization Scheme
NBFC
Non-banking Financial Company
NCC
National Credit Council
NCEUS
National Commission for Enterprises in the Unorganized Sector
NDTL
Net Demand and Time Liabilities
NKPC
New Keynesian Phillips Curve
NPA
Non-performing Assets
NRI
Non-resident Indians
NRU
Natural Rate of Unemployment
NSS
National Sample Survey
NSSO
National Sample Survey Office
OMO
Open Market Operation
Page 3 of 4
Abbreviations
PLR
Prime Lending Rate
PS
Principal Status
(p.xv) RBI
Reserve Bank of India
RHS
Right Hand Side
RRB
Regional Rural Bank
SAM
Social Accounting Matrix
SBI
State Bank of India
SCB
Scheduled Commercial Bank
SIDBI
Small Industrial Development Bank of India
SLR
Statutory Liquidity Ratio
SNCL
Second National Labour Commission
SRPC
Short Run Phillips Curve
SS
Subsidiary Status
TFC
Total Fixed Costs
TFC
Twelfth Finance Commission
UPS
Usual Principal Status
UPSS
Usual Principal and Subsidiary Status
UTI
Unit Trust of India
WPR
Worker–Population Ratio (p.xvi)
Page 4 of 4
Preface

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
(p.xvii) Preface
Prabhat Patnaik
A word about the nature of the present volume is in order. It is not meant to be a
survey of research undertaken in India on the macroeconomic issues covered in
its various chapters; nor is it a general literature survey on these issues. It is a
review of the issues themselves as seen by the various experts who have
contributed to this volume, who were given complete freedom to express their
own perceptions. The hope is that our intended readers, among whom we mainly
count teachers and students of economics (MA, MPhil, and PhD) in Indian
universities, will find such a review of issues useful. Even when they do not
agree with the points of view articulated here, they would nonetheless, we hope,
find this volume useful for organizing their own thoughts. Our objective, in
short, is to provide material that would stimulate thinking and discussion on
these important macroeconomic issues.
The chapters in this volume are diverse not just in their coverage but also in
their scope. Some are primarily theoretical while others are primarily empirical.
But all of them are motivated by a common desire, namely to understand the
macroeconomic reality of India in the period since the introduction of ‘reforms’.
Since this subject has of late been intensely debated in the public domain as
well, this volume, though meant for a restricted academic audience, should also
be of use in furthering this public debate.
Prabhat Patnaik (p.xviii)
Page 1 of 1
Open Economy Macroeconomics and the Indian Economy

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
Open Economy Macroeconomics and the

Indian Economy
Prabhat Patnaik
DOI:10.1093/acprof:oso/9780199458950.003.0001
Abstract and Keywords

Open economy macroeconomics has been largely concerned with (a) extending
standard Keynesian macroeconomics to problems relating to the current account
of the balance of payments and (b) showing that in situations where real
effective exchange rate movements are either ineffective for the current balance
or impossible to bring about, the foreign trade multiplier rather than the
Keynesian multiplier becomes the key determinant of the level of activity. The
autonomy of international capital flows has scarcely figured much in the
theoretical literature. The Mundell–Fleming model, which brought in
international capital flows, made them exclusively dependent upon interest rate
differentials, and therefore did not explore the implications of the autonomy of
such flows. But such autonomy is of great importance for economies like India,
which makes the level of activity crucially dependent upon the whims and
caprices of international speculators. The chapter is concerned with exploring
these issues.
Keywords: real effective exchange rate, foreign trade multiplier, Mundell–Fleming model, debt-
financed recession, foreign exchange reserves
John Maynard Keynes had advocated State intervention in demand management

in capitalist economies to push them close to full employment since ‘the world
will not much longer tolerate the unemployment which, apart from brief
intervals of excitement, is associated—and, in my opinion, inevitably associated
—with present-day capitalistic individualism’ (Keynes 1949: 381). In a closed
economy, there were no obvious constraints to such a State-effected denouement
Page 1 of 23
other than capitalists’ need for assertion of class power, to which Kalecki had
drawn attention in a seminal article (Kalecki 1943) and which arose from their
concern that the ‘workers would get out of hand’ if State intervention kept the
economy close to full employment. However, in an open economy, matters were
different. If at full employment, achieved through State intervention in demand
management, the economy experienced a current account deficit that exceeded
the availability of external finance, how would it sustain full employment?
For a while this problem was not taken as seriously as it should have been.
Tinbergen had shown that if an economy had n objectives and m ≥ n policy
instruments, then it could achieve these objectives; accordingly, it was generally
supposed that both objectives, namely full employment and balance of payments
(BoP) equilibrium could be achieved if, in addition to fiscal and monetary policy,
the economy could also use exchange rate policy. The economy could be pegged
(p.4) at full employment, and any unsustainable current account deficit arising
at that level of activity could be overcome through exchange rate depreciation.
The Bretton Woods system, of which Keynes and Harry Whyte were the two main
architects, provided for exchange rate depreciations in the cases of persistent
BoP problems. Keynes had wanted surplus economies too to share the burden of
adjustment in such cases, and had visualized an International Clearing Union for
this purpose. However, this could not be put to effect, and the entire burden of
adjustment when a country faced a BoP problem fell upon that country. Even so,
it was felt that since such exchange rate depreciation carried out with the
International Monetary Fund’s (IMF) concurrence would invite no retaliation, its
availability as a policy instrument would help economies to achieve both full
employment and BoP equilibrium.1
Foreign Trade Multiplier

There was, however, a problem with this position. If the economy wished to
overcome a current account deficit at full employment through exchange rate
depreciation, then, assuming that such a depreciation would switch world
demand, including its own, towards its commodities, its domestic absorption
needed to be reduced. Such a reduction could occur (if we ignore the ‘real
balance effect’ which in any case is questionable2) through the ‘forced savings’
generated by what Keynes had called a ‘profit inflation’, that is, through a rise in
prices at given money wages, and hence a rise in profit margins owing to the
creation of excess demand at full employment. However, what would happen if
the workers were unwilling to accept reduction in real wages? It still would not
matter because government expenditure could be reduced to make larger
exports (or larger import replacement) possible. Putting it differently, if forced
savings were not possible, increased government savings could be effected; this
would reduce domestic absorption so that even with full employment being
maintained, BoP equilibrium could be achieved.
Page 2 of 23
The problem, however, assumed an entirely different magnitude once imported

inputs were introduced. An exchange rate depreciation necessarily entailed an
adverse terms of trade movement against the country undertaking it. It meant,
irrespective of the level of output, an increase in the relative share in that output
of those from whom inputs (p.5) were imported into the country in question.
And, if the country was necessarily dependent upon such inputs that it could
neither substitute through domestic production nor do without, the increase in
the relative share in total output of the foreign suppliers of such inputs would
necessarily entail a reduction in the relative share of either the workers or the
capitalists of the economy in question. And, if the latter two classes were
unwilling to accept any decline in their relative shares, no real effective
exchange rate depreciation could take place at all; that is, any nominal exchange
rate depreciation would be accompanied by an equivalent price rise that would
ensure that it entailed no real effective exchange rate depreciation at all. Any
real effective exchange rate depreciation thus was ruled out, irrespective of the
level of capacity utilization, if neither the capitalists nor the workers were
willing to accept a reduction in their relative shares.
This argument put forward by Nicholas Kaldor (1978a) can be explained as

follows. Consider a country producing a manufactured good, into whose
production an imported raw material enters along with domestically supplied
labour as current inputs. (The argument is unaffected if we have more complex
patterns of input use.) Suppose the world price (in US$) of the imported input is
p′ per unit; the price of dollars in terms of domestic currency pf; the wage rate in
terms of domestic currency w; the mark-up margin is ; the amount of imported
input used per unit of final good is m; and the labour coefficient is l. Under these
assumptions, the final good price, assuming prime-cost-plus pricing which
typically characterizes manufactured goods, is:
from which we get
A real effective exchange rate depreciation means an increase in pf/p, which is

possible, for given p′ and m, only if either w.l/p or can be reduced, that is, if the
relative share either of wages or of profits in total output can be reduced. If this
is not possible, a nominal exchange rate depreciation will be accompanied by an
equivalent increase in the domestic price level, and hence not cause any real
effective exchange (p.6) rate depreciation, irrespective of the level of capacity
utilization in the economy.3
In such a case, the best that State intervention can do is to push the economy to
the maximal level of capacity utilization, and hence of output, compatible with
BoP equilibrium, that is, at which the current account deficit equals the external
Page 3 of 23
finance available; it cannot raise output beyond this level without causing an
unsustainable current account deficit. The real effective exchange rate being
given, the level of exports would depend upon the state of the world economy
(which would determine the world demand for the country’s goods), and hence
be given in any period. Likewise, the import propensity will also be given. The
maximal output to which State intervention in such a case can push the economy
is determined by the foreign trade multiplier. Assuming for simplicity zero net
availability of external finance for covering a current account deficit, denoting
exports in foreign currency by X, and the import propensity (imports in domestic
currency divided by output in domestic currency) by μ (which is different from
m, the amount of imported input per unit of output), we have X.pf = O.p.μ, or
X.pf /p = O.μ. The output O is simply determined by X.pf/p.μ, each of which,
namely X, pf/p, and μ, is given.
Kaldor used this idea for an understanding of the world economy (1978a,
1978b). He argued that since the output in any period in the ‘manufacturing
sector’ of the world, characterized by mark-up pricing and consisting mainly of
the advanced capitalist countries, is constrained by the foreign trade multiplier,
the maximal rate of growth of these economies, which would be the actual rate
of growth in the event of this constraint being binding in every period (which he
assumed to be the case), is determined by the rate of growth of their exports to
the primary-commodity-supplying underdeveloped economies. This rate of
growth of their exports, however, depends upon the rate of growth of incomes in
these primary-commodity-producing underdeveloped countries. Hence, the rate
of growth of the advanced capitalist countries is ultimately tethered to the rate
of growth of the underdeveloped countries. There is, in other words, a kind of
international harmony at work between the different segments of the world
economy, which arises from the fact that the growth rate of the advanced
segment is linked to the growth rate of the backward segment.
However, there is a problem with this vision of international harmony. It ignores

the possibility of advanced countries, that is, the (p.7) manufacturing segment,
growing at a rate higher than warranted by the rate of growth of their exports to
the primary-commodity-producing underdeveloped economies (he assumes that
trade has to be balanced), by simply appropriating products from the latter
gratis through colonial-style ‘drain’. It likewise also ignores the possibility that,
even when there is no appropriation gratis from underdeveloped countries and
exports have to be made from advanced countries to pay for their imports, the
growth of these exports may be completely unrelated to the growth of the
incomes of the underdeveloped countries. Such exports could be
deindustrializing exports that displace producers in these countries and cause
unemployment, as happened also during the colonial period. The drain of
surplus from underdeveloped countries, that is, the free appropriation of their
goods (required as inputs in the advanced segment) as well as the thrusting of
‘de-industrializing’ exports upon such countries entail the imposition of ‘demand
Page 4 of 23
deflation’ upon them (Patnaik 1999), whereby a part of the goods which were
being domestically used in these countries are snatched away from them to meet
the needs of the advanced countries by reducing their domestic absorption from
a given output of such goods. Instead of a larger output of such goods being
produced in underdeveloped countries, as Kaldor believed to be necessary, there
is a larger diversion out of a given output towards meeting the needs of the
advanced countries.
But while Kaldor’s specific use of it in the international context as a description

not of what ought to happen but of what actually happens may be questionable,
the idea of the foreign trade multiplier is an extremely pertinent one; and as I
shall argue later, it is particularly useful in the context of the present-day Indian
economy. However, to see its relevance, we must first remember that the
constraint on an exchange rate depreciation may arise not necessarily for the
reasons mentioned earlier, namely the fact that both workers and capitalists
prevent any reduction in their share in total output. It may arise even when the
workers (using the term in a more general sense than simply the manufacturing
or organized sector workers) lack the bargaining strength to prevent a fall in
their relative share, but the government does not wish, for political reasons, to
alienate them by imposing upon them an inflationary squeeze on real wages.
There may, in other words, be a political inflationary barrier (Patnaik 1972)
which may prevent exchange rate depreciation, as is perhaps the case in India at
present.
(p.8) When output is determined by the foreign trade multiplier, not necessarily
spontaneously4 but in the sense that State intervention in demand management
always ensures that it cannot fall below that level, the only way to raise output is
through lowering the import propensity (or raising exports) by more direct
means (since exchange rate depreciation is ruled out). Raising the overall
savings propensity in such a situation, or what is equivalent, curtailing the fiscal
deficit, would result only in a lowering of output below what the foreign trade
multiplier would permit. To put it differently, given the private savings
propensity and the level of private investment (autonomously determined), an
economy where export (and the amount of external finance available) as well as
the import propensity are given and cannot be altered through exchange rate
depreciation, the size of the fiscal deficit gets endogenously determined for a
government wanting to maximize employment and output, subject to the BoP
being in equilibrium.
To see this, let us take the two relations,

, and ,
where subscript w denotes measurement in wage units, F denotes the foreign
capital availability expressed, like exports, in foreign exchange, Y denotes
income, and the other terms have the same meanings as before. These two
Page 5 of 23
relations between them imply that for given Iw, X, F, and , the fiscal deficit (Gw
− Tw) gets endogenously determined, since pf /w becomes a constant (for the
same reason that the real effective exchange rate becomes a constant).
Capital Flows
Since the level of F enters into the determination of income, it becomes
important to examine the factors affecting F, especially in a ‘globalized world’
where capital has become internationally mobile. The Mundell–Fleming model
was among the first to examine the implications of capital mobility for the
macroeconomic behaviour of the economy and hence for government policy. And
its conclusions are well-known, namely that with free capital mobility monetary
policy ceases to be relevant in a world of fixed exchange rates, while fiscal policy
alone can affect employment and output; and fiscal policy ceases to be relevant
in a world of flexible exchange rates where monetary policy alone can affect
employment and output. Their argument can be stated simply as follows.
(p.9) The international mobility of capital implies that each country has to offer
the same interest rate as the others, for otherwise it would witness continuous
capital outflows or inflows and cannot settle down at equilibrium. (The Mundell–
Fleming model assumed static expectations with regard to the exchange rate,
and abstracted from country-specific risks.) Now, a subset of the following
equations must hold in single-period equilibrium, where the money wage rate is
given.
(1)
which is the internationally prevailing interest rate.

(2)
where N(.) represents net exports.

(3)
which is a standard Keynesian description of money market equilibrium.

(4)
(5)
(6)
Since there are only five unknowns—i, Y, pf, Ms, and G—we can have only five of
these equations holding in equilibrium.5 If pf = pf*, that is, we have a regime of
fixed exchange rates, then Ms = Ms* cannot hold, that is, money supply becomes
Page 6 of 23
endogenous. With the interest rate fixed by what prevails internationally, and
money supply being endogenous, monetary policy becomes irrelevant as an
instrument of policy. On the other hand, if equation 5 does not hold, then
equation 4 does, and monetary policy acquires relevance, since money supply
becomes exogenous and therefore can be varied to affect income Y. It obviously
affects output and employment since Y gets determined entirely from equations
1 and 3. Government expenditure G (or more generally fiscal policy) in this case,
however, can have no effect on (p.10) income; its variations, as is clear from
equation 2, can only affect pf and hence the size of N(.).
In both the cases considered by Mundell–Fleming, it should be noted that

government expenditure, whether it affected output or not, was exogenous. Only
money supply was exogenous in the case of flexible exchange rates but
endogenous in the case of fixed exchange rates; government expenditure was
exogenous in both cases, whether the exchange rate was fixed or flexible.
The Mundell–Fleming model, however, was flawed because it had a peculiar

property, namely that while money market and goods market equilibrium
conditions were specified, as was an asset market equilibrium condition (in the
form of i = i*), there was no equation for the foreign exchange market
equilibrium. The implicit assumption was that the net capital inflow was always
just sufficient to finance the current account deficit –N(.). Net capital inflow, in
short, was not deemed to be autonomous. The Mundell–Fleming model, for this
reason, is inadequate for examining the behaviour of economies in the era of
globalization, since this era is characterized, above all, by the autonomy of
capital movements.
Now, if we introduce the autonomy of cross-border capital flows and an equation

for the foreign exchange market equilibrium, that is, we have:
(7)
where F* is the net capital inflow that is given (as an autonomous decision),6 we once
again have an over-determined system. This can be overcome either by getting rid of
equation 5, and one of equations 4 or 6, or keeping equation 5 and getting rid of both
equations 4 and 6.
In other words, with autonomous capital flows, neither fiscal nor monetary
policy can have any effect on income, if the exchange rate is fixed (with domestic
absorption being adjusted merely to equilibrate the foreign exchange market
and with no Central Bank intervention in this market through changes in
reserves). If the exchange rate is flexible, then either G or Ms can be fixed
exogenously but not both.
Page 7 of 23
Fiscal Responsibility and Debt-financed Recession

Even the limited leeway that governments can have, according to the earlier
discussion, in the case of flexible exchange rates disappears (p.11) when fiscal
responsibility legislation is enacted, which limits the size of the fiscal deficit to a
certain percentage of the GDP (typically 3 per cent). Global investors wish to
have such legislation (we will discuss this later). Because of this, countries open
to capital flows (other than the US whose currency is usually deemed to be ‘as
good as gold’) are, more or less, forced to enact such legislation in the same way
that they are more or less forced to keep their interest rates aligned to what
prevails internationally. In this case, equation 6 becomes:
(6′)
where t is the tax–GDP ratio and d the fiscal deficit–GDP ratio permitted by fiscal
responsibility legislation. Now, even if we assume a flexible exchange rate regime, the
five variables, i, Y, pf, G, and Ms, get determined by the five equations 1, 2, 3, 6′, and 7.
In other words, even with flexible exchange rates, not only does money supply become
endogenous, so that monetary policy ceases to be of any relevance, but even fiscal
policy, which could make a difference to income and employment, ceases to be of any
relevance. The two variables—the level of income and the exchange rate—simply get
determined from the following two relations:
and
which describe, respectively, the goods market and foreign exchange market
equilibrium conditions.
This very simple economic system which embodies three characteristics, each of
which is considered to be desirable, namely a flexible exchange rate, an
openness to capital flows whose magnitude is autonomously determined, and an
adherence to fiscal responsibility legislation that limits the size of the fiscal
deficit as a percentage of GDP, has a remarkable property. If there is a rise in net
foreign financial inflow, which does not directly raise either C or I or G (as
distinct, say, from foreign direct investment (FDI), which has the effect of raising
I), it causes a reduction in the level of output and employment.
(p.12) The reason is simple. An increase in net financial inflow, since it is

unaccompanied by any increase in imports via greater domestic absorption, will
ceteris paribus raise the country’s exchange rate, that is, lower pf. This will
necessarily make the goods of the country uncompetitive and switch expenditure
away from them, leading to an increase in the size of the current account deficit.
In a situation where no other component of aggregate demand is being
increased, this must mean a reduced level of output and employment. Matters
would be different if the government could enlarge its expenditure to counter
Page 8 of 23
this reduction, but that is ruled out by fiscal responsibility legislation, which
actually makes government expenditure pro-cyclical rather than anti-cyclical.
A Closer Look
The proposition that an increase in net financial inflow in a flexible exchange
rate regime causes a reduction in output and employment is so much against
conventional wisdom, and indeed so counter-intuitive that it deserves a closer
look. Let us consider the obvious arguments that would be raised against it. The
first argument against this proposition would be that even if a rise in net
financial inflows does not directly raise domestic absorption, surely it must do so
indirectly.
Let us consider investment first, which, in accordance with simple Keynesian

theory, depends on the interest rate and the schedule of marginal efficiency of
capital. Since the interest rate remains unchanged (equation 1), there is no
reason for investment to increase via this route. However, what of the possibility
of an outward shift of the marginal efficiency of capital schedule?
Investment, let us remind ourselves, is not assumed to be constrained by any

specific shortages: indeed, in the entire foregoing discussion, ex ante investment
is assumed to be equal to ex post investment. We are talking, therefore, not of a
relaxation of any constraint on investment, but only of a general brightening of
investment outlook. However, the actual investment in any period is the result of
investment decisions taken earlier. Hence, any such brightening can at best
cause larger investment in the future but not in the current period, in which case
a contraction of output through an appreciation of the exchange rate will
necessarily occur, ceteris paribus, in the current period. However, if this occurs,
even the future increase in (p.13) investment will never come about since no
brightening of investment outlook can possibly occur if output is contracting.
The argument that the inflow of external finance will ease the availability of
finance in the economy and thereby shift the consumption and investment
functions outwards, is also not pertinent here since we are not assuming, as yet,
any Central Bank intervention to stabilize the exchange rate which will raise the
amount of reserve money in the economy. (This is done in a later section.)
The other argument which may be advanced is that consumption will get
stimulated via a rise in real wages because of exchange rate appreciation.
According to this argument, exchange rate appreciation lowers the prices of
imported inputs and, consequently, the price of the final good for a given money
wage rate, to a point where output and employment increase despite such
appreciation, that is, there is a mix of both output increase and exchange rate
appreciation.
Page 9 of 23
However, this argument too is far-fetched. A nominal exchange rate appreciation

leads to a real effective exchange rate appreciation, as is assumed in Mundell–
Fleming (and here) only via a distributive shift from foreign suppliers of
imported inputs to domestic capitalists and workers. The net effect on aggregate
consumption of such a shift depends upon a number of factors: the consumption
propensities of the three groups concerned, how their consumption is divided
between domestic and foreign goods, how this division itself is changed by the
exchange rate appreciation, and their relative gains and losses from the
distributive shift. If lower prices of imported inputs boost profit margins and do
not lower the price of the final good at all (we can, in fact, take the price of final
good to be fixed, irrespective of the nominal exchange rate, to give expression to
the Mundell–Fleming assumption that nominal and real effective exchange rate
movements go together), and if the propensity to consume out of profits is small,
there will be no rise in real wages at all, and, possibly, even a reduction, as
opposed to an expansion, of the consumption component of aggregate demand
for domestic output.7 (The issue of how final goods prices respond to exchange
rate movements is discussed in the next section.)
It follows then that an autonomous increase in the net capital inflow in the form
of finance has the effect of reducing output and employment in a regime of
flexible exchange rates (where the Central Bank does not act to stabilize the
exchange rate by holding larger foreign (p.14) exchange reserves), if
government expenditure is constrained by fiscal responsibility legislation.
But that is not all. Since finance that has flown into the economy constitutes
foreigners’ claims on the economy and hence its external debt, we have here a
case of debt-financed recession, that is, a country borrowing from abroad to
finance its own ruin.
The difference in this context between FDI and financial inflows, or between the
inflow of capital in production and the inflow of capital as finance, should be
clear. FDI not only raises the current account deficit in so far as it raises the
imports of equipment needed for the investment project, but also the level of
investment itself (unless it displaces some domestic investment that would have
otherwise occurred). Hence, it does not necessarily have any contractionary
effect on the economy. If, for instance, FDI worth US$ 100 takes place in the
form of US$ 100 of external funds being used to import US$ 100 of foreign
equipment in a project, which does not have the effect of reducing local private
investment, then there is no contractionary effect upon the economy. However,
in the case of financial inflows, an increase in inflows in a world where the
exchange rate is not fixed does have a contractionary effect of causing debt-
financed recession.
Page 10 of 23
A More Comprehensive Discussion

Let us now bring together our discussion of the foreign trade multiplier of the
first section with the subsequent discussion of capital flows with flexible
exchange rates where the foreign trade multiplier played no role.
Based on the above analysis of capital flows, it may be thought that since the
inflow of finance has the effect of contracting the economy, the outflow of
finance should have the opposite effect. It should lead to an enlargement of the
level of output and employment via a depreciation of the currency, a reduction in
the level of the current account deficit, and hence an increase in the level of
aggregate demand. This would of course follow from the simple model above;
but it is not the case. To see why it is not so, we have to bring in an additional
consideration, which is done further in a more comprehensive—but by no means
unrealistic—model.
(p.15) In the previous section we talked of an exchange rate appreciation

causing a domestic recession. Since we had argued earlier that nominal
exchange rate depreciation might not cause a real effective exchange rate
depreciation, the question naturally arises, why should a nominal exchange rate
appreciation cause a real effective exchange rate appreciation at all? The
answer lies in an asymmetry between the two situations: an appreciation and a
depreciation of the exchange rate. This asymmetry arises from the fact that a
reduction in the price of imported inputs owing to a nominal exchange rate
appreciation, does not generally cause a reduction in final goods prices. Rather
it gets absorbed in a larger profit margin, with final goods prices showing a
downward rigidity (a ‘ratchet effect’). But a rise in input prices, beyond a point,
causes final goods prices to rise. This is because there is a floor to the product
wage rate and to the profit margin. In principle, these floors should be
dependent upon the level of capacity utilization; but in what follows we shall
assume for simplicity that they are given in absolute terms (which is more
apposite when we are talking of a ‘political inflationary barrier’); we shall also
assume away productivity changes for the same reason and focus upon a single-
period situation. Relaxing these assumptions will not affect the thrust of the
argument.
It follows from these floors that there is a minimum non-inflationary exchange

rate. The real effective exchange rate can never fall below this minimum, but it
can rise above it. This implies that if we are at this level of the real effective
exchange rate, a nominal exchange rate appreciation will cause a real effective
exchange rate appreciation. However, either a nominal exchange rate
depreciation will not cause a real effective exchange rate depreciation at all (if
workers do not allow a fall in real wages) or it will not occur at all (if the
government does not want inflation for political reasons). In the latter case, the
government has to cut its expenditure and curtail the level of activity in order to
prevent inflation. Moreover, since fiscal responsibility legislation puts only a
Page 11 of 23
ceiling on the fiscal deficit as a percentage of GDP, and not a floor, this is
perfectly possible.
Let us denote the domestic currency price of foreign exchange, corresponding to

this floor level of the real effective exchange rate, by pf′. At this exchange rate
there will be a certain level of exports X′ (given world demand conditions) and a
certain import propensity . (p.16) Assuming for simplicity that C(Y) has the
form c.Y, the maximum level of income, when the floor real effective exchange
rate prevails, can only equal:
since the government will be running the maximum permissible fiscal deficit under the
fiscal responsibility legislation. However, whether this income (let us denote it by Y′)
can be achieved or not depends upon whether the current account deficit at this
income, which will equal , can be financed through the inflow of
external finance.
Let us denote this required external finance by F′. It follows that when F = F′,
the floor real effective exchange rate will prevail and, with the fiscal deficit
being at the maximum permissible level, income will equal Y′. If F > F′, then
income will fall below Y′ because of exchange rate appreciation, and when F <
F′, income will again fall below Y′, but this time because the government will
reduce the fiscal deficit below the maximum permissible level to prevent any
exchange rate depreciation and, hence, to prevent any inflation. In the latter
case, when F < F′, the level of income will be determined by the foreign trade
multiplier (since pf will be pegged at pf′) and will equal . It follows
that for all , income will be determined by the foreign trade multiplier,
and will equal .8 But for all F > F′, income will not increase above
but will actually fall below it. In other words,
represents the maximum income the economy can achieve.
The basic idea underlying the above argument can be stated as follows.
Whenever the capital inflows exceed what is required for meeting the current
(p.17) account deficit at the base exchange rate and base level of the fiscal
deficit, the current account deficit must expand to absorb the capital inflows. If
this cannot be induced through an expansion of government expenditure
because of fiscal responsibility legislation, then, since private investment is
governed by independent considerations which are unaffected by the magnitude
of capital inflow, the current account deficit must expand in some other way; and
that is through larger imports replacing domestic production via an exchange
rate appreciation (what we have called debt-financed recession).9 On the other
hand, whenever capital inflows fall short of the current account deficit at the
base exchange rate and the base level of the fiscal deficit, the current account
deficit must contract; and this occurs through a contraction of aggregate
demand owing to reduced government expenditure. In short, the capital account
Page 12 of 23
of the BoP forces an adjustment of the current account, and not the other way
around as Mundell–Fleming had postulated.
There is a common belief that while net financial outflows are injurious to the
economy, net financial inflows are beneficial, and that the more finance flows in,
the better for the economy. This, as the above analysis shows, is a
misconception. It is true that net financial inflows represent command over
resources, and the more finance flows in, the greater, in principle, is the
command over resources that the economy should be acquiring. However, there
has to be adequate aggregate demand to absorb these resources. Capital inflows
in the form of finance, if they are in excess of what is required for meeting the
current account deficit at the base exchange rate and the base level of domestic
absorption, need to create a demand for themselves. In a situation where the
government cannot make use of these excess resources by expanding its
expenditure, and the private capitalists’ investment, governed by other
considerations, does not get augmented by the sheer fact of excess financial
inflows, such inflows create their own demand by enlarging the current account
deficit through a reduction in output and employment via an exchange rate
appreciation.
Central Bank’s Accumulation of Exchange Reserves

To prevent such a denouement of a debt-financed recession, the Central Bank
typically intervenes, as it did in the case of India. This intervention is to prevent
the exchange rate from appreciating when the inflow of capital exceeds what is
required to finance the ex ante current account deficit, that is, the deficit that
would arise at the base exchange rate and base level of domestic absorption. We
assume that this base level is represented by an exchange rate pegged at the
floor rate, and a level of domestic absorption corresponding to the fiscal deficit
at the legislated ceiling. With such intervention, whenever F > F′, equation 7
becomes:
(7′)
(p.18) where the superscript on F is merely to underscore its autonomy; and equation
5 becomes:
(5′)
Equations 1, 2, 3, 5′, 6′, and 7′ together determine the six variables,

and . It is clear, therefore, that with Central Bank intervention
preventing a currency appreciation beyond the exchange rate that corresponds
to the minimum wage rate and profit margin, the level of income can be
insulated from any contraction below Y′ whenever F* > F′.
Page 13 of 23
On the other hand, when F* < F′, there are two possible ways that pf can be
stabilized at pf′, one is by a running down of foreign exchange reserves by the
Central Bank, and the other by a reduction in government expenditure even
below what fiscal responsibility legislation permits. For reasons to be discussed
shortly, the first option is usually ruled out and the second is exercised, in which
case for F* < F′, the six variables are determined by equations 1, 2, 3, 5′, 7′, and:
(8)
Government expenditure in this latter case is reduced to a level below (t + d)Y,

preventing a currency depreciation. The level of income as a result gets
determined by . At , the maximum level of income that can be
achieved is:
which also equals, by definition, (see note 7); and this is achieved when
the inflow of capital is , where F′ equals the current account deficit
corresponding to this income. If F* < F′, income is lower because of the contraction of
government expenditure to prevent inflation.
Central Bank’s intervention in the foreign exchange market to prevent an
appreciation of the currency thus eliminates the possibility of a debt-financed
recession. However, it has a number of problems associated with it. First, the
inflow of finance, too, like FDI, is motivated by the lure of earning a return; this
would consist of both the rate of return in the usual sense (such as the rates on
financial (p.19) assets), and capital gains on such assets, which must be
sufficiently high to lure finance to come into the economy. However, if a part of
such inflows is held only in the form of foreign exchange reserves by the Central
Bank, which typically earn a minuscule rate (in India the foreign exchange
reserves reportedly earn no more than 1.5 per cent on average), then the
country is ‘borrowing dear to lend cheap’. This is patently unwise and will create
problems for it in the future. In India, the reserves have been built up entirely
from financial inflows rather than any current account surplus. In this situation,
even if we assume an extremely modest interest rate differential of 12 per cent
per annum between the earning of the Reserve Bank of India (RBI) on its foreign
exchange reserves and the earnings of those who brought in the funds, India’s
loss on holding US$ 200 billion of foreign exchange reserves comes annually to
around 1.2 per cent of the GDP. Despite the fact that this amount is not actually
taken out of the country annually, it is a loss nonetheless.
The second problem is that as reserves accumulate, this very fact, by reducing
the risks of holding the host country’s currency, encourages ceteris paribus a
larger inflow of finance and hence contributes to a further accumulation of
reserves. In this way, India had become for a while in the words of a former
Page 14 of 23
Governor of the RBI ‘a favourite parking place for dollars’. This only increases
the total amount of loss on account of the interest differential mentioned above.
It may be thought that holding larger foreign exchange reserves insulates the
country against a possible depreciation of the currency. This is certainly what
the speculators believe, which is why ceteris paribus they tend to bring in more
funds as the country holds larger reserves. However, in fact, since in the event of
inflows during any period not covering the current account deficit any noticeable
running down of reserves can precipitate a capital flight, this insulation is rather
thin; governments are thus forced to appease speculators to prevent them from
taking funds out, even when there are massive reserves. In the Indian case, a
plethora of measures such as raising diesel prices, opening the multi-brand
retail business to multinational corporations (MNCs) like Wal-Mart, and allowing
FDI in the insurance sector have been undertaken to retain investor confidence
and arrest the depreciation of the rupee despite the existence of substantial
foreign exchange reserves. This clearly shows that the sheer size of the reserves
is not sufficient to insulate a currency from depreciating. Likewise, in the event
(p.20) of an outflow of funds from the economy for independent reasons,
governments would be loath to run down reserves to finance such an outflow, for
that may raise the outflow to a torrent.
The basic point here is of asymmetry: while finance comes into an

underdeveloped economy in moderate magnitudes if at all, its outflow can be
sudden and massive.10 One comes across numerous instances of precipitous
outflows from underdeveloped countries, but scarcely one of precipitous inflows.
Such addition to reserves has been criticized on the grounds that it artificially
keeps down the currency value and hence constitutes an unfair advantage for
the country doing so. The former President of the USA, George W. Bush, Jr, for
instance, systematically criticized Asian economies such as India for keeping
their currencies undervalued. The question that arises here is: undervalued
relative to what level? The answer of the Bush administration, as of many others,
would be: relative to the level that clears the foreign exchange market. In short,
there is an ‘equilibrium exchange rate’ at which the demand for foreign
exchange equals its supply and if the exchange rate is below that level, the
currency is undervalued.
The problem with this argument, however, is that the demand for and the supply
of foreign exchange also depend upon income and not just on its price. To say
that the exchange rate must be one that clears the foreign exchange market is to
assume implicitly that income is fixed at its full employment level. Since this is
not the case, no case can be made out for letting the exchange rate move freely
to clear the foreign exchange market. And if it is still argued that the exchange
rate should be allowed to move freely without Central Bank intervention, then
that amounts to endorsing ‘debt-financed recession’ and wilfully making the
Page 15 of 23
level of output and employment, and hence the livelihood of millions of people,
dependent upon the caprices of a few speculators.
It follows from the earlier discussion that inflow of capital is not, contrary to
common belief, necessarily beneficial for the economy. In the absence of Central
Bank’s intervention, it may result in an appreciation of the exchange rate and a
contraction in output and employment. With Central Bank’s intervention, while
such contraction is avoided, a pile-up of reserves occurs which entails a
significant cost to the economy. And, in any case, the holding of such reserves
does not per se stimulate the level of activity. In the above case, output cannot
(p.21) increase beyond Y′, which corresponds to the inflow F′; but it also
cannot exceed Y′ even if the inflow exceeds F′.
This last point may be contested. It may be thought that since the accumulation
of reserves with the Central Bank creates high-powered money, this fact should
boost credit availability in the economy and hence should stimulate activity
through that route. However, easier credit availability per se does not
necessarily stimulate activity. True, it may increase expenditures originating
from sectors that were credit-constrained to start with, such as small businesses.
However, larger reserves with banks do not necessarily entail larger credit to
such sectors. In India, for instance, during the period when foreign exchange
reserves were accumulating with the RBI and hence larger amounts of reserve
money were flowing into the coffers of the banking system, banks preferred to
hold government securities instead of giving larger loans to hitherto neglected
sectors. The RBI, therefore, ran down its stocks of government securities to
meet the demand of the banks and to put income-earning assets into their
portfolios. This was of course justified as a ‘sterilization’ operation, but the RBI’s
putting government securities into banks’ portfolios was more to mop up idle
bank reserves than to cut back on credit disbursements. In other words, what
the RBI did by way of sterilization was exactly what the banks wanted it to do
anyway.
Of course, to say this is not to suggest that larger availability of reserve money,
consequent upon the RBI’s adding to its foreign exchange reserves, would have
no impact whatsoever on output and employment on its own; credit availability
does stimulate expenditure, via easier consumer credit, better terms for car
loans, and for installment-based purchases of durable goods. However, easier
credit availability operates to great effect when there are in any case euphoric
expectations feeding into a boom, that is, when the marginal efficiency of capital
schedules are moving outwards, when financial asset prices are on an upward
trend, and so on. Easier credit availability sustains such expectations and
contributes to the boom. It neither generates such expectations on its own, nor
can contribute significantly to the level of activity in the absence of such
euphoria (for example, with given marginal efficiency of capital schedules).
India’s high growth phase therefore was not caused by the inflow of finance
Page 16 of 23
(held partly as reserves by the RBI). Both the inflow and the high growth were
caused by other factors.
(p.22) The main factor was the boom in the advanced capitalist world based on
the housing bubble in the USA which boosted India’s exports, especially of
software and IT-related services. This gave a boost to the domestic growth rate;
in addition, it was a major factor attracting external finance into the economy.
Of course what causes external finance to flow into an economy is not clear. It is
too simpliste to say that a large current account deficit per se puts off financiers
and reduces financial inflows by engendering fears of an exchange rate
depreciation, because what happens to the exchange rate itself depends upon
the size of inflows and not just on the current deficit. It is, therefore, likely that
the inflow is related to some other factors. It is commonly believed that the
growth rate itself tends to draw capital since it marks the country out as a
promising destination. However, the growth rate in a ‘liberalized’ economy itself
depends upon the growth rate of exports, so that if some particular factor is to
be picked out from this mesh of interrelated factors, then the rate of export
growth is perhaps the best candidate.
The bubble-based world capitalist boom that boosted India’s exports, therefore,
stimulated the growth rate of the economy as well as played a role in attracting
external finance that, by making credit availability easier, sustained this boom
and also added to it by promoting some local bubbles. However, what is striking
is that the Indian economy has now entered into a phase that is the very anti-
thesis of this.
Current Travails of the Indian Economy on the External Front

The change in the fortunes of the Indian economy has come about, above all,
because of the recession in the advanced capitalist world in the wake of the
collapse of the housing bubble in the USA; and the Eurozone crisis, itself a fall-
out of this collapse, has aggravated the problem. This global slowdown has
affected India’s export growth and caused a substantial widening of the current
account deficit in 2012, despite a slowing down of the overall GDP growth rate.
The inflow of funds has simply not been adequate to finance this deficit, because
of which there has been a pressure on the rupee to move down. It has done so
and, as a result, the rate of inflation, already high by the country’s past
standards, has got further aggravated because prices (p.23) of petroleum
products rise whenever the imported oil prices rise in domestic currency.
All this is well known. What needs discussion, however, is the policy response to
it. It has focused primarily on attracting external finance to cover the current
account deficit and, possibly, to engender a local bubble on the stock market
that may stimulate growth. However, the growth implications of stock-market
bubbles are not particularly remarkable, and the proposal to cut back
Page 17 of 23
government expenditures to rein in the fiscal deficit, while it may be attractive

to global finance, is likely to be a growth-dampener.
The matter can be explicated in terms of the above model as follows. In the high-
growth phase of the Indian economy, the external finance inflow exceeded F′,
and debt-financed recession was prevented by the RBI’s adding to foreign
exchange reserves instead of letting the rupee appreciate. This, by making
credit availability easier, also sustained the boom stimulated by the large
upswing in the world capitalist economy. However, now the economy is entering
a situation where the export growth has dwindled and the inflow of finance
would be insufficient to meet the current account deficit. Hence, if the economy
wishes to avoid unacceptable levels of inflation, it cannot escape the constraint
of the foreign trade multiplier. The foreign trade multiplier gives only the
maximal profile of output. A curtailment of the fiscal deficit that is aimed not
merely at achieving the output profile dictated by the foreign trade multiplier
but at other independent stringent targets, might lower the output profile even
below what the foreign trade multiplier would have warranted.11
In any case, what is likely in the coming months is a combination of some

inflation and a recession. Such a denouement is particularly likely because, as
argued here, the inflow of finance is also probably linked to the rate of growth of
exports, which is dependent upon the state of the world capitalist economy that
shows no signs of improvement.
In the discussion on India’s growth, there has been a tendency to underplay the
extent to which the state of the capitalist world economy contributed to the
country’s high growth. Liberalization linked the fortunes of the Indian economy
to what was happening in the capitalist world as a whole, and as the latter has
sunk into a recession, the Indian growth experience too has suffered, and is
likely to keep doing so as long as the world economy atrophies. Indian growth is
not so much the outcome of Indian entrepreneur’s ‘animal spirits’, that is, a (p.
24) purely internal affair of the economy; for if that was the case, then the
sudden upsurge in ‘animal spirits’ supposedly underlying the phase of high
growth would be hard to explain. It has been crucially dependent upon the
conditions prevailing in the world capitalist economy.
When the economy is governed by the foreign trade multiplier, and when
exchange rate depreciation is to be shunned both because it aggravates inflation
and reduces financial inflows by generating expectations of further depreciation,
output can be enlarged in any period and growth stimulated over time by direct
measures to limit imports, and other complementary measures that bring down
the economy’s import propensity. If the world economy cannot sustain India’s
growth performance, then India must delink itself from the world economy to a
certain extent by expanding its own domestic market, directly at the expense of
imports, and indirectly by an alternative growth strategy that emphasizes
Page 18 of 23
greater income and wealth equality (which lowers import propensity) and an
expansion of peasant agriculture (which boosts the domestic market).
Here too there is an intermeshing of factors since peasant agriculture-based

growth itself is more egalitarian than growth that bypasses peasant agriculture;
it also entails, with appropriate policy interventions, a lower import propensity.
What is true is that any attempt to usher in such an alternative strategy may
lower financial inflows even further; but if the economy can prepare itself to
delink from the world economy to the extent required by the circumstances, this
should not be a cause of worry. The real hurdle to such an alternative strategy is
likely to arise in the realm of the political.
Finance Capital and Globalization

The fact of capitalists’ need to assert class power, standing in the way of
achieving full employment through State intervention in demand management,
was mentioned earlier. However, capitalists’ fear of workers’ getting out of hand
was not confined only to the issues of wage demands or maintenance of
discipline, in the event of a disappearance of the reserve army of labour. It had
another component as well, namely that if the need for State intervention to
rectify the defects of the system was accepted, it undermined the social
legitimacy of the capitalist class. The question, it was feared, would inevitably be
raised: if we need the State to overcome the limitations of the (p.25) system,
why does not the State run the system itself? Why do we need a class of
capitalists at all? And the segment among capitalists that is most vulnerable to
the charge of being socially unnecessary was the financiers or the rentiers,
whom Keynes himself had characterized as ‘functionless investors’.
The opposition of finance capital to State intervention in demand management,

and indeed to any deviation from the principle of ‘sound finance’ (which believed
that budgets should be balanced) has therefore been the strongest. Even as
early as 1929, when Keynes had suggested through Lloyd George a programme
of public works financed by government borrowing to overcome unemployment
in Britain, the city of London, which was its financial centre, had opposed it
(Robinson 1962). This opposition of finance capital to Keynesian demand
management, and to any State activism in general, except that which aims at
boosting ‘investor confidence’, that is, which aims to appease financial interests,
has always been present, including even during the period when Keynesianism
was in the ascendancy in policymaking. Its opposition, however, was contained
during the period of this ascendancy.
With globalization of finance, things have changed: the capacity of the nation
state to resist the pressure of financial interests has been undermined, which is
why Keynesianism has been on the retreat and ‘sound finance’ back in vogue
(with the only difference that it now allows not nil, but 3 per cent of GDP, as
fiscal deficit). Keynes himself saw the danger arising from the process of
Page 19 of 23
globalization of finance to the agenda of intervention by the nation state in

making the capitalist economy work better. As early as in 1933, he had said, ‘and
above all, let finance be primarily national’ (Keynes 1933). However, the
accumulation of vast amounts of finance, first in the Eurodollar market from
persistent US current deficits, under the Bretton Woods system where the dollar
was officially sanctified to be ‘as good as gold’, and later through the amassing
of ‘petro-dollars’ in metropolitan banks after the oil-shocks, brought about a
situation where nation states had little option but to lift cross-border capital
controls. And this was the beginning of the globalization of finance.
Globalized finance is opposed to any State activism except in its own interests. It
is opposed to any imposition of controls over capital or even trade flows. It is
opposed to the delinking of the economy from the regime of unfettered global
movements of goods and services, and (p.26) of capital. This is the reason why
the political opposition to the pursuit of economic policies that release an
economy from the shackles of the foreign trade multiplier, even in the midst of a
world recession whose end is not in sight, will face severe opposition from
globalized capital, especially finance capital, which is no longer just a foreign
entity but of which domestic capital too forms an integral part.
References
Bibliography references:
Ghosh, J. and C.P. Chandrasekhar. 2001. Crisis as Conquest. Delhi: Orient

Blackswan.
Kaldor, N. 1978a. ‘What is Wrong with Economic Theory?’ in N. Kaldor (ed.),

Further Essays on Economic Theory, pp. 202–13. London: Duckworth Publishers.
———. 1978b. ‘Inflation and Recession in the World Economy’, in N. Kaldor (ed.),
Further Essays on Economic Theory, pp. 214–30. London: Duckworth Publishers.
Kalecki, M. 1943. ‘Political Aspects of Full Employment’, reprinted in M. Kalecki

(ed.), Selected Essays on the Dynamics of the Capitalist Economy, pp. 138–45.
Cambridge: Cambridge University Press, 1971.
(p.28) Keynes, J.M. 1933. ‘National Self-Sufficiency’, The Yale Review, 22(4):
755–69.
———. 1949. The General Theory of Employment, Interest and Money. London:
Macmillan.
Patnaik, P. 1972. ‘Disproportionality Crisis and Cyclical Growth’, Economic and

Political Weekly, 7(5–7): 329–36.
Page 20 of 23
———. 2008. The Value of Money. Delhi: Tulika Books; also published by
Columbia University Press, New York, 2009.
Patnaik, U. 1999. ‘Export-Oriented Agriculture and Food Security in Developing

Countries and in India’, originally published in Economic and Political Weekly,
31(35–37) in 1996; revised and reprinted in U. Patnaik (ed.), The Long
Transition, pp. 351–416. New Delhi: Tulika Books.
Rakshit, M. 2002. The East Asian Currency Crisis. New Delhi: Oxford University
Press.
Robinson, J. 1962. Economic Philosophy. London: C.A. Watts.
Notes:
(*) I wish to thank Amitava Bose for commenting on an earlier draft of this
chapter.
(1.) Full employment, it should be noted, did not mean that everyone willing to
work at the going money wage would find employment. It only meant an absence
of unemployment caused by an inadequacy of aggregate demand. It was, for
instance, perfectly compatible with unemployment, provided the economy was
operating at ‘full capacity’.
(2.) For a discussion of the questionability of the ‘real balance effect’, see
Patnaik (2008).
(3.) It may be thought that if the imported-input coefficients differ across

sectors, nominal exchange rate depreciation would affect input costs of different
commodities differently, and hence alter relative prices, in which case we can no
longer talk legitimately of an aggregate output. However, if domestically
produced commodities enter either as current inputs or through the wage
basket (as ‘labour-feeding inputs’) into each other’s outputs, then relative prices
remain unchanged, with mark-up pricing, for any given set of labour coefficients
and real wage vector. The augmented input–output matrix, consisting of current
inputs and ‘labour-feeding inputs’ (that is, goods entering into each other’s
production via the wage basket) is in this case indecomposable. Let there be m
imported inputs and n domestically produced commodities. Denoting the (m × n)
imported-input coefficient matrix by M, the import price (row) vector in foreign
currency by p′, the price of foreign exchange by pf, the (n × n) augmented
current input-cum-labour-feeding-input matrix by D, and the final price (row)
vector by p, we have
or
Page 21 of 23
It follows from this that a rise in pf will raise all prices equi-proportionately for given
input coefficients, labour coefficients, and real wage vector. In other words, there will
be no change in relative prices. It should be noted that the indecomposability of the D
matrix is a sufficient, not a necessary, condition.
(4.) Spontaneous determination of output by the foreign trade multiplier occurs
only when the government maintains a balanced budget and the private sector
merely invests its savings.
(5.) In this model, needless to say, nominal and real effective exchange rate
movements are assumed to go together, that is, the output is not determined by
the foreign trade multiplier. We also make this assumption in this section and in
the subsequent two sections.
(6.) Net capital inflow, of course, is the outcome of a number of different

decisions relating to the capital account. Assuming autonomy of net capital
inflow amounts to assuming that these decisions are themselves autonomous
and unrelated to one another. We are also assuming throughout this chapter, in
accordance with the Indian situation, that there are no foreign currency holdings
in the economy by any agent other than the Central Bank. (A relaxation of this
assumption will not necessarily alter the conclusions of the argument.)
(7.) Such a reduction will occur in this case if the foreign input suppliers’
propensity to consume domestic goods is higher than that of the domestic
capitalists.
(8.) In the borderline case when F = F′, the income Y′ determined by the foreign
trade multiplier will exactly equal the income determined by the
generalized Keynesian multiplier , by the
very definition of F′.
(9.) Since current account deficit equals (I − S) + (G − T), if the deficit cannot
be increased through an increase in (G − T) or in I, it must increase through a
fall in S, which occurs through a fall in Y, brought about via an exchange rate
appreciation.
(10.) This sudden outflow of finance is what precipitates a financial crisis. For a
discussion of the East Asian crisis in this context, see Ghosh and Chandrasekhar
(2001) and Rakshit (2002).
(11.) There is a formal difference between the above model and the actuality of
the Indian situation. In the model, the maximal fiscal deficit to GDP ratio is
assumed to correspond to what the fiscal responsibility legislation dictates.
However, in India this maximal ratio has always exceeded what is legislated.
This, however, makes no difference to the above argument since all that the
Page 22 of 23
argument requires is that there should be such a maximal ratio in the

government’s perception.
Page 23 of 23
Financial Liberalization

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
A Survey with Emphasis on the Indian Case
Vineet Kohli
DOI:10.1093/acprof:oso/9780199458950.003.0002

This chapter places the debate on financial liberalization within the specific
context of the Indian economy. Financial liberalization would fail to elicit a
positive investment response when money supply is endogenous. Also, the
reliance on foreign investment would make sense only when its recipient has
reached a supply side barrier, given the availability of foreign exchange or full
employment savings. An examination of the Indian case shows that a high
interest rate strategy pursued in the 1990s failed to improve investment rate in
India. Further, a reduction in government’s draft on the banking system did not
result in any improvement in credit delivery to the private sector. On the other
hand, a sharp increase in private sector credit in the 2000s, caused by a surge in
capital flows, has weakened the asset quality of banks and India’s growth
prospects.
Keywords: financial liberalization, financial globalization, McKinnon–Shaw framework, capital flows,

endogenous money, India
This chapter presents a survey on financial liberalization, broadly divided into

two parts. The first four sections present various theoretical debates and, very
selectively, some important empirical papers. The subsequent sections then
exclusively discuss the Indian experience. The process of financial liberalization,
in a somewhat simplifying manner, is divided into two compartments: the first
Page 1 of 40
relates to the relaxation of internal controls, especially those related to the

banking system, and the second relates to the liberalization of capital flows.
Given the broad theme of the survey, it is not possible to provide space to all
important references. The selection of papers, books, etc. for this review has
been based on judgement rather than any definite pattern. The reader may not
find the survey comprehensive in terms of themes covered. For example, while
the chapter presents the prior-savings critique of financial repression, the
structuralist critique has been excluded. Similarly, the case for capital flows is
understood by examining their beneficial impact on domestic investment using
the standard gap analysis. On the other hand, the impact of capital flows on
consumption volatility has not been discussed. Moreover, the section on financial
reforms in India discusses the reports prepared by Chakravarty and
Narasimaham committees since subsequent reports (p.30) mainly built upon
the groundwork for reforms prepared by them. Another important omission from
the discussion of the Indian case is the impact of foreign institutional investment
on exchange rate and stock price volatility; in fact, no separate analysis of
different types of capital flows is provided at all. These omissions reflect
constraints of both space and interest/limitations. The survey of this breadth also
cannot hope to provide in-depth review and analysis of various papers. It,
therefore, focuses on the basic concepts without involving itself in the specific
details contained in the papers. While discussing the Indian case, the effort is to
form an assessment that is both theoretically grounded and based on evidence
collected from Reserve Bank of India (RBI) data. The idea is to assess the Indian
picture against the backdrop of theoretical arguments for financial
liberalization.
Financial Repression: Theory

Beginning with the works of Shaw (1973) and McKinnon (1973), a large body of
literature has emerged that examines the costs of ‘financial repression’ in
developing countries. Financial repression is defined as a situation in which the
government intervenes in the banking system by imposing a ceiling on interest
rates to allocate cheap credit to favoured sectors. Low interest rates on loans, in
turn, necessitate a low interest rate on deposits with adverse effect on savings
and investment in the economy.
The conclusions of the financial repression theory follow from the impact of
interest rate on the volume of deposits managed and (hence) loans created by
the banking system. The argument can be explained with the aid of the simple
diagram taken from Shaw (1973) (Figure 2.1). Interest rates are represented on
the y-axis and loans and deposits on the x-axis. La shows that bank can make
more loans by lowering the loan rate and Da shows that it can attract more
deposits by offering a higher deposit rate. To maximize profits, the banking firm
must equate marginal revenue (represented by Lm curve) with marginal cost
(represented by Dm curve). If the banking firm is allowed to maximize profits, it
Page 2 of 40
will operate at point E. However, if the deposit rate is regulated at dc, the
volume of deposits will be equal to Dc and the loan rate that will exactly mop up
these deposits will be equal to la. However, in a repressed financial system, loan
rate is also (p.31)
regulated at lc. In this case the

demand for loans will be equal to
Lb and there will be an excess
demand for loans equal to Lb − Dc.
Since interest rates are regulated,
this excess demand for loans will
have to be rationed by the loan
officers of the bank. From this
simple framework, two main
conclusions are drawn by votaries
of financial liberalization:
1. Interest rate regulation
Figure 2.1 A Diagrammatic
restricts the volume of
Representation of Financial Repression
deposits available to banks
and, therefore, the volume Source: Adapted from Shaw (1973).
of loans they can create. If
interest rates were freed
from government control, the volume of deposits and loans as well as the
rate of interest would increase. The availability of more loans from the
banking system would lead to higher investment and growth.
2. The second effect of the repressive policies arises due to excess
demand for bank loans that gives bank managers the power to ration
their limited deposits. Low rates of interest enlarge the pool of potential
borrowers to include low productivity firms. Some of these low
productivity borrowers will be able to obtain loans when bank managers
make loan decisions randomly (Fry 1997). Additionally, bank managers
are likely to be susceptible to bribery and nepotism and, therefore, may
(p.32) simply ignore the productivity of borrowing firms. Repressive
policies are thus argued to have a negative effect on the productivity of
investment.
At this stage of the discussion it becomes important to enquire how exactly bank
deposits originate in the McKinnon–Shaw framework. For Shaw (1973: 54),
deposits are simply a form of savings: ‘The monetary system is a financial
intermediary attracting savings from spending units that forego consumption to
acquire increments of real money’. As real interest rate increases, people defer
consumption and place additional savings with the banking system in the form of
deposits. Savings, in other words, are assumed to be the source of deposits.1 The
independence of finance from savings that Keynesians emphasize is therefore
denied in the financial repression framework of McKinnon and Shaw.
Page 3 of 40
The Independence of Finance from Savings

Deposits are the liability of the banking system; loans are its asset. Deposits held
with the banking system can be transferred from one person to another through
the instrument of cheque (or some other form of bank transfer) and, therefore,
constitute the means of payment (finance) that can be used to effect purchases
in an economy. Keynesians emphasize that the creation of deposits does not
require the existence of prior savings. In fact, deposits are created as a
counterpart of loans in a simple book-entry operation.
Note how a new loan is created by a bank. When the loan request of a borrower
is granted, the bank simply makes a book credit to the deposit account of the
borrower and enters the same amount as loan on the asset side of its balance
sheet. In this manner, new deposits are created at the stroke of the banker’s
pen. Similarly, when an overdraft facility is used to make payments, bank
purchases the liability of the borrower and simultaneously sells its own liability
to payee of the borrower. Loans and deposits are jointly produced as bank sells
its own liability against that of its borrower. Savings, for that reason, cannot act
as a constraint on deposit creation.
Deposits of commercial banks need not always be created as a result of the loans
made by commercial banks. They may also arise when new loans are granted by
the central or note-issuing banks. For (p.33) reasons of safety and convenience,
extra notes may find their way into the commercial banking system as new
deposits. However, even in this case, savings did not cause deposits; notes,
which brought deposits into existence, were created as the note-issuing bank
sold them against the paper liabilities (IOUs) of non-bank public.
The view that deposit creation requires nothing more than a book entry
operation by banks has an impressive pedigree. It was emphasized by Keynes in
The Treatise on Money (1930), where he pointed out two ways of deposit
creation: one passive, in which notes or cheques are deposited with the bank,
and another active, when additional deposits are exchanged for the IOUs of
borrowers.2 Following the same tradition, Sayers’s classic text on modern
banking explained the creation of bank deposits thus:
The process of creation of bank deposits is essentially an exchange of

claims. The member of the public offers a claim of some sort—such as legal
tender state money, or a government bond, or a mere promise—and the
bank offers a book debt called a bank deposit. The claims that bank takes
from its customers, in exchange for the deposits entered in the books, are
the banks’ assets, and these assets bring the bank much of its income.
(Sayers 1967: 7–8).
More recently, de Carvalho (1997: 472–3) has argued: ‘The investors need
transaction balances that are provided by banks when deposits are created. As
Keynes and post-Keynesians insist, this is a bookkeeping operation, that involves
Page 4 of 40
no actual real resources and, in particular, no savings. The bank creates a

liability, the deposit that is accepted by sellers of investment goods as money’.
Moreover, there is a logical fallacy in the ‘savings create deposits’ argument.

Savings are that part of income that is not consumed. The existence of savings,
therefore, presumes the existence of income. However, the existence of income
in a monetary economy presumes the existence of money. Where incomes are
received in the form of deposits held with the banking system, those deposits
must have come into existence before savings could be made. What sense then
does it make to claim that the creation of deposits may be restricted by the
availability of savings? In this regard, following lines from Lavoie (1984: 775–6)
are worth quoting in entirety:
In a modern economy no savings can appear without income being

distributed and no income can be distributed without entrepreneurs (p.
34) getting into debt. Banks make loans to entrepreneurs without
someone having previously transferred purchasing power to them.
Therefore, investment plans can be made and carried on without there
being any need to consider savings plans. Several important implications
can then be drawn, one of which is that savings cannot be a dynamic
element of development strategy.
For Keynesians, therefore, finance, whether in the form of notes or deposits, is

independent from savings. This also allows investment to be carried out without
consideration for savings. Since investment always results in an equivalent
amount of savings, notes and deposits that provide initial finance for investment
are ultimately saved but savings have no causal force in determining the amount
of initial finance created in the economy. This idea of independence of finance
from savings was most cogently presented by Keynes in several articles written
in the post-General Theory period in response to the loanable funds arguments
of Robertson and Ohlin. Fernando J. Cardim de Carvalho (1997) presents a good
introduction to these writings and debates. Studart (1995) critically views
financial repression based arguments for liberalization within the prior-savings
paradigm. He argues that only the most primitive of banking systems relied on
savings to create deposits. In a modern economy, ‘supply of finance is
determined by the banks’ willingness to actively create deposits and credit and
not by savers’ preferences’ (Studart 1995: 276).
Evidence on Savings–Interest Rate Relationship

The core of the financial repression hypothesis rests on the positive relationship
between real interest rates and savings rate. The evidence on the positive
savings effect of higher interest rates is negative and it is generally accepted to
be so even by mainstream economists. Dornbusch and Reynoso (1989: 205), for
example, argue:
Page 5 of 40
It is well-known from the theory of savings that the offsetting income and
substitution effects of increased interest rates imply that the net impact on
savings must be ambiguous. In a framework of target saving increased real
interest reduce the necessary savings effort. It is surprising, therefore, to
find so strong a belief in the savings mobilization of higher rates. In the
US, with the best data and innumerable attempts to document the sign of
the effect there has been virtually no study that (p.35) can claim success.
Evidence from other industrialized countries points in the same direction:
no discernable net effect.
In a sample of 22 countries, Hussein and Thirlwall (1999) found that in a cross-

sectional regression of savings rate on real interest rate, the coefficients are
positive but insignificant. If we add per capita income as an explanatory
variable, the sign of interest rate coefficient becomes negative. In their panel
data regression, the sign of interest rate coefficient is negative.
Bandiera et al. (2000) study the impact of financial liberalization on savings in

eight developing countries. In six out of these eight countries, the relationship
between real interest rate and savings ratio turns out to be negative. The impact
of a more comprehensive index of financial liberalization, which includes such
measures as the reduction in reserve requirements and directed credit,
securities market development, entry of new private banks, etc., on savings ratio
appears to be mixed—positive in Turkey and Ghana and negative in Korea and
Mexico.
Bandiera et al. (2000) argue that financial liberalization is implemented as a

package and some elements of that package, such as greater credit flow to
finance household consumption, militate against increase in savings ratio. For
example, if, as a part of liberalization, banks are allowed to choose their portfolio
to include risky asset classes, they might push more consumption loans to
households. This measure of liberalization will be reinforced by pro-competition
measures that shrink the margin from traditional lending and force the banks to
push loans towards riskier asset classes, including households. The impact of
financial liberalization measures on savings, therefore, turns out to be
ambiguous.
Financial Globalization
Besides lifting internal controls on the functioning of the banking system,
financial liberalization also involves greater freedom to move capital across
borders. Literature has pointed out two benefits of capital mobility. Firstly, at
low levels of development, while capacity to save is limited, investment
requirements to carry out economic development are large. Developing
countries can overcome the shortage of domestic savings by tapping foreign
savings in the form of foreign aid (p.36) and investment (Cardoso and
Dornbusch 1988; Chenery and Strout 1966). Secondly, mainstream literature has
Page 6 of 40
pointed out collateral benefits of capital mobility on financial systems in

developing countries (Kose et al. 2006; Mishkin 2006; Rajan and Zingales 2003).
An open trade and capital account regime may spur institutional developments
such as greater information disclosure and stronger property rights that may
fuel the growth of both financial markets and intermediaries in developing
countries. Let us take these two arguments for financial globalization
sequentially.
Savings, as we have already noted, do not independently determine the level of

loans created by the banking system and hence the amount of investment. In the
standard Keynesian analysis, investment determines the level of output and
savings, being a function of output, follow suit. However, once the economy has
reached its potential output, further expansion of investment will generate
additional savings only by raising prices. It is in this sense that savings are
regarded as a constraint on development. The case for capital flows, therefore,
rests on the assumption of full employment of domestic resources. Sometimes, a
separate imported goods constraint to domestic expansion can bind before the
economy has exhausted its full employment savings. That is, while domestic
surpluses exist, it is not possible to convert them into exports to pay for the
imported goods necessary for domestic expansion. In this case, capital flows will
aid development by relieving the imported goods or foreign exchange (Forex)
constraint.
In the absence of the two constraints mentioned here, the reliance on foreign
savings to step up domestic investment would imply avoidable interest (or
dividend) costs and, therefore, a lower profile of future gross national product
(GNP) than if domestic savings were used to attain an identical increase in
domestic investment. Also, the inflow of foreign capital would have zero net
impact on actual output in this case since expansionary effect of investment
demand would be neutralized by an equivalent amount of trade deficit implied
by foreign savings. Further, it is assumed that when foreign savings enter the
economy, they find an automatic outlet in the form of higher investment. If
investment demand does not increase, foreign savings will displace domestic
savings by enlarging the trade deficit and reducing the domestic output. A good
case for capital flows can therefore be made only when its recipient has reached
the supply side barrier (given by the availability of Forex or domestic savings)
and faces no (p.37) shortage of investment demand to absorb inflow of
additional savings from abroad. The restrictive assumptions behind the
arguments for capital flows are never truly appreciated by votaries of financial
globalization.3
Bhaduri and Skarstein (1996) emphasized the role of demand constraint while
analysing the macroeconomic impact of foreign aid. Rakshit (2003) noted the
critical role of aggregate demand in his macroeconomic analysis of capital flows.
The role of demand side constraints was also elaborated by Patnaik and Rawal
Page 7 of 40
(2005), who showed that when foreign capital enters the economy, it enlarges
trade deficit by increasing real exchange rate. However, when it leaves the
country, which is a distinct possibility with liquid forms of foreign capital, it
again causes a reduction in demand and output. This happens because the
depreciation of currency caused by capital outflows increases the unit cost of
imported inputs and, for a given mark-up, the price level.4 If the government
displays sensitivity to inflation, it will respond by cutting its own expenditure
and reducing the level of aggregate demand in the economy. An economy
trapped between inflows and outflows of foreign capital is therefore likely to
suffer from a shortage of aggregate demand.
Moreover, flows of foreign capital should not be mechanically interpreted as a

transfer of real savings. Capital flows provide recipients the means of payment
(or finance) denominated in foreign currency. When this finance is used to
acquire goods from abroad, transfer of foreign savings is effected. However, if
the command over foreign finance is used to acquire financial assets abroad,
such as in the case of capital flows being used to build Forex reserves, no extra
savings are generated, let alone transferred to the recipient. An appreciation of
this distinction (between foreign finance and foreign savings) has now become
more pertinent than ever due to the extraordinary build-up of Forex reserves in
developing countries in the last decade or so. What use is foreign finance when
hoarded as Forex reserves and not absorbed through higher domestic
investment?5 This paradoxical turn (of developing countries investing abroad)
has two explanations. Firstly, in the absence of sufficient demand, capital flows
will simply displace domestic savings and contract total output. The increasing
demand for Forex reserves by the recipients of capital flows may reflect the
desire to avert this contraction. Secondly, the trend is also an outcome of the
string of crises that rocked the developing world in the 1990s (Rodrik 2006).
(p.38) Palma (2003) has pointed out that most developing countries liberalized
their capital accounts in periods of excessive international liquidity. Excessive
foreign finance was sought to be absorbed through expansion in domestic
liquidity that ultimately proved disastrous for most developing countries. In
Latin America, increase in bank credit resulted in consumption booms, increase
in asset prices, and widening of current account deficit due to increased imports
of consumption goods. On the other hand, in South Korea and other East Asian
countries, capital flows were absorbed through enlarged credit for the purpose
of investment and increase in corporate debt equity ratios. Expansion of
domestic credit, in an environment in which banking systems in host countries
had also been substantially liberalized, made the recipient countries prone to
internal banking crises whereas accumulation of foreign liabilities made them
vulnerable to balance of payments (BoP) problems. In each of these cases,
absorption of capital flows, therefore, resulted in financial crises with disastrous
implications for output and employment.6
Page 8 of 40
Due to their unfortunate experience with domestic absorption of capital flows in

the past, most developing countries have now made sterilized intervention their
preferred response to capital inflows. That is, central banks purchase inflowing
foreign currency and neutralize the consequent expansionary impact on supply
of reserve money through sale of government bonds and bills in the open
market.7 This has allowed them to build Forex reserves as a form of insurance
against external crises without causing expansion of domestic credit that was
responsible for the build-up of internal vulnerabilities in the past. However, the
expansion of Forex reserves has nullified the very rationale of attracting foreign
capital in the developing world. The strategy of building reserves has also
imposed intermediation costs on developing countries since the return on Forex
reserves held by them often falls short of the return paid out on capital flows
that financed the acquisition of those reserves. Rodrik (2006) has termed this net
loss the social cost of Forex reserves.8 Moreover, a part of this social cost is
borne by central banks in developing countries that are forced to replace high-
yielding domestic assets with low-yielding foreign assets in their portfolios.
Since central bank profits are transferred to government, the strategy of
building Forex reserves comes at the cost of government revenues.
Empirical work has also failed to detect any substantial impact of capital flows
on economic growth. Even the mandarins in the (p.39) International Monetary
Fund (IMF) now accept that the belief in the growth enhancing effects of capital
flows may have been overstated. In an IMF working paper, after surveying the
empirical evidence on the relationship between growth and capital flows, Kose et
al. (2006) concluded: ‘Our reading of this large literature based on aggregate
data is that it remains difficult to find robust evidence that financial integration
systematically increases growth, once other determinants of growth are
controlled for.’ Kose et al. (2006), however, maintain that researchers have failed
to detect positive relationship between capital flows and growth because they
have not searched in the right direction. Capital flows, they argue, do not aid
growth directly by providing foreign savings but indirectly by aiding the
development of financial markets, improving the institutions of corporate and
public governance, and disciplining macroeconomic policies. Since measures of
institutional quality, financial market development, and macroeconomic policies
are included in growth regressions as control variables, one fails to detect a
separate effect of financial integration on growth. However, as Rodrik and
Subhramaniam (2009) have pointed out, even unconditional or bivariate
regressions between financial integration and growth do not yield encouraging
results.
This brings us to the literature on collateral benefits of financial globalization. As

it stands, the literature is rather loose; it is almost entirely empirical and full of
strong assertions without much attempt at clarifying the underlying relationship
between financial integration and the collateral benefits it is supposed to
bestow. Take, for example, the idea that foreign investors reward
Page 9 of 40
macroeconomic discipline and penalize loose macroeconomic policies. It is not

clear why. So long as foreign investors know that IMF will bail them out in the
event of default, they will keep the financing taps on, no matter how
undisciplined the macroeconomic policies in the recipient country. This has, yet
again, been proved by the recent crisis in Greece where, despite bourgeoning
public debt that increased from 97.4 per cent of GDP in 2004 to 110.7 per cent
by 2008, foreign finance continued to pour in.9 In fact, it was well known before
the crisis that Greece was in violation of the conditions laid down in the
Maastricht treaty. It even received a warning from the European Commission for
window dressing its public finances in December 2004. Yet, not only did foreign
investors choose to ignore this warning, but they also connived with the Greek
government to mask its true borrowings by providing off-balance (p.40) sheet
loans.10 It is a little ironic that the very same foreign investors have bullied
Greece into accepting severe austerity measures in the post-crisis period.
Similarly, the relationship between financial integration and financial market

development is also not properly explained. Levine (2001) found structural
breaks in time series of stock market liquidity after the implementation of major
policy reforms regarding portfolio flows. However, he wasted no ink to explain
why this should be so. At the same time, one can cite counter-examples from
history where local stock market development sat comfortably with and, in a
way, necessitated controls on the capital account. Perhaps the clearest example
of this was Germany in the late nineteenth century, where companies did not
directly sell their shares on stock markets but required the help of large
universal banks in underwriting, placing, and, if necessary, owning their shares.
Needless to say, this kind of banking involved both illiquidity and credit risks to
which German banks were exposed in no small measure and would not have
been possible without the supportive role of the central bank. However, the
central bank’s liquidity support to universal banks came at the expense of its
commitment to the gold standard. Reichsbank, for example, never really allowed
German banks to export gold. While there was no written rule, banks observed
this diktat because they feared reprisal from the Reichsbank in the form of
denial of access to its discount window in times of liquidity shortage. This was
nothing but a form of capital control. The lesson to draw from this example is
that if functioning of stock markets requires the complimentary institution of
universal banks, some form of capital controls may have to be considered.11
Further, Anglo-Saxon institutions of corporate transparency, tight investor laws,

presence of information generating and disseminating firms, etc. do not ensure
higher share of equity in corporate financing. Singh (1995), for example, showed
that despite the relative absence of market-friendly institutions, corporations in
developing countries made much greater use of equity financing when compared
to those in developed countries. This was especially true of India in the 1980s
when large amounts of equity and bonds were sold by Indian firms despite the
absence of market-friendly institutions. In fact, the Indian experience examined
Page 10 of 40
later in this chapter would only confirm the importance of the complementary
institution of German style long-term banks in supporting security issue
activities of firms.
(p.41) The interest group theory of Rajan and Zingales (2003) is an interesting
and perhaps the only significant theoretical attempt to link capital and trade
openness to financial development.12 According to them, protection of property
rights and public disclosure of information are the pillars of a market-based
financial system. In a bank-dominated system, financiers use their close (non-
market) ties with borrowers to gather information about firms and ensure
repayment of loans. By definition, arm’s length financiers in stock markets do
not have recourse to such connections and rely on greater public disclosure to
gather information and stronger legal protection of property rights to ensure
repayment. Since strong property rights and public disclosure of information
spur entry on both supply and demand sides of the financial market, they are
opposed by industrial and financial incumbents. However, the authors argue that
the ability of incumbents to block financial development could be muted by
liberalization of both trade and capital flows. For example, free capital flows
would restrict the government’s ability to direct credit to favoured firms through
the use of monetary and fiscal policies. To seek credit from new financiers, with
whom they do not enjoy close connections, incumbent industrialists would need
to become more transparent and support greater legal protection of property
rights. Capital flows can, therefore, be used as an instrument to spur domestic
institutional development. Kohli (2012) has pointed out that the interest group
theory of Rajan and Zingales (2003) is awkward since it makes the government
both strong and weak at the same time. The government is considered too weak
to create market-friendly laws and institutions directly but it is nevertheless
assumed strong enough to do so through the backdoor by liberalizing trade and
capital flows. If the government can resist incumbents’ opposition to
liberalization of trade and capital flows, surely it can also resist their opposition
to institutional development.
The Process of Financial Reforms in India

The process of financial reforms in India was initiated by the proposals of the
Committee on the Working of Monetary System headed by Sukhamoy
Chakravarty. The committee was deeply concerned with the inflationary
potential of uncontrolled expansion in reserve money whose blame it laid on the
doors of government borrowings from the RBI. It was of the opinion that the
RBI’s target for reserve money (p.42) growth and government’s share in the
same should be fixed in the beginning of the year. For financing requirements
over and above its share in the reserve money, the government should sell its
securities to commercial banks. To induce commercial banks to increase their
voluntary holding of government debt, the committee recommended an upward
revision in interest rates on government securities. An increase in interest rates
on government securities was to be complemented by an increase in interest
Page 11 of 40
rate on term deposits, which, in the committee’s opinion, should offer a 2 per
cent real rate of return. Lending rates could also be adjusted upward to maintain
a spread of 3 per cent between maximum deposit rate and minimum lending
rate.
The crux of committee’s recommendations was based on the view that

government borrowings from commercial banks are less inflationary than those
from the central bank. As Datta (1986) explained in his review of the report:
‘[T]he possible inflationary impact of commercial bank holdings of government
debt has been ignored because it is held that such holdings merely canalize
private savings to the government through bank mediation’. That is, the
committee viewed commercial banks as mere intermediaries between savers and
investors rather than active creators of money. As we have already noted, both
central and commercial banks create new money by selling their liabilities
against those of non-bank public and neither form of money creation should be
considered inflationary if unemployed resources exist in the economy.
Commercial bank loans to government will not lead to new money creation only
when bank reserves have been fully used up and new loans to government are
made by retrenching private sector loans. That is, implicit in the committee’s
recommendation was the assumption that commercial banks always operate at
their maximum credit creating capacity.
It may, of course, be argued that new central bank liabilities entail the potential
for the multiplication of money and credit (due to the operation of money
multiplier) that new commercial bank liabilities do not. However, Patnaik (1986)
suggested that the utilization of this potential depends on the conditions in the
real economy, particularly the state of aggregate demand that determines the
demand for credit. Not only did the report come under attack for its monetarist
underpinnings, but it was even suggested that the reforms proposed by it might
ultimately cripple government finances with negative implications for the
government’s ability to discharge its developmental functions. In (p.43) an
early critique of the report, Dandekar (1986) noted that already in 1983 interest
liabilities constituted 23 per cent of central government’s total revenues and ‘in
the circumstance, it seems hazardous to experiment with higher interest/
discount rates’.
In spite of some serious reservations against the report, the government

accepted its core recommendation of cutting down government borrowings from
the central bank. Whereas government continued to issue ad hoc treasury bills
to RBI at a fixed rate of 4.6 per cent, it also started auctioning 182 days treasury
bills in the open market from mid-1980s. Dated government securities were also
issued at market rates of interest from 1992 (Bery 1994). The landmark was
reached in 1994 when government agreed to set binding limits on its issue of ad
Page 12 of 40
hoc treasury bills to the RBI. After 1997, financing of fiscal deficits through
government borrowings from RBI was discontinued altogether.13
The recommendations made by the Narasimham Committee in 1991 for the

banking sector marked the next stage of financial reforms in India. The
committee criticized the pre-emption of bank deposits by government and other
priority sectors at concessional rates that, among other things, also damaged
banks’ profit base. Government pre-empted deposits of the commercial banks
through high statutory liquidity ratio (SLR) and cash reserve ratio (CRR)
requirements. High SLR requirements meant that a very large share of bank
deposits had to be compulsorily invested in government securities at
administered rates of interest. High CRR also allowed the central bank—and
ultimately the government which relied on central bank borrowings—to impound
a portion of bank deposits. Since the rate of interest on bank reserves is lower
than the lending rates for commercial borrowers, CRR also implied a potential
loss of earnings to the banking system. The committee recommended that CRR
and SLR should be reduced to free the deposit base of banks for the purpose of
private sector credit creation (Khanna 1999). Notice, however, that the
committee’s idea that government pre-empts bank deposits is based on the
assumption that deposit base is fixed, perhaps given by the amount of savings
available in the economy.
Besides compulsory lending to government, the committee believed that the

commercial banking system was also crippled by the priority sector target which
is set at 40 per cent of net bank credit of commercial banks. Priority sectors
include agriculture, small (p.44) producers, and weaker sections. In the
committee’s view, not only did concessional lending to priority sectors compel
banks to charge higher rates of interest on commercial loans, it also imposed
substantial cost on banks because of the high administrative costs of small
borrower accounts. Moreover, the desire to attain priority sector targets implied
that inadequate attention was paid to qualitative aspects of lending. This
resulted in high delinquencies that eroded the capital base of banks. The
committee recommended that the share of priority sector credit should be
reduced from 40 per cent to 10 per cent of net bank credit. It also recommended
the abolition of concessional interest rate structure for these sectors (Khanna
1999; Kohli 1997).
The direction of reforms in Indian banking has broadly followed the

recommendations of the Narasimham Committee. The SLR and CRR
requirements increased through the 1980s and stood at 38.5 per cent and 15 per
cent, respectively, on the eve of reforms. They remained high in the early years
of reforms due to a heavy dose of stabilization but were gradually reduced 1993
onward. The SLR had fallen to its minimum level of 25 per cent by 1997, when
the CRR also stood at a much reduced level of 9.75 per cent. While Narasimham
Committee’s recommendation of phasing out priority sector lending targets was
Page 13 of 40
not accepted, concessional interest rates were done away with. This also set the
stage for removal of various controls on lending and deposit rates. Initially,
banks were given the freedom to set deposit rates within a ceiling. Subsequently,
in 1997, deposit rate ceiling was also abolished. Banks were also allowed to set
their own prime (minimum) lending rates (PLR) 1994 onward. From 1996, banks
had to announce the spread over the prime lending rate. From 2001, banks were
also allowed to charge rates that are sub-PLR.14 Lending and deposit rates in the
Indian economy are now, more or less, fully deregulated.
The concept of priority sector lending was, however, significantly redefined in

the period of financial reforms (Ramakumar and Chavan 2007). Firstly, indirect
finance which is not provided directly to the cultivators but to agencies (such as
state electricity boards and dealers in agricultural inputs) that support
agricultural operations was allowed to be counted as agricultural credit for the
purpose of reckoning priority sector advances of banks. Secondly, the concept of
indirect finance was itself widened. It now included loans to Non-banking
Financial Companies (NBFCs) for on-lending to agriculture, loans for
construction of storage facilities for agricultural produce (p.45) (including
those that were not located in rural areas), investment in securitized assets that
represent indirect finance to agriculture, loans to corporates and partnership
firms for agricultural and allied activities, etc. Similarly, inclusion of new heads
within the priority sector may have allowed banks to avoid credit creation in
favour of small-scale industry.15 Credit, for example, may have been diverted to
such priority sector heads as housing loans up to Rs 10 lakh that have registered
a massive increase in the post-reform period (Sen and Ghosh 2005).16 Also, as in
the case of agricultural lending, banks have been allowed to provide indirect
finance to small-scale industries by parking a part of their priority sector credit
shortfall with Small Industrial Development Bank of India (SIDBI) (Shajahan
1998).
Besides substantial liberalization of the banking sector, Indian economy was also
opened to capital flows after 1991. Limits on investment in Indian companies by
foreign direct investors, foreign institutional investors, and non-resident Indians
(NRIs) were relaxed substantially. Due to the liberalization measures, many
sectors of the economy now have 100 per cent foreign direct investment (FDI)
cap. Foreign Institutional Investors (FIIs), as a group, can invest up to 24 per
cent of the paid-up capital of companies. The FII investment limit can be raised
to the FDI sectoral cap with the approval of the general body of the shareholders
(Chandrasekhar and Pal 2006). The rules regarding foreign borrowings by both
Indian banks and companies have also been liberalized. However, unlike foreign
investment in equity, debt flows have not been fully liberalized. The RBI specifies
the ceiling on commercial borrowings by minimum maturity as well maximum
interest rate spread on them over the London Interbank offered rate (LIBOR).
Nayyar (2000) has ascribed India’s cautious approach towards liberalization of
debt flows to lessons learned from the crisis of the early 1990s that was widely
Page 14 of 40
recognized to have been caused by excessive commercial borrowings and

precipitated by outflow of short-term deposits held in the Indian banking system
by NRIs.
The Impact of Reducing Government’s Draft on Banking System and

Increasing Interest Rates
The main expectation from reforms was that by reducing the government’s draft
on the banking system, through a reduction in CRR and SLR requirements, more
credit will be made available to the private (p.46) sector. Unfortunately, for the
supporters of reforms, the share of government securities in total bank assets
increased whereas that of private loans fell in the post-reform period. The share
of investments (in securities) in total bank assets increased from 24 per cent in
1990 to 41 per cent in 2002–3. Post 2002–3, this figure fell steadily but even in
2010, the share of government securities stood at 27 per cent, which higher
than its pre-reform level (Figure 2.2). Why did banks voluntarily increase the
share of government securities in their portfolio? Chandrasekhar and Pal (2006)
as well as Sen and Ghosh (2005) have argued that since banks were under
pressure to reduce non-performing assets (NPAs) in the post-reform period, they
preferred risk-free government securities to risky private sector loans. While not
necessarily disagreeing with them, we will offer a different perspective
grounded in endogenous money theory. But before we lay out our arguments
fully, we take note of a few other important financial developments in the post-
reform period.
Firstly, there was a sharp increase in (real) interest rates, especially on

government securities, in the first decade after reforms; however, this was
followed by a sharp reversal in the subsequent period (Figure 2.3). Secondly,
whereas investment and savings ratio more or less remained stagnant in the
first decade of reforms when interest rates were high, they shot up after 2002–3
when interest rates were
Page 15 of 40
(p.47) much lower. This trend

seems to challenge the
mainstream belief in the efficacy
of high interest rates in eliciting
positive savings and investment
response (Figure 2.4).
Judged against the overall
objective of increasing credit to
private sector and improving
investment and savings Figure 2.2 Investment and Loans as a
performance, financial reforms Ratio of Bank Assets
in India were a disappointment. Source: Author’s calculations based on
In spite of a substantial data from Handbook of Statistics on
Indian Economy, RBI.
Figure 2.3 Real Interest Rates in India

(in per cent)
Source: Author’s calculations based on
data from Handbook of Statistics on
Note: Till 2009–10, lending rate
charged by SBI is taken; for the last
two years, average lending rate of
five major public sector banks is
taken.
Page 16 of 40
(p.48) reduction in government’s

draft on the banking system,
private sector credit did not pick
up and banks voluntarily
increased their holding of
government securities. In the
appendix to this chapter
(Appendix 2A), we use a simple
endogenous money model to
explain the growing share of Figure 2.4 Savings and Investment Rate
government securities in bank (in per cent)
assets in the post-reform period.
Source: Handbook of Statistics on Indian
In the second section, we
Economy, RBI.
examined how deposits are
created as an outcome of loans in
a simple book-entry operation.
However, when banks are required to hold reserves against deposits, for loans to
create deposits, the volume of deposits must not be constrained by the volume of
reserves; reserves should be freely created by the central bank, even if at a rate of
interest of its own choosing. Commercial banks behave in a manner that is analogous
to the central bank; they set the rate of interest on loans as a mark-up on the policy
rate set by the central bank and then freely create loans (in favour of all creditworthy
borrowers) at this rate of interest. Loans, so determined, create deposits that
determine the demand for reserves. The demand for reserves, in turn, is fully
accommodated by the central bank at its policy rate. This, in a nutshell, is the
endogenous money view.17
The impact of reducing government’s draft on the banking system would be very
different in the endogenous money framework when compared to the exogenous
money framework. When money is exogenous, a reduction in the CRR would
have a multiplier effect on the volume of loans and deposits. However, when
money is endogenous, a reduction in the CRR would not translate into more
loans (and deposits) since loan supply is demand constrained. Instead, banks
would make use of additional resources placed at their disposal by a CRR cut to
purchase government securities. The central bank, committed to its policy rate,
would oblige by selling government securities in the market. A CRR cut, in the
absence of any increase in loan demand, would lead to an increase in the share
of government securities in commercial bank assets.
An increase in reserve money due to expansion in foreign assets of the central

bank would have the same effect. It may be worth noting that the RBI, like other
central banks around the developing world, has greatly expanded its holding of
Forex reserves in the last two decades (see Table 2.1). Whereas in 1990–1, Forex
reserves of RBI stood at 2.5 months of imports, in 2003–4, they stood at 16.9
months of imports. Moreover, the accumulation of Forex reserves was mainly an
outcome of capital inflows since current account was in deficit in (p.49)
Page 17 of 40
Table 2.1 Balance of Payments Indicators
Current Account Foreign Investment Forex Reserves

Deficit (% of GDP) (% of GDP) (months of imports)
1990–1 −3.0 0.0 2.5
1991–2 −0.3 0.1 5.3
1992–3 −1.7 0.2 4.9
1993–4 −0.4 1.5 8.6
1994–5 −1.0 1.5 8.4
1995–6 −1.6 1.4 6.0
1996–7 −1.2 1.6 6.5
1997–8 −1.4 1.3 6.9
1998–9 −1.0 0.6 8.2
1999– −1.0 1.2 8.2

2000
2000–1 −0.6 1.5 8.8
2001–2 0.7 1.7 11.5
2002–3 1.2 1.2 14.2
2003–4 2.3 2.6 16.9
2004–5 −0.4 2.2 14.3
2005–6 −1.2 2.6 11.6
2006–7 −1.0 3.1 12.5
2007–8 −1.3 5.0 14.4
2008–9 −2.3 2.3 9.8
2009– −2.8 4.8 11.1

10
2010– −2.7 3.4 9.6

11
2011– −4.2 2.7 7.1

12
Source: Handbook of Statistics on Indian Economy, RBI.
all but two years after 1990. The expansion in reserve money, due to increasing Forex
reserves, must have led to accumulation of government securities with commercial
Page 18 of 40
banks in the absence of sufficient upward movement in loan demand (see especially
Patnaik [2001]).
Similarly, an increase in interest rate would also cause the share of government
securities in commercial bank portfolio to increase. An increase in loan rate (due
to higher interest rate on government securities by the central bank) would
cause loan demand, loan supply, and deposits to fall. This would reduce the
demand for reserves by banks. Even if investment and loan demand are not very
sensitive to changes in interest rate, banks’ demand for (excess) reserves would
fall as higher interest rate would induce portfolio reallocation in favour of
government securities. Since supply of reserve simply tails demand, the central
bank would now be required to sell government (p.50) securities to maintain
its policy rate. The increase in interest rate in the 1990s, therefore, must have
contributed to the increase in share of government securities in bank assets.18
Interest rates were kept high partly because of the mistaken belief that high real
interest rates are good for overall investment rate. However, Khanna (1999) and
Patnaik (2001) have argued that it also became difficult for the RBI to pursue an
independent monetary policy after reforms due to a more liberal capital flows
regime; the RBI had to set rate of interest at a level that would appease
internationally mobile capital.19
High rate of interest also greatly increased the interest bill of the government.
In an overall policy context in which government expenditure itself came under
intense attack, the committed nature of interest payments implied that the axe
had to fall mainly on developmental expenditure of the government (Figure 2.5).
Despite a significant reduction in the government’s draft on bank deposits,
overall the financial reforms failed to improve investment and savings
performance of the economy and improve credit supply to the private sector. At
the same time, high rate of interest on government securities had an adverse
impact on government finances and overall developmental expenditure in the
economy.
Figure 2.5 Interest Payments and

Developmental Expenditure of the
Central Government (percentage of GDP)
Page 19 of 40
(p.51) Some Implications of Source: Author’s calculations based on

Post-2002 Capital Flow Boom
There has been a substantial
inflow of foreign investment in
India in the post-reform period,
especially after 2002. Two important reasons behind the post-2002 capital flows
surge are low real interest rates worldwide and the abolition of long-term capital
gains tax on shares sold in Indian stock markets. The latter was certainly
responsible for the sudden increase in portfolio flows after 2002 (Chandrasekhar
and Pal 2006). The fiscal cost due to the abolition of the long-term capital gains
tax was substantial. Chandrasekhar and Pal (2006) pegged the revenue foregone
due to non-taxation of long-term capital gains in 2005 at Rs 7,857 crore for 30
Sensex companies alone. Bagchi (2007) estimated this tax loss at Rs 14,000
crore in 2005 for the Bombay Stock Exchange (BSE).
Capital flows are supposed to aid development by enlarging the pool of savings
available for investment. An assessment of how far did capital flows succeed in
ensuring this in India can be made from Figure 2.4 that plots savings and
investment rates in the Indian economy. It emerges that investment and savings
rates in India have been highly correlated and the gap between the two has been
less than one percentage point in most of the post-reform period. Even when the
investment ratio increased appreciably after 2002, the savings ratio did not drop
behind, suggesting that neither Forex nor savings were a serious constraint on
domestic investment in India. Also, since capital inflows far exceeded overall
current account deficit in India, capital inflows have been used to accumulate
Forex reserves (Table 2.1). On the other hand, if inflows of foreign finance were
converted into foreign savings, they would have imposed a demand contraction
on the Indian economy and dented its much-celebrated growth performance.
Indian economy has faced all the problems typically associated with a large
build-up of foreign assets. The holding of these Forex reserves has imposed
severe social costs à la Rodrik (2006). These costs have been so large that
Chandra (2008) was forced to draw a parallel between the current phase of
financial globalization and the colonial phase of the Indian economy when a
large amount of tribute was transferred by India to its foreign rulers.20 A portion
of these costs was borne by the RBI that had to replace high yielding domestic
assets with low yielding foreign assets in its portfolio. Chakravarty and Dasgupta
(2010) show that if the RBI maintained the actual amount (p.52) of total assets
but held domestic assets in the same average proportion (to total assets) as it
did between 1982 and 1992, its total income between 1992 and 2007 would have
been higher by Rs 50,949 crore. If proper compound interest was added to
income foregone before 2007, the loss to RBI would have been much higher.
Page 20 of 40
Moreover, since the increase in foreign assets increases the supply of reserve
money and, therefore, banks’ demand for government securities, the RBI was
forced to sell government securities to maintain its policy rate (see Appendix 2A).
It may be worth noting that although capital inflows were not very large in 2001
and 2002, the Indian economy had current account surplus in these years and,
therefore, sharp increase in RBI’s Forex holdings started even before the foreign
investment surge of 2003 (Table 2.1). As a result, by the end of 2003, the RBI
had almost completely run down its holdings of government securities. To
manage interest rate in the economy, RBI and government agreed to sell
securities under the market stabilization scheme (MSS), the proceeds from
which were kept as government deposits with the RBI (Chandrasekhar and Pal
2006). Unlike standard public debt, there was no public expenditure to show up
against MSS proceeds whereas interest on MSS securities was paid out of
government budget. Interest cost of this scheme must have limited its appeal to
the policymakers. Given these difficulties, mopping up of additional reserve
money due to forex interventions was incomplete and the RBI simply allowed the
rate of interest on government securities to fall.21 Moreover, banks, flush with
liquidity, refocused their strategy to lend to less creditworthy and risky
borrowers, especially within the personal loan segment, after 2002
(Chandrasekhar 2013). The former would have caused a downward shift in the
loan supply curve whereas the latter would have resulted in an outward shift of
the loan demand curve; and both would have resulted in an expansion of loans
and deposits and, therefore, ensured in this manner the absorption of additional
reserves created by RBI’s Forex interventions.
We have already documented the decline in interest rates. It would be

interesting to see how the universe of borrowers expanded in the post-2002
boom. The period after 2002 saw a sharp expansion in personal loans, especially
for housing (Figure 2.6). The share of personal loans in bank credit increased
from around 13 per cent in March 2002 to around 20 per cent in March 2008.
Households with limited credit histories were thus brought within the purview of
the banking system. (p.53)
Similarly, commercial banks have

also expanded loans to activities
considered risky, namely real
estate and capital markets. The
share of risky or, as RBI classifies
them, sensitive sectors in total
assets of scheduled commercial
banks increased from 1.76 per
cent in March 2003 to 11.29 per
cent in March 2011 (Table 2.2). Figure 2.6 Personal Loans (as
Overall, the shift to easy credit percentage of total)
policy was associated with
Page 21 of 40
tendencies like increased exposure to risky sectors and the inclusion of new class of
borrowers with limited credit histories within the fold of the banking system.
data from Basic Statistical Returns of
Scheduled Commercial Banks in India,
RBI.
Page 22 of 40
Table 2.2 Banks’ Exposure to Sensitive Sectors (Rs crore)
As on 31 March Capital Markets Real Estate Commodities Total Total as % of Total

Bank Assets
2000 4,115 2,418 2,089 8,622 1.01
2003 3,278 12,376 8,982 24,636 1.76
2004 4,336 15,544 9,349 29,228 1.78
2005 5,422 24,803 10,912 41,137 2.07
2006 22,303 262,048 1,406 285,758 11.81
2007 30,637 370,690 2,207 403,534 13.47
2008 61,638 456,858 1,644 520,141 14.06
2009 55,225 523,617 897 579,740 13.41
2010 59,489 492,689 0 552,178 10.89
2011 93,035 717,774 0 810,809 11.29

Source: Author’s calculations based on data provided by Statistical Tables Relating to Banks of India, RBI.
Page 23 of 40
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(p.54) Scorching pace of credit growth affected asset quality of banks. After
falling from Rs 708.6 billion in March 2002 to Rs 504.8 billion in March 2007,
non-performing assets (NPAs) of the Indian banking system increased to Rs 979
billion by March 2012. The significant increase in the volume of NPAs did not
translate into a significant increase in the NPA ratio because of a reasonable
growth of outstanding credit (Table 2.3).
However, in examining the asset quality of Indian banks it would be a mistake to

restrict attention to NPAs. In December 2008, the RBI had granted permission to
banks to restructure loans that were likely to turn bad. This was deemed
necessary at that point because the collapse of the global financial system was
putting tremendous strains on the Indian financial system. As a part of this
restructuring exercise, banks lowered interest rates and increased the loan
repayment period for borrowers under stress. At the same time, they could
continue to treat restructured assets as standard assets with zero provisioning
requirements. Together, NPAs and restructured loans accounted for around 8
per cent of gross advances of the banking system in 2012 (Table 2.3).
The encouragement to capital flows in India has produced some undesirable

outcomes. These include the fiscal costs of attracting these flows as well as
hoarding them as Forex reserves. Besides, rapid expansion of credit has affected
the asset quality of banks. On the
Table 2.3 Asset Quality of Commercial Banks
As of 31 Gross NPAs (% of gross Restructured Assets (% of gross

March advances) advances)
2004 7.19 –
2005 5.15 –
2006 3.29 –
2007 2.51 –
2008 2.25 –
2009 2.25 2.73
2010 2.39 4.23
2011 2.44 3.45
2012 3.10 4.68

Source: For NPAs, Handbook of Statistics on Indian Economy,
RBI (till 2011) and Report on Trends and Progress of Banking,
RBI (for 2012); for Restructured Assets, Chandrasekhar (2013).
Page 24 of 40
(p.55) other hand, flows of foreign finance did not have a positive impact on
investment ratios that were largely supported by domestic savings for the majority of
the post-reform period. In spite of the disappointing record with capital flows so far,
the official line is to liberalize capital flows further. This has partly happened due to
the failure to comprehend fully the macroeconomic role of capital flows. Take, for
example, the encouragement to private equity flows from abroad because such flows
help Indian firms by providing long-term finance. However, so long as savings (or
Forex) are not a constraint, the policy should be to provide long-term finance through
internal sources, so as to save the country the costs inflicted by capital flows. Yet, as
we shall now see, financial reforms have systematically destroyed internal sources of
long-term finance.
Financial Reforms, Stock Markets, and the Institutional Structure for
Funding Industry
An important component of domestic financial reforms in India was the rapid
development of stock markets. Those sympathetic towards such reforms have
focused on institutional developments such as the creation of the Securities and
Exchange Board of India, the creation of National Stock Exchange, the move
from floor-based trading towards electronic trading, etc. This resulted in the
creation of transparent markets where trading could be conducted at relatively
low costs (Shah 1999). Some of these institutions may have been created to
attract capital flows and can even be thought of as collateral benefits of financial
globalization. However, despite these institutional developments, the
performance of stock markets in funding industry has remained dismal in the
post-reform period (Pal 2008). After registering a sharp increase in the first half
of the 1990s, stock market issues of both shares and debentures subsequently
fell below their pre-reform level (Figure 2.7).
There were two main reasons for the expansion of stock market financing in the
early 1990s. Firstly, price–equity ratio increased in the early years of reforms,
perhaps because of the inflows of finance in thin markets (Pal 2008). Secondly,
liberal rules for setting up merchant banks ensured that large number of
merchant banks of dubious character existed to arrange issues of companies
with equally dubious standing (Rao et al. 1999). The primary market boom of the
early 1990s inflicted losses on the Indian investors. Many of the companies (p.
56)
simply vanished after issuing

equity. Also, the number of
companies that did not meet basic
listing requirements such as
payment of listing fees, were much
larger. Household investor survey
carried out by the Society for
Capital Market Research and
Development (2005) found that 38
per cent of the sample households
Page 25 of 40
held such delisted stocks in 2004. These factors clearly reduced the demand for shares
by Indian households.
But what is often missed in the Figure 2.7 Shares and Debentures Issues
literature is that the demand for (percentage of corporate investment)
new issues has also fallen due
to the retreat of government
financial institutions as
investors in new capital issues
(Table 2.4). In the pre-reform
Table 2.4 Absorption of Private Capital Issues by Government

Financial Institutions and Underwriters (percentage of issue
value)
Government Financial Institutions Underwriters
1981–2 to 1985–6 8.80 10.4
1986–7 to 1990–1 10.80 5.4
1991–2 to 1995–6 7.40 3.6
1996–7 to 2000–1 10.60 0.0
2001–2 to 2003–4 0.33 0.0

Source: Author’s calculations based on data from Handbook of
Statistics on Indian Economy, RBI.
(p.57) period, these institutions played an important role in stabilizing the overall
demand for primary issues in periods of poor household demand. There has been a
sharp decline in the proportion of capital issues subscribed by underwriters, both as a
part of their underwriting obligation and as direct investors, in the post-reform period
(Table 2.4). This means that in the post-reform period, merchant banks (who
underwrite issues) have mainly worked as intermediaries between issuing firms and
outside investors without committing their own funds to issues. But, more importantly,
since most of the underwriting business in the pre-reform period was dominated by
term lending institutions owned by the government, fall in the share of capital issues
lapped up by underwriters is also a reflection of the retreat of government financial
institutions. Private merchant bankers have not been able to fill the vacuum created by
exit of term lending institutions.
In the event, the buffer that was available to primary markets in periods of poor
household demand for shares and debentures has been removed. This is evident
in the increase in correlation coefficient between equity and debenture issues
(as a percentage of corporate investment) and household demand for shares
after reforms.22 For the period 1981–90, the correlation between annual change
in shares and debentures held by the household sector (as a percentage of total
change in household sector’s financial assets) and equity and debenture issues
Page 26 of 40
(as a percentage of corporate investment) was 0.34. The correlation coefficient

increases to 0.81 for period 1991–2000 and further to 0.87 in 2001–8.
In the pre-reform period, term lending institutions were crucial for firms seeking
funding through stock markets. Reforms proved destructive for these banks by
shutting down their access to subsidized SLR funds; their access to RBI’s long-
term operation funds was also curtailed. Further, by bringing down regulatory
walls between commercial and investment banking, term lending institutions
were also exposed to competition from commercial banks (Khanna 1999). Some
of these institutions such as ICICI and IDBI ultimately reinvented themselves as
deposit-taking banks with limited ability to take risks associated with long-term
financing. In the ultimate analysis, reforms created new institutions while
simultaneously damaging others. The net effect of these changes appears
negative since stock (p.58) markets are a smaller source of funds today than
they were in the pre-reform period.
The assessment of financial reforms provided here is largely negative. The

banking sector reforms did not lead to any significant acceleration in provision
of credit to the private sector. Neither did capital inflows result in any significant
savings or resource transfer to the country. At the same time, some of the
limitations of this chapter need to be noted again. Important areas where
assessments are sparse at the moment have been left out. These would include,
for example, the role of foreign banks. It is sometimes argued that foreign banks
with their internationally diversified asset and liability base, superior risk
management practices, and tighter home country regulations lend stability to
the host countries. Can a case for foreign banks be made, now that the
inadequacies of their risk management practices and home country regulations
have been glaringly exposed by the credit crisis of 2007 and 2008? How have
these banks affected the Indian economy? Similarly, there is surprisingly little
work on the size and activities of non-bank financial institutions in India. Their
asset liability mismatches, interconnectedness with banks and weak regulation
were widely noted during the global crisis, and subsequently, became the subject
of enquiry by a dedicated committee of the RBI. Finally, some of the areas where
accounts exist have also been left out. Here the intention was to deliberately
leave out those issues that are well-discussed in the mainstream literature.
These include such positive developments as improvements in bank profitability
and efficiency, and stronger capital and provisioning requirements. They have
been noted, among many others, by Mohan (2005). The purpose was to give an
alternative account that sought to emphasize the impact of liberalization on
credit supply, supply of long-term funds, investment performance, and
government budgets.
Page 27 of 40
A Simple Macro Model of Banking with Endogenous Money

The purpose of this simple model is to examine the factors that have contributed
to growing share of government securities in commercial (p.59) bank portfolios
in the post-reform period. We believe that some of the reform measures are
directly responsible for such an outcome. The model we propose is Keynesian—
with an independent investment function and endogenous money supply.
The Model
In each period, investment is financed by bank loans. Investment, so financed,
generates an equivalent amount of savings, which augment the deposit base of
the banking system. In such an economy, it must be the case that private capital
stock (K) is identically equal to outstanding (private) loans of the banking system
(L). Investment is assumed to be negatively related to the rate of interest on
loans, i, and positively related to output, Y (via the accelerator route). Since
investment is financed by bank loans, the determinants of loan demand are the
same as those of investment:
(1)
where is loan demand (from creditworthy borrowers) in the given short period.
We assume that rate of interest on government securities (ig) is policy
determined. Banks fix the rate of interest on private loans as a mark-up over the
rate of interest on government securities. The mark up is charged because of
greater liquidity and lower default risk of government securities compared to
private loans. The mark-up would, therefore, depend on liquidity and default risk
on two kinds of assets and on the degree of competition in the banking sector.
(2)
We further posit that banks meet entire loan demand of creditworthy borrowers:
(3)
After summation, we get:
(4)
(p.60) In other words, total loan supply must be equal to loan demand in all
previous periods and current loan demand.
In addition to the private sector, our model also includes government. Fiscal
deficit of the government is policy determined and fixed (we may assume that
taxes are lump sum and therefore do not change with output). We also assume
Page 28 of 40
away the availability of foreign savings—that is, trade deficit is zero (although a
non-zero trade deficit would do as well). Moreover, we assume that trade deficit
remains zero, no matter what happens to domestic output or, for that matter, to
any other variable in the model. This would greatly simplify the argument and
help us avoid clutter due to too many variables and notations. The condition for
goods market equilibrium in such an economy is:
(5)
where I stands for private investment, FD for fiscal deficit, S for private savings, and s
for savings propensity. For a positive and stable equilibrium to exist we need to assume
that: (i) demand injection (either through investment or through fiscal deficit or
through a combination of the two) is positive when output is zero; and (ii)
responsiveness of investment to output is smaller than savings propensity. We make
these assumptions.
Since investment in any period is equal to loan supply in that period, equation 5
may be re-written as:
(5′)
After summation, we get:
(6)
Since fiscal deficit aggregated across periods must be equal to the stock of
government securities, we rewrite equation 6 as:
(6′)
where GS refers to the stock of government securities.

We assume that the economy is open to flows of foreign capital, that capital
flows are exogenous in nature (that is, they are not necessarily equal to the
current account deficit), and exchange rates are fixed. (p.61) These
assumptions imply that any excess of capital inflows over current account deficit
must be absorbed by the central bank through increase in its holding of foreign
assets. While trade deficit in our model is zero, a deficit (or surplus) in current
account may still exist, say, because of difference in interest earned on foreign
assets compared to interest paid on foreign liabilities. Since foreign assets and
liabilities in the beginning of the period are given and so is the rate of return of
return on those assets and liabilities, current account deficit in the period is also
fixed. Current account deficit must be subtracted from net capital inflows before
addition to foreign assets is determined in the period under consideration. An
increase in foreign assets must be matched by an identical increase in the
liabilities of the central bank that, we assume, are deposited with commercial
Page 29 of 40
banks. Since foreign assets are matched by an equivalent amount of deposits

held with commercial banks and private savings are held as deposits, total
(outstanding) deposits are given by:
(7)
where FA is the stock of foreign assets and D is the stock of deposits.

Substituting from (6′), we get:
(8)
Once loan supply, government securities, and foreign asset holding of the central
bank are determined, deposits are determined endogenously. In other words, as
mentioned in the chapter, loans create deposits and therefore savings do not act
as a constraint on the volume of financial intermediation.
We assume that the central bank stipulates a reserve to deposit ratio of r (known
as CRR in India) and banks hold excess reserves. Since banks forego interest
income on government securities by holding excess reserves, the demand for
excess reserves varies inversely with ig. On the other hand, reserves obviously
provide greater liquidity than securities. Therefore,
(9)
where Rd is reserve demand and e() determines the demand for excess reserves as a
negative function of ig and a positive function of liquidity preference A.
(p.62) Since there is no bank capital, deposits must be identically equal to the
sum of loans supplied and government securities and reserves demanded by
commercial banks:
(10)
where b is the subscript for commercial banks.

Since Ls is determined from equation 4, D is determined from equation 8, and Rd
is determined from equation 9, equation 10 determines commercial banks’
demand for government securities. If, for given deposits, supply of loans or
reserve demand falls, banks’ demand for government securities would
accordingly rise. Finally, to close the model, we impose equilibrium condition in
the market for government securities, namely, that the total demand from
commercial banks and central bank is equal to available supply.
(11)
Page 30 of 40
where cb is the subscript for central bank.

We need not impose a separate condition to ensure equality between supply and
demand for reserves because that is implied by equations 8, 10, and 11.
We now carry out four experiments and examine their impact on banks’ holding
of government securities. These include the impact of: (i) an increase in interest
rate on government securities; (ii) a reduction in fiscal deficit; (iii) an increase in
capital inflow; and (iv) a reduction in reserve–deposit ratio. While (i), (ii), and (iv)
are main ingredients of economic and financial reforms, (iii) is an outcome of
various reforms that culminate in the improved attractiveness of an economy to
capital inflows. As pointed out by Palma (2003), it is also an outcome of opening
up in the environment of abundant international liquidity.
1. An increase in interest rate on government securities

An increase in ig will cause i to increase in equation 2 and, therefore, loan
demand to fall in equation 3. As investment and output fall, loan demand will fall
further. As a result, loan supply will fall in equation 4 and, therefore, deposits
will fall in equation 8. This will cause (p.63) demand for reserves to fall in
equation 9. Since deposits fall by the same amount as loans, and reserves also
fall, it follows from equation 10 that banks’ demand for government securities
must increase. To maintain equilibrium in the market for government securities,
the central bank must therefore reduce its demand for government securities in
equation 10. Since, in the new equilibrium, commercial banks’ holding of
government securities would have increased whereas the volume of deposits
managed by them would have fallen, the share of government securities in total
assets of banks would have increased. It is not difficult to see this point more
formally. Since, , it follows from (8) that . Using this
fact in equation 10 and using equation 9, we get:
(12)
Since in this case dD < 0, commercial banks’ demand for government securities
must increase.
2. A reduction in fiscal deficit

The second policy experiment relates to a reduction in fiscal deficit. A reduction
in fiscal deficit would cause output Y to fall in equation 5. A fall in output would
reduce investment and therefore, loan demand in equation 1, which in turn
would cause loan supply to fall in equation 4. As a result, deposits would fall in
equation 8 and, therefore, reserve demand would fall in equation 9. If the total
fall in reserve demand and loan supply is greater than the fall in deposits, the
demand for government securities would increase. Let us see the conditions
under which this would happen. From equation 5 we get:
(13)
Page 31 of 40
Since loan supply in a given period is equal to investment in that period, from
equation 3 we get dI ≈ LYdY. Since I is everywhere an increasing function of Y,
dropping ≈ for =, it follows that:
(14)
(p.64) Substituting from equation 14 to equation 13, we get:

(15)
Since it follows that . Similarly, . We

therefore rewrite equation 15 as:
(15′)
Noting that and using equations 8 and 15′, we get:
(16)
Finally, using equations 9, 10, and 16, we get:
(17)
The first term in curly bracket in equation 17 is responsiveness of investment to

output divided by savings propensity. Stability of equilibrium requires that this
ratio be less than 1. The second term is reserve to deposit ratio, which is also
less than 1. The sum of these two terms, however, may well exceed 1 causing
banks’ demand for government securities to rise even as deposits fall due to a
fall in fiscal deficit. The intuition behind this result is simple. Let us assume that
a reduction in fiscal deficit amounts to a reduction of an equivalent amount of
government securities from the portfolio of commercial banks. This would cause
deposits to fall in the same amount. Additionally, as output falls, private loan
demand would also fall, causing a further reduction in deposits. Consequently, in
view of the fact that liabilities of central bank and, therefore, reserves held by
commercial banks have remained unaltered, banks would end up holding more
reserves than they demand. The extent of undesired reserve holding would
depend on the responsiveness of investment and loan demand to output, the
value of output multiplier (1/s) and the reserve to deposit ratio of banks. Greater
are the undesired reserves held by commercial banks, greater would be their
Page 32 of 40
demand for government securities. If private loan demand falls sufficiently and
reserve to deposit ratio is high, additional demand for government securities
may well offset the initial reduction in government (p.65) securities from
commercial bank portfolio. Finally, it must be noted that even if absolute demand
for government securities falls due to a fall in deposits, the share of government
securities in deposits may still increase. This would require that marginal
change in banks’ demand for government securities due to a marginal change in
deposits is less than the ratio of banks’ government security holdings to their
total deposits (that is, the marginal curve is below the average curve):
(18)
which, after using relevant equations 10 and 17, becomes:

(19)
3. An increase in capital inflows

Since we have assumed that capital flows are absorbed as foreign assets, an
increase in capital inflow would cause both foreign assets of central bank and
deposits of commercial banks to increase. As a result, reserves held by
commercial banks would increase by the same amount. As banks end up holding
more reserves than they demand, their demand for government securities would
increase. With interest rates fixed, central bank would have to oblige
commercial banks by selling government securities. Moreover, since loan supply
remains unchanged whereas deposits increase, loan to deposit ratio must fall. At
the same time, reserve to deposit ratio remains unchanged and, therefore, it
must be the case that the share of government securities in total deposits
increase as a result of capital inflows. More formally, from equation 8:
(20)
Noting that and using equations 9, 10, and 20:
(21)
Since both the term in bracket and the one outside it are positive, it follows that
commercial banks’ demand for government securities must increase as a result
of capital inflows.
(p.66) 4. A reduction in reserve–deposit ratio

As r falls, banks would find themselves holding more reserves than they demand.
This would result in an increase in demand for government securities. The
Page 33 of 40
central bank would then have to reduce its demand to maintain the rate of
interest on government securities. Since , we note from
equation 9:
(22)
Using equations 10 and 22:
(23)
Since dr < 0 it must be the case that .
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Notes:
(*) Prabhat Patnaik suggested a number of improvements for the earlier versions
of this chapter. In its present form, the chapter owes much to his insightful
comments. I take full responsibility for any errors and omissions that remain.
(1.) This chapter has used the framework provided by Shaw. However, even in
McKinnon’s framework, savings play the causal role. This is, for example,
evident in the complementarity between real deposit rate and investment ratio
proposed by McKinnon. According to McKinnon, this complementarity arises due
to conduit effect as higher interest rate allows more savings to flow through
financial intermediaries.
(2.) See Studart (1995) for a short and accessible account of banking and
monetary theory developed by Keynes (1930).
(3.) A good example is a comprehensive review paper by Kose et al. (2006) who,
after failing to detect any relationship between financial integration and growth,
abandoned the very idea that foreign capital aids growth through provision of
savings. They did not explore the possibility that the presence of demand side
constraints may have been the reason behind their result.
(4.) The crucial assumption is of oligopolistic price setters who respond to higher
unit costs by increasing prices but respond asymmetrically to lower unit costs by
pushing up their profit mark-ups.
(5.) Using the data taken from IMF, in 2010, private capital flows to developing
countries stood at 2 per cent of their collective GDP whereas reserve
accumulation by developing countries stood at 4 per cent of their collective GDP.
(6.) Kaminsky and Reinhart (1999) note that the incidence of banking and
currency crises increased after the 1970s. Moreover, their study also notes that
the probability of banking crisis increases if the country has undertaken
financial liberalization. Palma (2003) discusses the various financial crises that
hit the developing world in the 1980s and the 1990s using the framework of
Minsky and Kindleberger.
(7.) As pointed out by Rakshit (2003), there are two alternatives to sterilized
intervention. The first is non-intervention which not only imposes contractionary
pressure by enlarging the trade deficit but also ensures that foreign capital so
Page 38 of 40
gets absorbed leaving the recipient country with little cushion of safety when the
reversal of capital flows happens. The other option is to undertake non-sterilized
intervention to mop up foreign currency and check its adverse effect on trade
deficit through currency devaluation. However, had this been the case one would
have observed persistent weakening of currencies of countries such as India that
have emerged as favoured destinations for foreign capital. This is far from the
case as developing economies often witness real exchange rate appreciation in
the wake of financial liberalization.
(8.) Rodrik estimated the cost of excess Forex reserves at around 1 per cent of
developing countries’ GDP.
(9.) The source of these values is Eurostat.
(10.) Greece, for example, arranged currency swaps with Goldman Sachs by
selling debt in dollars or yens against euros at an inflated value of euros. This
way, euro denominated loans to Greece could be disguised as currency swaps.
(11.) This specific link between capital controls and stock market development in
Germany is drawn in Kohli (2012). Following the path-breaking work of
Alexander Gerschenkron, there is a large literature on the role of universal
banks in financial and economic development. See Chandrasekhar (2005) for a
good summary treatment of Gerschenkron’s work and Kohli (2012) for related
literature.
(12.) This seems to be an important paper with around 1,500 citations on google
scholar. Other enthusiasts of financial globalization, such as Mishkin (2006),
seem to have wholeheartedly accepted the arguments offered in this chapter.
(13.) The government could still borrow from the RBI through ‘Ways and Means’
advances to bridge temporary shortage of cash for a period not exceeding 10
days, but financing of fiscal deficit through government borrowing from RBI was
stopped.
(14.) A good description of interest rate reforms can be found in Mohan (2005).
(15.) Here, it may be necessary to point out that within the priority sector target
of 40 per cent, a sub-target of 18 per cent is specified for agriculture but no sub-
target is specified for small-scale industry.
(16.) The housing loan limit for the purpose of calculating priority sector
advances has since been increased to Rs 20 lakh.
(17.) Classic reference for endogenous money theory is Kaldor (1995). See also
the references in Lavoie (1984).
Page 39 of 40
(18.) Admittedly, in an exogenous money framework, a reduction in reserves

through an open market sale of government securities would also cause the
share of government securities in bank portfolio to increase.
(19.) It is shown in the appendix that, besides factors discussed in the main text,
a reduction in fiscal deficit, which is an important component of economic
reforms, may, under certain conditions, increase commercial banks’ demand for
government securities.
(20.) Chandra noted that the estimation of this loss in India is difficult since
most of the liquid foreign investment in the country comes to stock markets.
However, capital gains earned by foreign investors are not recorded as a
separate item in the current account; instead, when taken out, they are counted
as outflows in the capital account.
(21.) There was a fall in both nominal and real interest rates. Between 2000 and
2004, which was a period of persistent BoP surplus, nominal interest rate on
government securities fell from 10.95 per cent to 6.11 per cent. For real interest
rate, see Figure 2.3.
(22.) In the household financial assets data, shares and debentures include
direct ownership of these instruments as well as their indirect ownership
through mutual funds. However, it does not include indirect ownership of shares
and debentures by households through their investments in banks, insurance,
and pension and provident funds.
Page 40 of 40
A Macro-theoretic Survey of Monetary Policy in a Closed Economy

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
A Macro-theoretic Survey of Monetary Policy

in a Closed Economy
Rohit Azad
C. Saratchand
DOI:10.1093/acprof:oso/9780199458950.003.0003

Monetary policy has been under discussion both before and after Keynes’s
General Theory. While he was sceptical of its efficacy, the current mainstream
macroeconomic consensus accords it primacy in the process of maintaining price
and output stability. Moreover, between these two objectives, the former has
been accorded primacy over the latter in the policy prescriptions of the
mainstream macroeconomic consensus. To locate the rationale behind monetary
policy, we have presented here a macrotheoretical survey of monetary policy
ranging through Keynes, Monetarists, New Keynesians, and heterodox
approaches. We argue that, unlike the heterodox interpretations of Keynes, the
neoclassical synthesis or the current macroeconomic consensus have, at best,
only partially developed Keynes’s theoretical insight as set out in Keynes’s
General Theory.
Keywords: monetary theory, new Keynesian synthesis, Keynes–Kalecki framework, Taylor’s rule, non-
accelerating inflation rate of unemployment (NAIRU), inflation targeting, Phillips curve, liquidity
preference
The repo rate should be the single policy rate to unambiguously signal the
stance of monetary policy to achieve macro-economic objectives of growth
with price stability.
—Reserve Bank of India (RBI) 2011
Page 1 of 38
Monetary policy has been an area of intense debate in macroeconomics. The

achievement of the twin objectives of price and output stability1 and the role of
monetary policy in the former have been important components of this debate.
For instance, the central bank could seek to determine the interest rate to
achieve the aforementioned twin objectives. This could work in the following
manner: The central bank, through its control of the interest rate, could possibly
regulate the level of aggregate investment (and also aggregate consumption)2
and, hence, the level of economic activity. Here aggregate investment refers to
the sum of the magnitudes of investments undertaken by all capitalists. Since
inflation is linked to the level of economic activity, these twin objectives can be
goals of monetary policy.
The aim of this chapter is to locate the role of monetary policy in various
theoretical frameworks of macroeconomics that are relevant to capitalist
economies in general and the periphery in particular. During an examination of
the debates between these alternative macroeconomic frameworks, it would not
be out of place to remark that in many ways current mainstream
macroeconomics has come a full circle to pre-Keynesian monetary concepts. To
understand why this is (p.76) the case, let us begin with a brief perusal of
Keynes’s work, The General Theory of Employment, Interest, and Money (Keynes
1936; hereinafter referred simply as The General Theory).
Keynes’s General Theory and Monetary Policy

During the Great Depression that began in 1929, the capitalist world saw
historically unprecedented decreases in the level of output and concomitant
increases in the rates of unemployment (Duménil et al. 1987). In the periphery
(which was mostly colonized at that time), the Depression manifested itself
additionally as heightened peasant distress (Patnaik 2012).
Keynes (1936) put forward the following argument to account for crises faced by
capitalist economies (of which the Great Depression was a notable example): In
the absence of government intervention, a capitalist economy settles at a state
where there is both excess capacity and involuntary unemployment. He further
argued that the capitalist state can play a role in stabilizing the economy
through the use of fiscal and monetary policies. In many ways, subsequent
debates on macroeconomic theory and policy have been shaped, in myriad ways,
by these arguments of Keynes (Patnaik 2009).
In a response to the critics of The General Theory (1936), Keynes (1937) argued
that his principal contribution (in The General Theory) was to question the basic
propositions of the orthodox framework which had not only failed to understand
the Great Depression but, provided no remedies to overcome it. His general
theory of overproduction (excess capacity along with involuntary unemployment)
can be understood in the following (albeit simplified)3 manner:
Page 2 of 38
In order for an economy to be in full employment equilibrium, two conditions

have to be fulfilled:
1. the level of aggregate investment that leads to the full employment

level of output (through the Keynesian multiplier)4 lies on the marginal
efficiency of investment (MEI) schedule; and
2. the interest rate perchance is at the level at which this MEI is
materialized.
Now there is no reason why either of these conditions, leave alone both, would
be fulfilled. Let us see why.
(p.77) The first condition requires the MEI to be a stable function of the
magnitude of investment.5 Keynes argued that it is true that in equilibrium, MEI
is equal to the rate of interest. But this, by itself, does not tell us the level of
employment at which this equality obtains. In particular, the level of employment
so achieved need not equal full employment.
To begin with, the MEI itself is an unstable function of the magnitude of

investment, because it depends on, among other things, the expectations of
capitalists about the future profitability of current investment projects. Unless
one assumes away the irreducibility of uncertainty about the future to
probabilistic calculations of risk, there is no reason why the MEI would be a
stable function. The individual capitalist has access to (partial) information
about variables such as past output, prices, wages, and interest rates. The
magnitude of investment that s/he intends to undertake will require her/him to
form estimates of the future magnitude of these variables.
Let us assume that that the life of an investment project is n time periods. If the
prospective stream of yields are q1, q2 … qn, then the rate of return (ε) on this
investment is that rate which when used to discount the above mentioned
stream of prospective yields, gives rise to a magnitude that equals the value of
the investment project.
(1)
The magnitude of prospective net profit for the capitalist would then be
given by the following expression:
(2)
Page 3 of 38
The magnitude of prospective net profit equals the return on investment less the
calculable risk. It needs to be noted here that the rate of return is postulated by
Keynes to be a decreasing function of the magnitude of current investment. The
tenability of this negative functional relation is examined later in this chapter
under the section entitled ‘A Heterodox Approach to Monetary Macroeconomics’.
The rate of interest enters this decision on investment in terms of the

opportunity cost of earning returns on interest-bearing financial (p.78) assets
such as bonds. A capitalist is making a choice between investing in real capital
(I) and in financial assets (F). The prospective real return on financial assets
is given by:
(3)
But how is this choice arrived at? On the margin, the expected returns on the
two types of activities should be equal.
(4)
The left hand side (LHS) of the second line in equation 4 is obtained by partially
differentiating equation 2 with respect to I. This is then labelled as MEI(I, qi) in
the LHS of the third line of equation 4.
One can see that despite the inclusion of calculable risk, there is an uncertain
factor in the MEI schedule depending on what are the long-term expectations
about the state of the economy, which has been captured here by the spectrum
of qi. This makes the investment schedule volatile. Moreover, the expected
inflation rate may not equal the actual inflation rate, adding to the
uncertainty underlying decisions about capital accumulation.
In terms of the mathematical model set out above, this can be captured as
follows:
1. Let Qi denote the sum of the qi that may accrue to all capitalists on all
current investment projects, that is
(5)
Page 4 of 38
(p.79) 2. Ceteris paribus, the spectrum of Qi are positively related to the

magnitude of aggregate investment of the ith period (Kalecki 1939).
However, the functional dependence between aggregate investment
(leave alone individual investment) and the spectrum of qi of an individual
capitalist is uncertain.
Let us examine the second condition that the interest rate is at the particular
level which ensures that the magnitude of aggregate investment is such that full
employment obtains. The interest rate is determined in the single period by the
equality between the demand and supply of the money stock (Keynes 1936).
Money has the following roles in a capitalist economy: a unit of account, a means
of transaction (denoted as transactions demand for money by Keynes [1936]), as
a means to settle debt and a store of wealth (denoted as liquidity preference by
Keynes [1936]). To begin with, let us focus solely on two roles, that is,
transactions demand for money and liquidity preference.
It is plausible to assume that the transactions demand of money is proportional

to the aggregate magnitude of transactions in terms of money which, in turn, is
some (not necessarily constant) multiple of money income (denoted here by k).
Once this amount is deducted from the total money supply, we are left with a
given stock of money. Liquidity preference has to adjust to this given level of the
money stock. Given that the returns on holding money is zero (a fiat money
world is being assumed here), the very fact that it is still held as a store of value
is indicative of the fact that at least some individuals (including some capitalists)
do not attribute certainty to their calculations of future returns on different
assets.
For a given magnitude of the stock of money, the equilibrium between the
demand and supply of money can come about only if individuals (including
capitalists) are induced into holding that given magnitude of money.6 According
to Keynes (1936), the rate of interest is set at that level which equilibrates the
demand and supply of money. A higher rate of interest means a higher
opportunity cost of holding money. So, the interest rate moves to make this
adjustment on the margin. Besides the interest rate, the expected interest rate is
(p.80) also a determinant of the speculative demand for money. This can be
expressed as follows:
(6)
Page 5 of 38
This can be trivially rewritten as:
(7)
It can be seen that the interest rate is determined not only by the supply of
money (which is assumed to be subject to the influence of monetary policy), but
also by the state of expectations (of capitalists among others) about the future.
For instance, when expectations about the future are pessimistic, the liquidity
preference schedule would move outward (that is, L rises for a given i), thereby,
requiring the current interest rate to increase to adjust to the given stock of
money.
In Keynes’s The General Theory (1936), the level of economic activity is

determined by the level of ex ante aggregate investment given the magnitude of
the marginal propensity to consume. Ex ante aggregate investment is
determined, in turn, by an unstable MEI and the interest rate. The latter is
dependent on an unstable liquidity preference schedule. So, there are two
independent reasons for why the economy might not settle down at a level of
equilibrium output that corresponds to full employment except by chance. It is
this chance that the orthodox pre-Keynesian theories focused on. This is the
reason why Keynes denoted the equilibrium which correspond to it as a special
case of his general theory of employment, interest, and money.
Output stability, one of the two objectives of monetary policy, can be looked at
from this perspective, as derived from Keynes’s (p.81) The General Theory
(1936). Monetary authorities (such as the central bank) might be ineffective in
overcoming pessimistic expectations about the future state of the economy,
because the impact of monetary policy is felt indirectly on output. Let us
elaborate on how, according to Keynes (1936), this impact is manifested in
capitalist economies.
The transmission mechanism of monetary policy is as follows: an increase in

money supply will cause a decrease in the nominal rate of interest rate if the
other determinants of money demand remain unchanged. If the price level
Page 6 of 38
remains unchanged, the real interest rate falls. The latter, in turn, causes
aggregate investment and output to rise.
However, it is possible that a rise in money supply might not increase the
nominal rate if the public (including the capitalists) decide to hold the entire
magnitude of the money injected by the central bank. In other words, if liquidity
preference (the term L in the right hand side [RHS]of equation 7) rises to the
requisite extent, the first link between money supply and the nominal rate of
interest will be snapped.
Even if the nominal rate of interest falls, there is no reason why the real rate of
interest must fall consequently. Further, even if the real rate of interest does fall,
it is possible that the MEI schedule is insensitive to the real interest rate or that
it shifts inwards due to pessimistic expectations about future profitability of
current investment. In terms of equation 4, the foregoing argument amounts to
saying that a decrease in the LHS of equation 4 nullifies wholly or partly the
positive impact that a fall in might bring about on the MEI schedule.
In each of the above instances, monetary policy would be ineffective in helping

the economy come out of recession.
Despite Keynes’s scepticism about monetary policy, the mainstream

interpretations of his economics, whether of the IS-LM variety or the current
New Keynesian paradigm, have largely ignored the role of uncertainty that was
central to The General Theory. These mainstream interpretations will be
critically examined in the next section on ‘ (p.82) Mainstream Macroeconomic
Consensus’. Besides this, there developed heterodox interpretation(s) of The
General Theory, which stayed close to Keynes’s insights. These are discussed
later in this chapter in the section entitled ‘A Heterodox Approach to Monetary
Macroeconomics’.
Mainstream Macroeconomic Consensus

The mainstream macroeconomic consensus emerged as a partial development of
the ideas expounded in Keynes (1936). Over time, it has incorporated a number
of pre-Keynesian formulations. Some variants of mainstream macroeconomic
consensus such as the New Classical macroeconomics, are quite distant7 from
the macroeconomic universe elucidated in Keynes (1936).
A key dividing line that distinguishes different variants of the mainstream

macroeconomic consensus is the manner in which money is incorporated into
the respective macroeconomic frameworks. The taxonomy that is adopted in our
treatment of the different variants of the mainstream macroeconomic consensus
involves a distinction between: those with exogenous money which are surveyed
in the following section on ‘Mainstream Macroeconomic Consensus with
Exogenous Money’ and those with endogenous money which are surveyed later
Page 7 of 38
in the chapter in the section on ‘Mainstream Macroeconomic Consensus with

Endogenous Money’.
Mainstream Macroeconomic Consensus with Exogenous Money

The first mainstream macroeconomic consensus was christened the neoclassical
synthesis. Drawing on Hicks (1937),8 it was also denoted in macroeconomics
textbooks as the IS-LM-PC model.
Not only was the IS-LM model a simplistic representation of Keynes (1936), it
overlooked many of his insights, thereby leaving enough room for a resurrection
of pre-Keynesian ideas like the quantity theory of money.
The departure of the IS-LM model from Keynes (1936) can be traced to at least9
two issues: First, it undermined a differentiated treatment of stock and flow
equilibria by making the determination of interest rate and money income
simultaneous. By doing so, it assumed away the problems in the monetary
transmission mechanism that were mentioned in the last part on the section on
‘Keynes’s General Theory and Monetary Policy’ earlier in this chapter. Second,
by assuming that the investment and liquidity preference schedule are stable
functions of the rate of interest, it left the theory elucidated in Keynes (1936)
denuded of one of its basic insights that expectations (p.83) about the future
play a central role in the determination of both the interest rate and money
income in a capitalist economy wherein uncertainty is ubiquitous.
In the IS-LM-PC framework, aggregate investment is a negative function of the

real rate of interest. Here the rate of interest determines the level of investment
and consequently the level of output and income through the multiplier (whose
magnitude equals 1/s when there is no taxation and the propensity to save is
identical for all classes).
This investment function does not have the uncertainty component of the MEI.
The IS curve is derived in the following manner:
(8)
The IS curve is an inverse functional relation between the real rate of interest
and the level of output.
Page 8 of 38
Given the level of nominal income, the nominal rate of interest is determined by
the equilibrium between the demand and supply of money. Through its
postulation of liquidity preference as a function solely of the current nominal
rate of interest, this model removes by assumption the instability arising out of
uncertainty that was central to Keynes (1936).
This positive functional relation between output and the nominal interest rate is
known as the LM curve.
(9)
The nominal and real rates of interest are linked by the following identity:
(10)
(p.84) There are three equations, IS, LM, and the accounting identity set out
above in four variables, namely output, the inflation rate, the nominal rate of
interest, and the real rate of interest. There is a need for one more equation to
make this macroeconomic model just determined.
That additional equation within the IS-LM-PC model is the Phillips curve, which
is a functional relation between the rate of inflation and the level of output.10 It
is derived as follows.
Workers negotiate for an ex ante wage share depending on their expectation of

the future price level. A hat over a variable denotes its rate of growth.
Some initial formulations of the Phillips curve assumed that the workers naively
expect that the price level of the last period will prevail in the current period
. This naive expectation on the part of workers implies that they
expect a zero level of inflation. This ex ante wage share itself is dependent on
their bargaining strength which varies inversely with the rate of unemployment.
For simplicity, it is assumed that there is an inverse relation between the level of
output and the level of unemployment (v).
These formulations can be expressed in the form of equations in the following

manner:
(11)
Page 9 of 38
For simplicity, we assume the mark-up of prices over average costs to be

constant. Therefore, with the change in wage cost as given above (p.85) and a
random supply shock term with zero mean, the expression of inflation would be
given by the following equation:
After removing the time subscripts, we get the Phillips curve,
(12)
If the magnitude of the labour force is normalized to unity, the Phillips curve
derived above can be expressed as:
(13)
For ready reference, the three equations of the IS-LM-PC model, with naive
expectations, are set out below:
(14)
(15)
(16)
Let us now proceed to a discussion of monetary policy in the IS-LM-PC model

(Figure 3.1). If the central bank wants to increase the level of output in a
capitalist economy, it could do so by increasing the rate of growth of the supply
of money supply so that it exceeds the rate of inflation. This will increase the
value of real balances in the economy, thereby pushing the level of demand up
through two independent channels: (i) a decline in the interest rates (Keynes
Page 10 of 38
effect); and (ii) an increase in consumption due to an increase in real wealth

(real balance effect or Pigou effect).
Serious doubts have been cast on the existence of the real balance effect
(Patnaik 2009, 1994, 1995; Palley 1996). This requires, in the case of ‘outside’
money, increase in the consumption demand of those who gain from the
appreciation of their wealth, such as creditors, to be more than the fall in
consumption demand of those whose wealth falls, such as debtors. (p.86)
(p.87) In order for the Keynes

effect to work, two conditions
have to be to be fulfilled: first,
this increase in the rate of
growth of the money supply
must not be nullified by a
commensurate decline in the
rate of change of velocity of
circulation of money. In other
words, liquidity preference
must not grow in the same
proportion. Second, since this
increase in the rate of growth of
the money supply will also
result in a higher rate of
inflation, the IS curve shifts
inward (independent of the
outward shift due to the real
balance effect), that is, for
every level of the real rate of
interest, the level of output is
lower. So, if the inward shift of
the IS curve dominates the Figure 3.1 Expansionary Monetary Policy
movement along the IS curve in IS-LM-PC Framework
(in response to a decline in the Source: Authors’ own compilation.
nominal rate of interest), the
level of activity could actually
decline instead of rising.
Therefore, only when the real balance effect and the Keynes effect are not
undermined in the manner indicated above, a downward sloping aggregate
demand curve can be generated. However, it is often presumed to be so in the
IS-LM-PC framework.11 This assumption is necessary to obtain the anti-
Keynesian result that a sufficient degree of flexibility of wages and prices will
allow the achievement of full employment. Such a conclusion runs contrary to
Page 11 of 38
Keynes’s argument that a capitalist economy, where wages and prices are very
flexible, will be perpetually unstable.12
Monetarists’ Phillips Curve

Unlike the original Phillips curve, which could be understood in terms of
equation 11 without the price expectation term (static expectations), Friedman
argued that the workers would expect the previous period’s inflation to continue
(an elementary form of adaptive expectations). This would give us the following
expectations-augmented Phillips curve relationship:
(17)
This gives us Friedman’s short-run Phillips curve (SRPC) as shown in Figure 3.2.
From equation 20, ceteris paribus, we get the long-run Phillips curve (LRPC in
Figure 3.2) at an exogenous NAIRU, corresponding to some v* where
that is, inflation is constant. Under certain other additional conditions on the f(.)
function, such as linearity, the exogenous NAIRU may also be unique.
The effectiveness of monetary policy in this setup, in the short run, can be
expressed in the following manner (drawing on a modified version of Gordon
[1976]).
The Phillips curve, in this setup, is in effect a supply-side relationship between

inflation and output. From the demand side, the (p.88)
structural relationship between

inflation and actual rate of money
growth and a random demand
shock is given by:
(18)
Figure 3.2 NAIRU in the Mainstream

Framework
Source: Authors’ own compilation.
Page 12 of 38
Combining the Phillips curve and equation 18 that emerges from the demand
side, one would get a Friedmanian equilibrium:
(19)
Here, even in the absence of unexpected supply and demand shocks, the
economy could deviate from a NAIRU even if there is an planned change in the
money supply because, in the short run, workers suffer from some sort of a
temporary money illusion, unlike the previous case of permanent money illusion.
(p.89) New Classical Phillips Curve

Lucas (1972), however, argued that adaptive expectations essentially means that
the economic agents (in our case workers) do not learn from their mistakes
regarding predictions of inflation. On the contrary, if the agents are rational,
their subjective expectation will be the same as that predicted by the
macroeconomic model at hand if:
1. There is perfect information which implies, for instance, that there are
no unanticipated shocks.
2. There are either no non-linearities in the macroeconomic model or the
problems that arise out the existence of these non-linearities are assumed
away.
Broadly, two approaches have been followed:
1. Lucas and Rapping (1972) argue that firms and workers take rational
decisions reflecting optimizing behaviour on their part;
2. Lucas (1972) argues that the supply of labour (or output) by workers
(or firms) depends on relative prices in a conventional neoclassical
manner. In order to maintain continuity in notation, we will show these
results in the framework that we have used so far.
This changes equation 12 into the following,
(20)
This would mean that the workers would correctly anticipate the inflation
resulting from increase in money supply, that is, . This would
change the Friedmanian equilibrium given in equation 19 into:
(21)
Page 13 of 38
This means that in the absence of random demand and supply shocks, any
expected monetary policy would have to be ineffective since f(vt) = 0. Only
unanticipated monetary surprises can make the unemployment rate deviate from
the NAIRU. Hence, the name Lucas’s surprise function. In that case, even in the
short run, the economy is at the NAIRU (see LRPC in Figure 3.2). In other
words, there is a vertical Phillips curve.
(p.90) Even while remaining in a neoclassical framework such as the one set
out above, some criticisms of Lucas (1972) can be advanced. Here, we confine
ourselves to problems that arise out the existence of non-linear macroeconomic
relationships.
1. If there are non-linear macroeconomic relationships, there may exist

multiple equilibria. Rational expectations in such a situation will no
longer coincide with perfect foresight. Therefore, it is possible that
different agents may have rational but different expectations regarding
the equilibrium (Asada et al. 2010).
2. If there are non-linear macroeconomic relationships, the dynamic
processes underlying the learning algorithms of agents may not be stable.
This means that agents may not be able to develop perfect foresight
(Evans and Honkapohja 2001).
Mainstream Macroeconomic Consensus with Endogenous Money

So far, what we have considered are cases where the money supply is given
exogenously. However, more recent developments in mainstream consensus have
accepted (though hardly ever acknowledged) Kaldor’s argument against the
monetarists’ assumption of exogenous money stated by him in The Scourge of
Monetarism (1986). In other words, it is not money demand which adjusts to
money supply but the other way round.
In the new Keynesian macroeconomic consensus, endogenous money is present

in, for instance, ‘Keynesian Macroeconomics without the LM Curve’ (Romer
2000). Romer argued for a Keynesian macroeconomics without the LM curve
since the central bank attempts to influence the economy by changing the rate
of interest rather than the money supply. Bofinger et al. (2006) present a three-
dimensional macroeconomic model of the New Keynesian macroeconomic
consensus. This subsection draws on that contribution and advances a critique
of the same. While we present below a static version of the New Keynesian
model, it is actually a dynamic model with microfoundations. A depiction of this
approach can be found in Gali (2009).
The IS curve remains the same as before.13 In the money market, instead of
fixing the supply of money, the central bank fixes the policy (p.91) rate of
interest. It does so keeping in mind the twin objectives of price and output
stability. While it is true that the central bank can only fix the nominal rate of
Page 14 of 38
interest, the authors argue that a central bank with credibility also anchors
expectations about inflation by making forecasts. If their announcements are
credible, the central bank can influence the rate of inflation. Under these
circumstances, the central bank controls the real rate of interest by controlling
directly the nominal rate of interest and indirectly the expectations about
inflation. This policy stance has come to be known as the Taylor rule or, more
generally, as an interest rate adjustment rule.
Coming in the backdrop of the Lucas’s surprise function, the Phillips curve of
the New Keynesian framework resembles the shape of a Friedmanian Phillips
curve, though for a completely different reason. While agreeing with Lucas in
the long run on the Phillips curve being vertical, New Keynesians question his
argument for the short run because of the presence of price/wage rigidities
arising out of imperfect competition (see New Keynesian SRPC in Figure 3.2).
Since the New Keynesian Phillips Curve (NKPC) is a key component in the New
Macroeconomic Consensus, it needs to be discussed in some detail. (Goodfriend
and King 1997 present a comprehensive survey of this approach.) New
Keynesians attempt to resurrect the traditional idea underlying the Phillips
curve that monetary policy can be effective in the short run, which they show in
models with microeconomic foundations and rational expectations.14
There are different ways of formulating price rigidity. Calvo (1983), Fischer
(1977), and Taylor (1979) introduced some of the best known formulations. Gali
(2009) and Gali and Gertler (1999) follow the simpler Calvo pricing, which is
used here. Price rigidity is captured by assuming that in each period, only a
random fraction of firms reset their price based on a profit maximization
exercise. The optimal price under monopolistic conditions is given by
, where is a constant mark-up. When reseting its price, each firm
takes into account that this price might be fixed for many periods. Hence, it
chooses a price zt such that the following expected loss function is minimized,
(p.92) This would give us NKPC (after solving the stochastic differential
equation above)15 in a familiar format, where ON is the level of output
corresponding to the NAIRU and O − ON is called the output gap.
(22)
Page 15 of 38
It can be checked that in the absence of price rigidities , the NKPC

becomes vertical at O = ON, that is, the Phillips curve à la Lucas. However, in the
presence of price rigidities O, need not necessarily be ON. Aggregate demand
becomes the determining factor of the actual level of output in the short run.
The central bank can direct the output level towards ON by changing r in the
following manner. It has been assumed in what follows that the credibility of the
central bank about inflation announcements alters the NKPC as shown in Figure
3.3.
(23)
This has become a benchmark model for making monetary policy. It can be seen
that through the the use of a policy of adjusting the interest rate along the lines
set out in Figure 3.3, a capitalist economy can be driven towards the ‘bliss point’
of output and price stability by aiming at the achievement of the
desired level of r which is r0 (see Figure 3.3). How does this work?
Suppose, to begin with, the economy is functioning at a level of output that is

lower than the desired one. A lower level of output also gives rise to an inflation
rate that is lower than the desired rate. This prompts the central bank to bring
down the interest rate. Due to the decline in the interest rate, investment and
output will rise. This goes (p.93)
Page 16 of 38
(p.94) on till the bliss point is

achieved after which no monetary
policy intervention is required.
A critique of the New Keynesian
Macroeconomic Consensus is
advanced in the next section.16
A Heterodox Approach to
Monetary Macroeconomics
While the mainstream
consensus, old and new,
interpreted Keynes in a
particular way, there has been a
parallel development of the
ideas of Keynes and Michal
Kalecki.17 Working within a
heterodox perspective,
Robinson (1971: 82–4) authored
a critique of the IS-LM version
of the neoclassical ‘synthesis’,
characterizing it as a counter-
revolution against Keynes
(1936).
Some criticisms of the Figure 3.3 Monetary Policy in the New

mainstream macroeconomic Keynesian Framework
consensus from a heterodox Source: Authors’ own compilation.
perspective are as follows:
1. In the mainstream macroeconomic consensus, investment is postulated

to be a function of the rate of interest in the IS curve. Thereby, a critical
determinant of investment, that is, the expectations of future profits that
may accrue to current investment projects is assumed away.
2. An upward sloping LM curve which is only a function of the current
rate of interest assumed: (i) explicitly, money to be exogenous and (ii)
implicity, a stable liquidity preference independent of the state of
expectations about the future rates of returns on financial assets.
The effectiveness of monetary policy in the IS-LM framework is undermined

once expectations à la Keynes are introduced in both these relationships.18
While it is true that by bringing in the possibility of a liquidity trap, the IS-LM
framework put a limit to the role of monetary policy, Keynes’s emphasis on the
limitation of monetary policy was independent of the liquidity trap.
Page 17 of 38
In this context, Joan Robinson (1971: 84) writes: ‘If Keynes own ideas were to be
put into this diagram, it would show IS as the volatile element, since it depends
upon expectations of profit; the case where full employment cannot be reached
by monetary means would be shown by IS falling steeply and cutting the income
axis to the left of full employment’.
(p.95) Therefore, even in the absence of the liquidity trap, the economy would
not necessarily settle down at the full employment equilibrium. See Patnaik
(2009: 161) for a more nuanced critique of the IS-LM interpretation of Keynes.
In terms of our AD-PC framework, it would mean that the AD curve cuts the
unemployment axis before v0. It can be understood that, contrary to Lucas’s
logic of a capitalist economy being in full employment equilibrium in the absence
of rigidities and surprises, there will be no equilibrium if the PC is vertical at
v0.19 Therefore, in a world of exogenous money as depicted by the IS-LM model,
monetary policy might not be effective if the expectation of future profits from
current investment is tinged with pessimism.
A critique of the new macroeconomic consensus and the development of an

alternative requires us to break down the different relationships mentioned in
the three functions IS-MP-PC of equation 23.
Kriesler and Lavoie (2007) present a critique but they focus primarily on the
Phillips curve, while keeping the other two functions intact. Our attempt here is
to present a more comprehensive critique. We start with the investment
function.
In the following, for simplicity, an inverse relationship is postulated between the

degree of capacity utilization and the rate of unemployment. The technological
output capital ratio is also normalized to unity.
Towards a Heterodox Investment Function

Kalecki (1937) is a point of departure in formulating a heterodox investment
function. In the heterodox tradition, as set out in this section, since investment
of the individual capitalist is not modelled separately, investment refers solely to
aggregate investment, unless the contrary is explicitly indicated.
Kalecki (1937) argued that the two reasons put forward to explain the negative
slope of the MEI in Keynes (1936), namely diseconomies of scale and imperfect
competition,20 are both invalid.
To begin with, diseconomies of scale may be relevant only when the capital stock
is given but the very act of investment increases the capital stock, invalidating
the premise of diseconomies of scale, that is, the fixity of some factor of
production.
Page 18 of 38
Further, Kalecki (1937) argued that in competitive conditions the MEI schedule
should be horizontal, the level of which would be given (p.96) by the project
which has the highest prospective profitability. This would, however, make the
level of investment indeterminate as can be seen from equation 4 since both the
LHS and the RHS are constant. What brings about the equilibrium then?
Kalecki (1937) argued that the assumption that the magnitude of risk borne by
capitalists is independent of the level of investment, is untenable. As the
magnitude of investment increases, it is likely that a part of that investment
starts getting financed by external sources. Given the asymmetry of information
about profitability between lenders and the borrowers, the lenders ask for a
higher risk compensation as the leverage (or debt–equity ratio) rises.
Capital accumulation in such a macroeconomic framework would be different

from its counterpart in Keynes (1936). In the margin, the choice between holding
capital stock and financial assets may be expressed mathematically as follows:
(24)
The LHS of the second line of equation 24 is obtained by differentiating

with respect to I.
This equation may be compared to equation 4 in order to see the differences

between the viewpoints of Kalecki and Keynes as far as the MEI is concerned
(see Figure 3.4).
We now extend this framework to the case of a capitalist economy characterized

by both pervasive oligopolistic structures and increasing returns to scale. This
implies that the MEI is an increasing function of the amount of investment
(Steindl 1945). Further, an upper bound to the magnitude of investment by a
firm is set by the market share of that firm.
These macroeconomic formulations can be represented mathematically as

follows:
(25)
(p.97)
Page 19 of 38
This would give us a kinked

investment schedule with an
upward sloping portion that
depicts increasing returns to
scale followed by a vertical
schedule determined by the
current rate of capacity
utilization (p.98) (Figure 3.4: a
and b). It can be seen that for
such a system,21 a change in the
rate of interest would not
significantly impact investment
Figure 3.4a Keynes’s Downward Sloping
unless:
MEI vs Kalecki’s Horizontal MEI and
• the rate of interest is very Principle of Increasing Risk
high or Source: Authors’ own compilation.
• that the risk of leverage is

very high (typically true for
smaller firms) (see Figure
3.4: a and b).
An inverse relation between the

rate of interest and investment
follows only in these two cases.
This can be captured by
postulating an investment
function:
Figure 3.4b MEI in an Oligopolistic
• which is less responsive to
Setup
the rate of interest,
especially when the interest
rate is low;
• even this response depends on the degree of capacity utilization. At higher

rates of capacity utilization, the effect of interest rate is limited.
Moreover, in heterodox macroeconomic models, the distribution of income plays

a central role in the determination of aggregate demand. This is incorporated
into our framework by assuming that workers consume all their wages while a
fraction s, where (0 < s < 1) of profits is saved.
The aforementioned arguments can be represented mathematically as follows:
(26)
Page 20 of 38
The above investment function is merely one way of expressing the

aforementioned arguments. No special significance need be attached to the
particular functional form that has been advanced.22
The three components of the investment function, set out above, can be
explained as follows:
(p.99) 1. is the autonomous component of the investment function

reflecting the role of long-term expectations;
2. represents the accelerator wherein an increase in the current
degree of capacity utilization increases investment in the future;
3. the third term of the investment function represents
the impact of the real rate of interest on investment. The sensitivity of
investment to changes in the real rate of interest is itself an increasing
function of the degree of capacity utilization.
The resulting IS curve is a rectangular hyperbola in the (u, i) plane.23 Totally

differentiating the IS curve in order to calculate the derivative of u with respect
to i, one obtains:
(27)
The following properties are deducible from this IS curve.
First, the impact of a change in the interest rate on the degree of capacity
utilization is negative, along an IS curve. By inspection it is clear that the
aforementioned negative relation requires the following term in the numerator
to be negative. This can be demonstrated as follows: to begin
with, in equation 26, the denominator of the IS curve is assumed to be positive.
In macroeconomic terms this implies that savings is more sensitive than
investment to changes in the degree of capacity utilization. Further, subtracting
unity from sides from the LHS and RHS of the IS equation in equation 26 we
obtain an expression whose RHS has the term in the numerator.
Since the LHS of the aforementioned transformed equation is negative by
Page 21 of 38
definition (since ) and the denominator of the RHS has been assumed to be
positive, it follows that .
Second, in accordance with the arguments made above, we are assuming a small
magnitude of . In our formulation, the impact of changes in the interest rate on
the degree of capacity utilization is limited, along an IS curve. Further, when the
degree of capacity utilization is in the neighbourhood of unity, the
aforementioned impact becomes negligible.
Third, the degree of capacity utilization is directly related to the state of long-
term expectations captured here by , along an IS curve.
(p.100) Towards a Heterodox Phillips Curve

We begin with a critique of the NKPC. For any policy of inflation targeting to be
meaningful, the Phillips curve needs to be downward sloping in the (v, π) space.
This is clear from a perusal of equations 12, 20, and 22.
As shown in the previous section, in mainstream macroeconomic frameworks the

central bank steers the economy towards a desired combination of output and
inflation by using either the money supply (exogenous money) or the nominal
interest rate, which along with credible projections of the inflation rate affects
the real rate of interest (endogenous money). However, if it can be shown that
the Phillips curve is horizontal, any change in the level of economic activity will
not lead to a change in the rate of inflation.
Given the importance of the slope of the Phillips curve for ascertaining the
effectiveness of monetary policy, let us scrutinize the Phillips curve in the light of
heterodox macroeconomics. Kriesler (2007), Patnaik (2009), and Rohit (2013),
among others, present macrotheoretical formulations that can be read as
containing a Phillips curve with horizontal segments, as a constitutive
component.
The genesis of an downward sloping Phillips curve, both old (equation 12) and
new (equation 22), alike, lies in an upward sloping average cost curve. Let us
examine the factors that underlie the positive slope of the average cost curve.
In equation 11, where we first established a positive (negative) relationship

between inflation and the capacity utilization (unemployment rate), it came from
the fact that the rate of growth of the ex ante wage share rises (falls) with the
level of capacity utilization (unemployment rate). In most of these
macroeconomic frameworks, it is taken as self evident. Let us scrutinize this
allegedly self-evident phenomenon.
There are two components of the rate of growth of the ex ante wage share,
namely, the rate of growth of real wages and rate of change of labour required
Page 22 of 38
per unit of output (reciprocal of labour productivity). It is usually assumed that

both rise (fall) with capacity utilization (unemployment rate):
1. The rate of growth of the real wage rate is postulated to be an

decreasing function of the unemployment rate because (p.101) higher
unemployment reduces the wage bargaining power of the working class.
2. The productivity of labour is occasionally postulated to be a decreasing
function of the unemployment rate on account of diseconomies of scale.
However, both these arguments can be questioned, especially in the context of a

labour surplus economy like those in the periphery.
Due to the persistence of a burgeoning reserve army of labour, the bargaining

strength of the workers as a whole in peripheral economies24 such as India, is
not linked to the rate of unemployment (or capacity utilization). This tendency
has accelerated after the contingent evolution of the neoliberal project in
countries such as India (after 1991).25
Moreover, Kalecki (1937) had argued that there is no reason why there should be
diseconomies of scale when capital stock is expanding due to investment. When
the employed labour force and the utilized capital stock rise in tandem, it would
be imprudent to postulate diseconomies of scale.
The accounting expression for the rate of growth of real wages can be
mathematically expressed as follows:
(28)
In the absence of diseconomies of scale (y is constant) and a lack of adequate

bargaining strength of the workers in countries such as India ( is constant),
the Phillips curve might become horizontal:
(29)
(p.102) Equation 29 has been derived from equation 28 through a process of

logarithmic derivation with respect to time. The horizontal Phillips curve can be
expressed in geometric terms as follows: in the (π, u) space, the Phillips curve is
Page 23 of 38
independent of u. Further, in the derivation of the horizontal Phillips curve (that

is, equation 29), it has also been assumed, for simplicity, that: the profit margin
is constant and the rate of change of the nominal wage rate equals the expected
rate of inflation.26
Some heterodox macroeconomic models of inflation deal with a peripheral

economy along the lines of Taylor (1983), who attempted to formalize the
following insight of Kalecki (1943): Whereas the the prices of manufactured
products are cost-determined (due to the presence of excess capacity and
oligopoly), the prices of primary commodities are demand-determined. Let us
divide the overall price level into two parts: price of manufactured goods pm and
primary commodities pa with their relative weights being and ,
respectively. Here is assumed to be a constant for simplicity.
These formulations can be mathematically expressed as follows:
Cost-determined Manufacturing Prices

The equation of the price of the manufactured commodity in a peripheral
economy such as India can be expressed as follows:
(30)
(p.103) Here, it has been assumed that the production of the manufactured
commodity requires a floor level of imported circulating capital inputs, that is,
raw materials such as oil (Patnaik 1994).
Workers, as a whole,27 in peripheral countries such as India, do not have

adequate bargaining power to even proximately aggravate the inflationary
problem as we have argued here.
However, the problem of price stability could still arise at higher rates of
capacity utilization when the inflationary barrier is encountered if the real
wages of the workers are already at a subsistence level. This problem could
arise due to the increased strength of the capitalists whose profit margins have a
Page 24 of 38
tendency to rise with the rise in the degree of capacity utilization (Rowthorn
1977).
Further, there is a tendency for a downward inflexibility in profit margins in the

manufacturing sector of peripheral countries such as India on account of:
• a relatively large fixed capital component in total costs of production.

Average cost (AC) equals the sum of average variable cost (AVC) and average
fixed cost (AFC):
(31)
Let prices be set as a mark-up over average variable costs where the mark-up
is large enough to yield a positive profit margin after accounting for total
fixed costs (TFC). Now, if there is a fall in output, that would increase AFC
and, therefore, impart a downward inflexibility to profit margins.
• increases in the bargaining power of capitalists that are supplementary to

changes in the degree of capacity utilization. These may be broadly defined as
a process of further concentration and centralization of capital and are
promoted by the actions of the state in a neoliberal regime (Patnaik 2007).
On the basis of these arguments, the price equation for manufactured products
(in peripheral countries such as India) yields the following expression for the
rate of inflation for manufactured commodities:
(32)
(p.104) Here, a negative value of represents the effect of a rise in prices of

imported raw material like oil (rise in p0) or a currency devaluation (rise in ).
Equation 32 gives us a kinked inflation curve with the kink occuring at u = u0. To
the left of the kink, the Phillips curve is horizontal for the reasons explained here
and to its right, it is positively sloped. It is quite clear that inflation targeting
through monetary policy can be effective only when the economy is operating at
a degree of capacity utilization that exceeds u0.
When the economy is operating to the left of this kink, monetary policy that aims
at inflation targeting through output-deflationary means will cause a decline in
the degree of capacity utilization without any appreciable decline in the rate of
inflation. Such a policy would be stagflationary. Unsuccessful attempts of the
RBI in the recent past in controlling high inflation through interest rate hikes
are possibly attributable to the Indian economy currently operating on what
could be designated as a horizontal segment of the Phillips curve.
Page 25 of 38
Demand-determined Primary Commodities Prices

Inflation in the primary commodities market can be understood as the
interaction between the demand and supply of these products. This process does
not occur in a neoclassical manner since the neoclassical law of supply and
demand requires the operation of the imaginary Walrasian auctioneer.28 Owing
to the fact that the output is fixed in the short run, an increase in their
demand would lead to an increase in the prices of these commodities.
A straightforward decomposition of the demand for such commodities would

include components such as:
• consumption (Ca),
• circulating capital inputs (Ja),
• exports (Ea), and
• speculation stock holding .
One source of demand for primary commodities is the domestic manufacturing

sector. This will include demand for food (and related items) by the workers and
demand for these commodities as circulating capital inputs by the capitalists of
the manufacturing sector. This establishes a positive relation between the
demand for these primary commodities and the degree of capacity utilization in
the (p.105) manufacturing sector. This can be expressed as follows: both (Ca)
and (Ja) are increasing functions of u.
However, the extent of this influence is dependent on the fraction of income

devoted by workers to the consumption of primary commodities and the input of
primary commodity required per unit of manufactured sector output.
The equation expressing the rate of inflation of such primary commodities can
therefore be expressed as follows:
(33)
It can be seen that an increase in exports or a larger volume of speculative stock

holding of these primary commodities will enhance the tendency towards
inflation of their prices, if the output of such commodities does not rise pari
passu.29
This inflationary tendency will be more marked in case of primary commodities:
• for which speculative stock holding as a proportion of output rises over

time;
• such as minerals, where concentration of mine ownership rises over time;

Page 26 of 38
• such as food crops which are facing adverse shifts in acreage in land
devoted to their cultivation.
If all these three factors are induced by the contingent evolution of the
neoliberal project in peripheral economies such as India, deflationary monetary
policy will have little role in containing the inflationary tendency in these
commodities.
Macroeconomic Interaction of Cost-determined and Demand-determined Prices in a

Peripheral Economy
By bringing the two components together and assuming adaptive expectations,
we obtain the following expression for what may be christened a heterodox
Phillips curve for peripheral countries such as India:
(34)
(p.106) This tells us that the steady state rate of inflation in such an economy
depends on those factors which:
• underlie the inflationary tendency in primary commodities,
• determine the trends in the prices of imported circulating capital inputs,

and
• determine the profit margin in the domestic manufacturing sector.
A horizontal Phillips curve may be represented as a relationship between and u

for a given level of in equation 34. An increase in will lead to a parallel
upward shift of the horizontal Phillips curve (or its horizontal segment) in the
space. Along the steady state, the overall rate of inflation does not equal,
in general, the rate of inflation of primary commodities.
Monetary Policy Rule in a Peripheral Economy

The modus operandi of every interest rate policy adjustment process (such as
the Taylor rule) derives, in a way, from Kaldor (1986). Kaldor argued that
interest rate—and not money supply—is a policy instrument of the central bank.
The operability of a monetary policy based on the Taylor rule is based on the
presumption that the central bank can influence the real rate of interest.
However, as shown in the previous section, the rate of inflation is a complex
phenomenon, especially in peripheral economies such as India. It may not be
unduly influenced by central bank announcements.
Page 27 of 38
In such a situation, to assume that there is a one-to-one correspondence

between the nominal and real rates of interest would, at best, be a facile reading
of an involved economic phenomenon. Since the central bank can only control
the nominal rate of interest, one variant of a central bank’s monetary policy rule
can be written as:
(35)
Let us assume that the central bank is targeting a rate of interest which, for a
given rate of inflation, yields a real rate of interest which satisfies the stated
objective of output and price stability. Despite this, (p.107) the central bank
might not be in a position to steer the economy towards the twin objectives of
output and price stability. Let us see why.
Effectiveness of Monetary Policy

Monetary Policy and Output Stability
An attempt to increase the level of activity towards u = u0 requires the interest
rate to decline. But this would increase the level of activity only if:
1. A decrease in the bank rate or any other policy interest rate of the
central bank results in a decline in the lending rate at which fixed capital
loans are advanced. However, the existence of oligopoly in the
commercial banking system may not allow any fall in the aforementioned
lending rate when the policy interest rate is reduced (Lima and Meirelles
2007). Further, if the degree of capacity utilization is low or falling, then
banks would not want to reduce lending rates since that would attract
less credit-worthy borrowers. However, if commercial banks did go ahead
and reduce lending rates, more or less, in proportion to the policy
interest rate, when the degree of capacity utilization is low or falling, it
would result in an increase in financial fragility (Ghosh and
Chandrasekhar 2009).
2. Inflation does not decrease in the same proportion to leave the real
rate of interest constant. However, inflation could rise if this borrowing is
used for a variety of speculative activities that need not result in
appreciable increases in output; at best it may result in boom–bust cycles
in asset prices (Patnaik 1994).
3. Investment function is responsive to real interest rates. However, if the
investment function is such that at low rates of capacity utilization the
responsiveness of investment to the real interest rate is itself negligible, a
reduction in the real interest rate may not cause an appreciable increase
in investment. This phenomenon is represented by the third term of the
investment function set out in equation 26.
Page 28 of 38
(p.108) Monetary Policy and Price Stability

A horizontal Phillips curve (or a Phillips curve with a horizontal segment) in the
manufacturing sector is an impediment in any endeavour to control overall
inflation. Inflation resulting from an increase in speculative activities or exports
of primary commodities or inflation in imported commodities such as oil cannot
possibly be tackled by monetary policy. This is so because the only role that
monetary policy can play is through an indirect decline in the level of inflation of
primary commodities by compressing the demand for these commodities (Figure
3.5).
Moreover, even this deflationary monetary policy will reduce the rate of inflation
only in the following cases:
1. An increase in the bank rate or any other policy interest rate of the
central bank results in an increase in the lending rates of commercial
banks. However, deregulation of the commercial banking system, which is
an inalienable part of the contingent evolution of the neoliberal project in
peripheral countries such as India, has resulted in a decline in the central
bank’s sway of commercial bank lending. This manifests itself as a
reduction in the effectiveness of the transmission mechanism of monetary
policy (Chandrasekhar and Pal 2006).
2. Inflation does not increase in the same proportion to leave the real rate
of interest constant. However, inflation may rise steeply due to the cost
push channel of monetary policy wherein a higher nominal interest rate
leads to an increase in the average costs of capitalists and therefore
prices, for a given spectrum of their profit margins (Lima and Setterfield
2010; Patnaik 1997).
3. The investment function is responsive to increases in the interest rate.
However, when the degree of capacity utilization is high, the impact of a
higher interest rate may be swamped by the strong accelerator effects of
higher capacity utilization. This may be represented as follows in the
investment function set out in equation 26: If the degree of capacity
utilization is high, the magnitude of the second term of the above-
mentioned investment function may exceed its third term. This is likely as
the third term of the above-mentioned (p.109)
Page 29 of 38
(p.110) investment
function tends to zero
when the degree of
capacity utilization is in
the neighbourhood of
unity.
4. A decline in the
degree of capacity
utilization in the
manufacturing sector
has a substantial and
concomitant negative
impact on primary
commodity prices.
Further, this will require
a fall in (Ca) and (Ja) to
be accompanied by non-
compensatory changes in
the levels of speculative
stock holding and
exports of primary
commodities Ea.
However, the latter may
Figure 3.5 Stagflationary Monetary
rise due to policies that
Policy in a Heterodox Framework
arise out of the
contingent evolution of
the neoliberal project in
peripheral countries such as India (Chandrasekhar 2012; Patnaik 2012).
In the model presented here, there is a likelihood of the non-satisfaction of all

the four conditions listed. This could lead to the inability of monetary policy to
control inflation. The more likely outcome is stagflation.
Monetary policy has been under discussion both before and after the general
theory propounded by Keynes. While Keynes was sceptical of its efficacy, the
current mainstream macroeconomic consensus accords it primacy in the process
of maintaining price and output stability. Moreover, between these two
objectives, the former has been accorded primacy over the latter in the policy
prescriptions of the mainstream macroeconomic consensus.
To locate the rationale behind monetary policy, we have presented here a

macrotheoretical survey of monetary policy ranging through Keynes,
Monetarists, New Keynesians, and heterodox approaches. We argue that, unlike
the heterodox interpretations of Keynes, the neoclassical synthesis or the
Page 30 of 38
current macroeconomic consensus have, at best, only partially developed

Keynes’s theoretical insight as set out in The General Theory.
To conclude, unlike fiscal policy, which has the potential of directly influencing
the level of activity, monetary policy can only have an indirect influence as there
may be several links in the chain between cause and effect that may fail to work
along the lines presumed by orthodox macroeconomics.
(p.111) There are a few areas that are not dealt with in this chapter. One, it
deals with monetary policy in a closed economy context. However, with the tools
presented here, one could develop an open economy counterpart of these
macroeconomic frameworks as well. Two, within the heterodox tradition, we
have have not dealt explicitly with Marx’s theory of money. Readers may refer to
Patnaik (2009) for an analysis of the relationship between the monetary theories
propounded by Keynes and Marx. This will require a theoretical reckoning with
the unit of account and means of debt settlement roles of money in a capitalist
economy.
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———. 2012. ‘The Peasant Question and Contemporary Capitalism: Some

Reflections with Reference to India’, Agrarian South: Journal of Political
Economy, 1(1): 27–42.
(p.116) Patnaik, Utsa. 2012. ‘Some Aspects of the Contemporary Agrarian

Question’, Agrarian South: Journal of Political Economy, 1(3): 233–54.
Reserve Bank of India (RBI). 2011. Report of the Working Group on Operating
Procedure of Monetary Policy. Mumbai: Reserve Bank of India.
Robinson, Joan. 1971. Economic Heresies: Some Old-Fashioned Questions in

Economic Theory. London: Macmillan.
Rohit. 2013. It’s Not Over: Structural Drivers of the Global Economic Crisis. New
Delhi: Oxford University Press.
Romer, David. 2000. ‘Keynesian Macroeconomics without the LM Curve’, The

Journal of Economic Perspectives, 14(2): 149–69.
Rowthorn, R.E. 1977. ‘Conflict, Inflation and Money’, Cambridge Journal of

Economics, 1(3): 215–39.
Setterfield, Mark. 2010. Handbook of Alternative Theories of Economic Growth.

Cheltenham: Edward Elgar Publishing.
Steindl, Josef. 1945. ‘Capitalist Enterprise and Risk’, Oxford Economic Papers,
Issue No. 7: 21–45.
Taylor, J.B. 1979. Staggered Wage Setting in a Macro Model’, The American
Economic Review, 69(2): 108–13.
Taylor, Lance. 1983. Structuralist Macroeconomics: Applicable Models for the

Third World. New York: Basic Books.
Taylor, Lance and Stephen A. O’Connell. 1985. ‘A Minsky Crisis’, Quarterly

Journal of Economics, 100(Supplement): 871–85.
Notes:
(1.) Here, output stability refers to a steady positive rate of growth of output
accompanied by a socially acceptable rate of unemployment.
(2.) The demand for some means of consumption may be enhanced when credit
availability to finance the aforementioned demand is enhanced.
(3.) A more complete treatment is available in Patnaik (2009) which provides an

interpretation of Chapter 17 of Keynes (1937).
Page 34 of 38
(4.) A detailed account of how a given level of investment results in a level of

output, that is, the working of a Keynesian multiplier, is provided in Bhaduri
(1986: Chapter 2).
(5.) It is to be noted that we do not treat MEI as a function of the interest rate.
Such a functional relation is a constituent component of the IS-LM interpretation
of Keynes (1936). In many ways, it is a misreading of Keynes (1936). This issue is
further clarified when we discuss Kalecki (1937) later in this chapter, in the
section entitled ‘A Heterodox Approach to Monetary Macroeconomics’.
Moreover, in the latter, the magnitude of investment is not the sole argument of
the MEI function.
(6.) According to Keynes (1937: 216), ‘fluctuations in the degree of confidence

are capable of having quite a different effect, namely, in modifying not the
amount that is actually hoarded, but the amount of the premium which has to be
offered to induce people not to hoard. And changes in the propensity to hoard,
or in the state of liquidity-preference as I have called it, primarily affect, not
prices, but the rate of interest’.
(7.) Buiter (1989) advances a critique of New Classical Macroeconomics from

within a mainstream macroeconomics framework.
(8.) It is to be noted that Hicks (1980) himself pointed out some of the limitations
of Hicks (1937).
(9.) Alternative interpretations of Keynes (1936) are discussed at some length in

Patnaik (2009).
(10.) This functional relation can be derived in ways other than the Phillips
curve; for example, an aggregate supply curve, which even Keynes (1936)
alluded to. In Keynes (1936), while the money wages are fixed, prices increase
with the level of output, marginally at lower levels but significantly as the
activity level gets closer to full capacity.
(11.) The mathematically inclined reader can totally differentiate the three
equations of the IS-LM-PC model with respect to a change in and calculate
the resulting changes in O, i, and . A note must be made here of the fact that
the text talks about the rate of growth of money supply while the LM equation
set out here is in terms of the level of the money supply. The real balance effect
has not been explicitly shown in the model but it can be incorporated through an
increase in .
(12.) Flaschel et al. (1997) provide a demonstration of the conditions under

which wage and price flexibility give rise to macroeconomic instability in an IS-
LM-PC framework.
Page 35 of 38
(13.) While we are using a static IS curve in the text solely for reasons of
tractability, the IS curve in the New Keynesian framework is derived through an
optimization exercise where a representative household is trying to determine
its path of labour supply and consumption over time. Gali (2009) calls the
resulting relation a dynamic IS function. This inter-temporal optimization
condition results in today’s consumption being directly related to the expected
consumption tomorrow and inversely related to the expected real rate of interest
minus the discount rate. The inverse relation results from the fact that a higher
expected rate of interest means a higher opportunity cost for today’s
consumption while a higher discount rate gives lesser importance to tomorrow’s
consumption. Therefore, what matters is the net impact of the two in deciding
the optimal path of consumption. This consumption function, in a baseline
model, is converted into the (v, r) space by abstracting away from other sources
of demand, that is, all output is consumed.
(14.) Gali and Gertler (1999: 196) write as an appraisal of the New Keynesian
approach, ‘[it casts] the price setting decision within an explicit individual
optimization problem. Aggregating over individual behaviour then leads,
typically, to a relation that links inflation in the short run to some measure of
overall real activity, in the spirit of the traditional Phillips curve’.
(15.) See Gali (1999) for the derivation of this relationship.
(16.) Empirical concerns about the tenability of the New Keynesian Consensus
Macroeconomic Framework are not addressed in the critique that is presented
in a later section tited ‘A Heterodox Approach to Monetary Macroeconomics’.
(17.) Though certain parallels can be drawn between the ideas of Kalecki and
Keynes, in many ways their approaches were distinct. While most of Keynes’s
discussions pertained to perfectly competitive markets, Kalecki’s point of
departure was an introduction of imperfect competition into macroeconomic
models of capitalism in a distinct Marxist manner.
(18.) As a critique of the IS-LM interpretation of Keynes (1936), Minsky (1984)

explored the role uncertainty could play in introducing volatility into a capitalist
system through both these relationships. He did it through an alternative
interpretation of Keynes’ theory of investment in terms of demand and supply
price of capital but the essence of his argument has been captured in the
discussion of the investment function further in the section.
(19.) That is why Keynes had argued that fixity of money wages in a short run is
not only a depiction of reality but a logical necessity for existence of equilibrium.
See Patnaik (2009).
Page 36 of 38
(20.) In a perfectly competitive economic regime, the supply curves of individual

firms are horizontal at a given price but the supply curve of an industry is a
decreasing function of its price.
(21.) While this formulation remains true to Steindl and Kalecki’s theory of
investment, it also captures some components of Minsky (1984). Minsky’s
argument that optimism in a capitalist economy results in high investment both
because of buoyant expectations about the market as well as easy credit
availability can be interpreted here as an increase in β even as σ and σ′ decrease.
On the other hand, a pessimistic view results in a decrease of investment
because of a decline in expectations about the market as well as tight credit
markets (a decline in β and sharp increase σ in and σ′). A recovery from such a
pessimistic condition requires the revival of both the conditions, which limits the
role of monetary policy due to its incapacity to influence the first factor; see
Taylor and O’Connell (1985) for details.
(22.) A recent discussion of different investment functions is available in

Setterfield (2010).
(23.) A more appropriate macroeconomic formulation could be one involving an

investment function where changes in the real rate of interest have a limited
impact on investment, both at lower and higher rates of capacity utilization.
Further, the aforementioned impact may be less limited for intermediate degrees
of capacity utilization.
(24.) Patnaik (1997) provides a discussion of the reasons for the persistence of a
burgeoning reserve army of labour in the countries of the periphery.
(25.) Chandrasekhar (2010) provides an analysis of the transition of the Indian

economy from a dirigiste to a neoliberal regime.
(26.) In a peripheral economy such as India, the rate of change of the nominal
wage rate is likely to be less than or equal to the expected inflation rate.
(27.) This does not preclude the possibility that some workers, in peripheral
economies such as India, may be able to protect their real wages in the face of
inflation (such as government employees), while some workers are able to
increase their real wages in tandem with increases in labour productivity,
especially when the level of activity is on the upswing.
(28.) Benassy (1988) is an example of attempts to develop a neoclassical theory

with price making agents.
(29.) Patnaik (1996) presents a theoretical discussion of why an increase in the

export of primary commodities from a peripheral economy may not increase the
output of those commodities. This may be summarized as follows: in peripheral
economies such as India, the scale of production of many primary commodities,
Page 37 of 38
agriculture in particular, is such that complementary overhead means of

production such as irrigation are unlikely to fructify as a result of private
investment. Such complementary overhead means of production require a
suitable magnitude of public investment.
Page 38 of 38
The Evolving Contours of Monetary Policy and Commercial Banking in India

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
The Evolving Contours of Monetary Policy and

Commercial Banking in India
S.L. Shetty
Partha Ray
DOI:10.1093/acprof:oso/9780199458950.003.0004

This chapter traces the evolution of monetary policy and financial sector reform
in India. In terms of broad brush, the chapter presents an analytical account of
the following phases: early years of economic planning, bank nationalization and
credit planning, adoption of monetary targeting, operationalization of liquidity
adjustment facility (LAF) through repo / reverse repo, and the recent
introduction of inflation targeting. In describing the story of commercial banking
development in India, the chapter slices the post-Independence Indian
experience in three wide-ranging segments, and highlights the early years of
banking consolidation, social banking and bank nationalization experience, and
the initiation of financial sector reform process. In presenting an eclectic
critique to neo-liberal financial sector reform, the chapter also raises questions
on institutional and infrastructural weaknesses in the strategy of financial
inclusion in recent period.
Keywords: monetary policy, structural view, multiple indicators approach, monetary targeting,
inflation targeting, bank nationalization, finance-led growth, financial inclusion
The idea of monetary policy in its most primitive form is perhaps associated with
existence of currency—metallic, paper, or any other form. From this standpoint
it can be traced back in ancient civilizations. However, institutionally, monetary
policy as independent of executive action perhaps began to be established with
the creation of the central bank of Sweden (Riksbanken), the world’s first
central bank founded in 1664, and the Bank of England in 1694, which acquired
Page 1 of 106
the responsibility to print notes and back them with gold. From that standpoint
the notion of monetary policy is intimately interlinked with that of a central bank
and the idea is little over 300 years old—in the timeline of progression of ideas it
can, thus, be seen as a relatively young entrant.
What is monetary policy? The Frequently Asked Questions (FAQs) section of the
US Federal Reserve Board, the central bank of the US, defines the term
monetary policy as, ‘the actions undertaken by a central bank…to influence the
availability and cost of money and credit as a means of helping to promote
national economic goals’.1 But, in reality, monetary policy operations are more
complex in nature and they differ from period to period, from country to country,
and from one stage of development to another. It may be useful to turn to what
(p.118) the UK’s Radcliffe Committee said in this context: ‘Monetary Policy is
necessarily moulded by the world in which it takes shape. The scope for its
exercise is not invariable, and the aims which it is intended to serve, the
resolution with which it is applied, and the techniques which give it effect are all
conditioned by the facts of the economic situation and the ideas of the time’ (The
Radcliffe Committee Report 1959: 6).
From a purely functional viewpoint, since the early twentieth century, central
banks have been found to have played four traditional roles: (i) conducting
monetary policy, including the possible use of lender-of-last-resort powers; (ii)
preserving financial stability; (iii) supervising and regulating banks; and (iv)
safeguarding payment and settlement systems (Blinder 2010). In terms of the
perimeter of this chapter, we focus our attention to the first two functions of
central banks.
The issue of influencing cost and availability of money and credit brings us to
intricate questions on paradigms as well as institutional detail. In a modern
credit-based economy, households and corporates approach primarily the
commercial banks for their credit needs—be it for production (say, working
capital) or for consumption (say, housing) purpose. The determination of cost
and availability of credit is different from the intermediate textbook world of
demand and supply. After all, as the credit market is marked by asymmetry of
information between the suppliers of credit (that is, commercial banks) and
those who demand it, the problem of adverse selection and moral hazard are
common there (Stiglitz and Weiss 1981). Thus, apart from the typical anti-
monopoly concerns in the credit market, a central bank needs to ensure smooth
functioning of the market.2
There is another, perhaps more important, justification for the existence of

central banks. Commercial banks by the functioning of credit multiplier under a
proportional reserve system are extremely leveraged firms, so that winding up
or closing a commercial bank is far more difficult than closing a commodity-
producing firm.3 Besides, as the recent financial crisis has shown, banks could
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be extremely interconnected firms, and hence liquidating them could have

systemic implications and a bank could turn out to be too big to fail. In such a
situation, a central bank needs to ensure the liquidity and solvency of a
commercial bank. Thus, functionally monetary policy and commercial banking
get intimately interlinked.
(p.119) Finally, what are goals of monetary policy? There are two strands of
literature. While in general it is accepted that the goals of monetary policy can
hardly be different from those of national economic policies, during the last two
decades or so, there is an influential view of inflation targeting, whereby the
central bank places an exclusive emphasis on inflation targeting. While a
discussion of the pros and cons of inflation targeting is beyond the scope of the
present chapter, suffice it to say that worldwide there are a number of central
banks that do not place exclusive and singular emphasis on inflation alone.
Illustratively, monetary policy in the US has two basic goals: (i) to promote
maximum sustainable output and employment; and (ii) to promote stable prices.
Central banks all over the world are entrusted with the responsibility of
conducting monetary policy. The agents through which their action gets
transmitted to the economy at large are primarily the commercial banks.
However, unless it operates in an absolute command economy, the central bank
tries to influence the behaviour of commercial banks through various monetary
policy instruments. Thus, the very premise of effectiveness of monetary policy is
that central banks can control the behaviour of commercial banks through the
operations of various instruments of monetary control. Thus, monetary and
banking policy become intimately interlinked.
Against this background, this chapter attempts an analytical account of the

Indian monetary and commercial banking policy over the 60-year period 1950–
2010.4 Three traits of this chapter may be mentioned at the very outset. First, in
the spirit of a survey, the chapter tries to present the opinion and counter-
opinion on any issue and makes a conscious attempt to refrain from imposing
any prior opinion on the reader. This is all the more important in dealing with
charged issues such as public ownership of banks, financial liberalization, or
financial exclusion. Second, it goes beyond a survey and looks into the evolution
of monetary and banking policy in India and discerns the broad trends and
twists in it. Finally, the sweeping account (for the sake of brevity) of the chapter
is complemented with citation of relevant works, so that while getting a broad
view, the reader can always go back to the references, depending on his/her
interests. Thus, in character, the chapter stands mid-way between a survey and
an analytical description of broad trends in monetary and banking variables over
a fairly long time period.
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(p.120) It is indeed difficult to cover the story of the evolution of monetary and
banking policy in the Indian economy over a long, 60-year period 1950–60 in the
space of a short chapter. As its path is often non-linear, in telling a cohesive story
one tends to find landmark developments which make it possible to slice the
time domain into sub-periods of coherent policy themes. We follow this approach
in describing the evolution of monetary and banking policy in India over the
period 1950–2010. We thought this descriptive abstraction is going to provide a
useful handle on periods of time with relatively stable characteristics. While
these blocks are determined on the basis of timing of introduction of a new
policy regime, the extent of overlapping attributes around the year of
demarcation for each time block cannot be ruled out.
The organization of rest of the chapter is fairly straightforward. While the

following two sections are devoted to the evolution of monetary and banking
policy, respectively, the subsequent section presents the broad tentative
conclusions.
Evolution of Monetary Policy in India5

In describing the evolution of monetary policy in India, we identify four blocks:
(i) 1950–68, portraying a conservative phase of ‘controlled expansion’ and
coinciding with the first three Five Year Plans; (ii) 1968–85, experiencing
structuralist flavour of policy following the nationalization of the commercial
banking sector in 1969; (iii) 1985–97, beginning a liberal phase and coinciding
with the period of monetary targeting; and finally (iv) 1998–2010, beginning
with the ‘multiple indicators’ approach.
While these phases are discernible rather distinctly as the underlying operating
environment for monetary policy has undergone significant transformation,
transition from one phase to another has not been sudden and discontinuous. In
fact, as expected, there has occurred spill-over of the monetary policy
framework constituting objectives, instruments, strategies, and operating
procedures from phase to phase and thus considerable overlap can be seen
between such phases. Also, being an integral part of overall economic policy, the
ultimate and broader objectives of growth with price stability or, in its later
formulation, of accelerating economic development with augmentation of
domestic savings and their efficient and equitable (p.121) deployment have
remained the cornerstone of the conduct of monetary policy throughout the five
phases enumerated above. Similarly, the most proximate objectives of monetary
policy, namely, price stability and adequate flow of credit to the productive
sectors at reasonable rates of interest, have remained a common feature in all
credit policy statements of the Reserve Bank of India (RBI) in almost all the
phases. Likewise, many traditional instruments of monetary policy such as the
Bank Rate, cash reserve ratio (CRR), and statutory liquidity ratio (SLR) have
continued to be code names in monetary operation throughout the past 60 years
or so; it is just that their relative importance has waned or diluted over time.
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Besides, the primacy of societal concerns has continued including priority sector
targets in credit distribution, expansion of bank branch network, and other
institutional changes, which dominated the second phase, have faced no let up in
the subsequent phases except for the emphasis on correctives introduced in the
post-reform period to the rapid quantitative growth following bank
nationalization which gave rise to many infirmities; these correctives have also
finally culminated in placing greater focus on ‘financial inclusion’ as a banking
strategy because of the incidence of massive ‘financial exclusion’ in the post-
reform period; the subject has attracted a number of RBI initiatives in the recent
period.
Monetary Policy Instruments

The range of monetary policy instruments deployed in India has been wide,
encompassing both direct (quantity) and indirect (price) approaches (Joshi and
Little 1994). The instruments can be classified according to the area of their
strongest initial impact, that is, whether they operate principally on the supply
of money, through changes either in base money or the money multiplier, or on
the demand for credit through cost and other influences (Singh et al. 1982). As a
prelude to the discussion of monetary policy over different phases, a digression
on the monetary policy instruments is in order.
Reserve Requirements
Reserve requirements or CRR refers to the proportion of the deposit and other
liabilities of the banks suitably defined that has to be kept with the central bank
as a measure of influencing their credit creating (p.122) capacity. At times, it is
considered as a tax on intermediation that constraints the growth of liquidity in
the system. In the Indian context, during the 1980s and particularly during the
1990s, the CRR, with frequent use and its predictable impact, has been most
effective both as an instrument of monetary control and as an anti-inflationary
tool. The effectiveness of the CRR instrument has been further augmented on
occasions in two ways: (i) by making the cost of default on reserve maintenance
expensive for banks; and (ii) by imposing additional CRR requirements (in the
form of incremental CRR) from time to time. In some sense, CRRs have turned
out to be the most used monetary policy instrument.
Statutory Liquidity Ratio

In addition to CRR, central banks in many countries have resorted to stipulating
liquid asset requirements for ensuring liquidity of the banks’ balance sheet.
Adequately designed, they are helpful for prudential purposes in less developed
economies, and can make the banking system more resilient. In India, the SLR
prescription was systematically raised to finance the growing budgetary
requirements of the government. It was once as high as 38.5 per cent during
1990–2; however, subsequently it had been brought down to the statutory
minimum level of 25 per cent by October 1997 or even 24 per cent once.
Page 5 of 106
Bank Rate
The Bank Rate is essentially the rate at which funds are available from the
central bank and have a bearing on the cost of credit. Changes in the Bank Rate
tend to have a dual impact on interest rates, namely, the direct cost of funds for
banks and an indirect signalling impact on interest rates in general. While
changes in the Bank Rate per se are reflective of a shift in the stance of policy
and convey a message about the central bank’s assessment of the monetary
conditions and the directions in which interest rate should more. In India, after
its active usage during the period 1950–65, the Bank Rate as an instrument of
monetary policy became inactive for a long period of time but was reactivated in
April 1997. Even so, its importance has been diluted because of the reductions in
banks’ dependence on RBI for funds, (p.123) particularly in the context of a
more active liquidity management and the emergence of repo/reverse repo rates
as interest rate signals.
Quantum and Cost of Refinance

The refinance mechanism is often used by central banks to influence the level of
bank reserves and short-term interest rates. Although the relative importance of
refinance has gone down in recent years, it plays an important role in
emergency funding of end-of-day imbalances. In India, refinance by RBI had
generally functioned as one of the most active instruments of credit regulation,
but after reforms, sector-specific refinance has been dispensed with except for
the standing facility mainly for export finance. The relative importance of
refinance has varied depending on the degree of liquidity constraints in the
banking system.
Interest Rate on Deposits

Changes in deposit rates are indicative of the overall stance of monetary policy,
which affects the cost of funds of banks and their profitability. During periods of
financial fragility, active competition among banks is discouraged by the
imposition of a ceiling rate on deposits.6 In India too such ceiling rates were
prescribed, but after the 1990s the deposit rates were freed from regulations
except for the singular saving deposit rate.
Interest Rate on Bank Lending

Lending rates have an impact on the demand for credit and the investment
scenario of the economy. While high lending rates may choke investment
demand, they may themselves be indicative of the heating up of the economy
beyond full capacity utilization. In the pre-1991 period, lending rates in India
were also subjected to a host of regulations. Since the mid-1990s, considerable
flexibility has been given to banks to determine their own lending rates with the
introduction of the prime lending rates (PLRs) slated for the best borrowers of
the bank, but the banks in the competitive environment lent about 77 per cent of
Page 6 of 106
loans at sub-PLR rates (Mohanty 2010b). The PLR system has been replaced by a
system of base rate, effective from July 2011.
(p.124) Selective Credit Control

Selective credit controls are usually applied to achieve a reduction in excessive
advances against certain sensitive commodities in short supply and to reduce
pressure on demand originating from bank credit They were introduced by RBI
in 1956 as an adjunct to general credit control and were intended to ensure an
adequate flow of credit to the desired sectors while preventing excessive credit
withdrawal for less essential economic activities.7 Over the years, selective
control measures had become more complex and were subsequently phased out
during the 1990s; the banks have been advised to fix themselves prudential
margins on sensitive commodities.
Open Market Operations

Open market operations (OMOs) refer to outright buying and selling of
securities by the central bank with the money market players, primarily banks.
Central banks use OMOs as a key instrument in managing liquidity conditions in
the system. In India, with increases in capital inflows since the mid-1990s,
OMOs have also served the added purpose of sterilizing inflows to mitigate the
monetary impact. Post-1991, OMOs have complemented the liquidity adjustment
facility (LAF) through repo/reverse repo operations of the RBI as well as the
CRR as a key monetary instrument for liquidity management.
Repo and Reverse Repo

Instead of outright purchases and sales of securities that happen under OMOs,
often the monetary operations of the central bank take place under a repurchase
agreement (repo), referring to the purchase of securities tied to an agreement to
resell them back soon later; the selling parties repurchase them. Similarly, a
reverse repo is the sale of a security tied to an arrangement to buy back later.
The discount rates at which these transactions occur are called repo and reverse
repo rates. Thus, repo rates are the discounted rates at which central banks
purchase government-backed securities for very short periods and inject
liquidity into the banking system. These serve as a method of conveying interest
rate signals and controlling the money supply to promote favourable economic
conditions. For instance, raising (p.125) the rate at which securities are
purchased tends to raise the cost of funds for the banks, influences the size of
bank credit and, in turn, the amount of money available in the economy.
Lowering the discount rate at which securities are purchased creates the
opposite effect. Likewise, raising reverse repo rate, apart from giving the firm
interest rate signals, is expected to contract liquidity accompanied by other
monetary consequences. It is in this context that the RBI introduced the LAF in
June 2000 to manage market liquidity on a daily basis and also to transmit
interesting rate signals to the market. Under the LAF, the RBI’s policy of reverse
repo and repo rates set the novel corridor for overnight market interest rates. In
Page 7 of 106
recent times, as stated earlier, OMOs including LAF have emerged as the
dominant instrument of monetary policy, though CRR continued to be used as an
additional instrument of policy.
Market Stabilization Scheme

With the flood of capital inflows making the sterilization instruments in the
hands of the RBI insufficient, a novel Market Stabilization Scheme (MSS) was
operated for eight years from 2004–5 to 2009–10, with the government agreeing
to bear the cost of such stabilization (discussed later in this chapter).
The history of monetary policy in India in some sense narrates the evolution of
usage of different monetary policy instruments (Table 4.1).
A Period of Controlled Expansion (1950–68)

The dawn of the planning era with the establishment of the Planning
Commission in 1950 introduced a series of challenges for monetary
management. Deficit financing became a major source of plan financing and
hence, the primary source of monetary expansion. In the initial period of
Independence and for the next decade and a half, RBI was confronted with a
number of developments which frontally challenged it to face two sets of
conventional monetary policy objectives, namely, (i) price stability, and (ii)
ensuring of an adequate flow of credit to the productive sectors so as to support
aggregate demand and help high and sustained growth (Mohan 2007).8 (p.126)
Page 8 of 106
Table 4.1 Evolving Usage of Monetary Policy Instruments in India
1950–68 1969–85 1986–97 1998–2011
CRR Active Active Active Active
SLR Active Active Active Active
Bank rate Active Inactive Inactive Active
Refinance facilities Active Active Sector-specific refinance Sector-specific refinance

deemphasized deemphasized
Administered interest Active Active Deregulation of interest Deregulation of interest

rates on deposits and rates started rates almost complete
lending
Selective credit control Active Active Phased out Inactive
OMOs Active Inactive Reactivated since 1992–3 Active
Repo and reverse repo Inactive Inactive Inactive Active

Source: Adapted from Bhattacharyya and Ray (2007).
Notes: CRR: Cash Reserve Ratio
Page 9 of 106
The First Five Year Plan (FYP) period (1951–6) was a quiet one for the economy.
The size of the plan was moderate, befitting the low savings rate prevailing then.
Improved agricultural output and favourable external developments had helped
restore stability in the national economy, particularly after the preceding Korean
boom of 1950–1. Even though the plan programmes were of a modest nature,
the First FYP advanced the concept of developmental central banking and
required the RBI to create an institutional framework for industrial as well as
rural credit to support economic growth all over the country. It pointedly
prescribed the monetary framework thus:
The process of economic development, once started, will make new

demand on the banking system, and this may necessitate changes in
organisation and structure. Central banking in a planned economy can
hardly be confined to the regulation of the overall supply of credit or to a
somewhat negative regulation of the flow of bank credit. It would have to
take on a direct and active role, firstly, in creating or helping to create the
machinery needed for financing (p.127) developmental activities all over
the country and, secondly, in ensuring that the finance available flows in
the directions intended. (First FYP, para 30)9
The period of the Second and Third FYPs threw up unprecedented challenges for
monetary policy. Many years of the period were marked by harvest failures. The
third plan period (1961–7) was found to be the hardest. With two border
hostilities and two years of unprecedented droughts (1961–6), there arose years
of considerable price instability. The two plan periods saw years of
unprecedented inflation rates, touching 13 per cent in 1964–5, 8 per cent in
1965–6, and a post-war high of 16 per cent in 1966–7. The balance of payments
(BoP) situation came under considerable pressure with the current account
deficit shooting up from 1.7 per cent of GDP in 1964–5 to 3.7 per cent in 1966–7.
By the mid-1960s the expansionary impulses from fiscal operations on monetary
aggregates had become more pronounced. The two plan periods saw
progressively stiffer monetary measures as the years rolled by.
The general stance of monetary policy during this phase was described as one of
‘controlled expansion’, in which ‘expansion is at least as important as the
control’ and the RBI depended essentially on conventional instruments of credit
policy ‘devised to meet the objective of a regulated easing of pressures in the
busy season and a similarly regulated constriction of liquidity in the slack
season’ (Pendharkar and Narasimham 1966). The strategy of ‘controlled
expansion’ signified a two-track policy of generally restraining demand while
selectively easing credit. Monetary measures taken during the second plan
period included measures such as increase in the bank rate from 3.5 per cent to
4 per cent in May 1957, signalling selective raising the cost of credit;
introduction of selective credit controls in May 1956; introduction of a system of
higher marginal cash reserve requirements at 25 per cent of the incremental
Page 10 of 106
deposits (for which for the first time interest was allowed) in May 1960; banning
of badla financing by banks against shares; introduction of a quota-slab system
with ‘graded lending rates’ or ‘penal rates’ in October 1960; and active use of
the method of ‘moral suasion’ exhorting banks to desist from expanding bank
credit beyond limits and also to bring down the credit–deposit (C–D) ratio levels
without reducing assistance to essential sectors, particularly industry (Table
4.2). (p.128)
Page 11 of 106
Table 4.2 Bank Rate and CRR during 1950–68
Bank Rate CRR
Effective Date Bank Rate Effective Date CRR Incremental CRR
15-11-1951 3.5 06-03-1960 (a) 5% of DL, (b) 2% of TL 10% of the increase in

NDTL over the level as on
14 January 1977
16-05-1957 4 06-05-1960 (a) 5% of DL, (b) 2% of TL 10% of the increase in

NDTL over the level as on
14 January 1977
11-11-1960 (a) 5% of DL, (b) 2% of TL Measure withdrawn. Cash

balance remained
impounded
03-01-1963 4.5 16-09-1962 3.00% of NDTL
26-09-1964 5
17-02-1965 6
02-03-1968 5
Source: Handbook of Monetary Statistics of India, RBI, 2006.
Notes: TL: Time liabilities
DL: Demand liabilities
NDTL: Net demand and time liabilities
Page 12 of 106
A number of special features stand out from the RBI’s monetary policy
operations during the period. First, fiscal dominance and government’s
interference in RBI’s policy came to the fore. Second, the objective of price
stability became a dominating aspect of the RBI’s thinking in policy operations.
Third, the RBI had followed a specific perspective of monetary policy, ‘which was
to pre-empt funds for a resource hungry public sector and virtually “physical”
rationing of bank funds between competing claimants within the private
sector’ (Balachandran 1998: 127).
A Structuralist Phase of Monetary Policy (1968–85)

An important turning point of this period occurred around the initiation of social
control over banks and the eventual nationalization of major commercial banks
in July 1969. The transition to the second phase was not smooth. The severe
crop failures of 1965–6/1966–7 (p.129) were accompanied by high inflation and
devaluation of the rupee and thus, for a while during the Plan holiday period
1967–9, ‘issues of growth yielded the place of primacy to problems for
stabilisation’ (Chakravarty 1986: 5). Despite sizeable investment in the Second
and Third FYPs, industrial growth had begun to sag much before the crop
failures of 1965–7.10 With a view to providing further fillip to private sector
investment in industries, steps were already taken during 1963–4 and 1964–5 to
set up the Industrial Development Bank of India (IDBI) and the Unit Trust of
India (UTI) as subsidiaries of the RBI. This period was indeed ‘stormy’. Apart
from the political crisis reflected in the fall of two governments and the voting
back of Mrs Indira Gandhi to power in January 1980, failure of monsoon during
1979–80 leading to a steep fall of 15.5 per cent in agricultural production, the
second oil crisis and quadrupling of oil prices, doubling of the overall budget
deficit during the year, were all manifested in nearly 40 per cent increase in
prices in two years, 1979–80 and 1980–1.
In the monetary history of India, this period stands out for the discarding of
conventional strategies of monetary control such as monetary targeting, use of
reserve money or money multiplier processes for monetary policy analytics, or
the reliance on other intermediate targets to signal the stance of monetary
policy. Instead, the RBI consciously moved to focusing on bank credit and its
sectoral distribution as the quintessence of the central banking policy during the
period. The RBI embraced that structuralist viewpoint which was best expressed
by Nicholas Kaldor (1984) in a later lecture he delivered in its very portals:
In my view, the proper test of competence of a Central Bank is how far its
success in ensuring that the banking system grants sufficient credit at the
disposal of industry and commerce so that the true economic potential of
the economy can be reasonably fully exploited without being over-
exploited. In other words, bank credit should expand at the right rate,
Page 13 of 106
neither more nor less. This is neither ensured nor prevented by attempts to
control the vagaries of the money supply.
There were a few socio-political developments of this period which brought

about this radical transformation.
First, there was all-around deep disappointment with the fact that fruits of
development had not reached the vast segments of the population. In this regard
it was worth recalling the growth versus distribution theme Mahbub ul Haq
advanced subsequently, which eventually (p.130) became a major aspect of
India’s development strategy for the Fifth FYP period (1974–5 to 1979–80). In
that context, it was perceived that the banking and financial system could help
to reorient the benefits of development through the following processes: (i)
wider territorial and regional spread of branch network; (ii) faster mobilization
of financial savings through bank deposits; (iii) reorientation of credit
deployment in favour of small and disadvantaged groups all along the production
spectrum which had enormous scope for improving productivity and general
purchasing power; and (iv) as a corollary, reducing economic concentration and
consequential harrowing of the domestic market which was apparently emerging
as a constraint on domestic investment.
Second, analytical works within the RBI had raised misgivings. The second
volume of the RBI history talked of a discernible ‘tightness fatigue’ amongst
senior economists within the bank (Balachandran 1998: 107). The volume
reported how ‘this fatigue was more marked in V.G. Pendharkar’s somewhat
despairing note which questioned whether any link existed between credit policy
and prices in the peak seasons’ (Balachandran 1998: 107). It has also been
reported that apparently T.T. Krishnamachari, the then Finance Minister, also
echoed Pendharkar’s scepticism about the impact of monetary policy in a letter
to the then RBI governor P.C. Bhattacharya: ‘beneficiary effect of monetary
policies on prices was very faint’ (Balachandran 1998: 108). With regard to the
causes of inflation, the RBI Annual Reports and other publications of the period
articulated the perception that inflation was not monetary in character. The
supply side factors and other non-monetary factors played a more dominant role.
K.S. Krishnaswamy, an authority on macroeconomic issues and a Deputy
Governor of RBI, went a step further and described inflation as ‘not so much a
monetary as a social phenomena; its nemesis has to be sought at a fundamental
level, that is, in changes reflected in the socio-economic
structure’ (Krishnaswamy 1976).
Finally, the fundamental driving force in the RBI’s fresh thinking was the series
of institutional steps that the government took at that time: the initiation of
societal control over banks in 1967, the nationalization of banks in 1969, the
Prime Minister’s new economic policy, and the 20-point programme. This was
followed up by introducing an important step of what has come to be known as
Page 14 of 106
‘directed credit’ in the form of targets for ‘priority sectors’ covering all
agriculture, weaker sections, and all other informal sectors.
(p.131) The formulation and conduct of monetary policy by the RBI during the
period was mainly guided by developments on the supply side, essentially trends
in agricultural production, the management of government finances, the size and
mode of financing of the fiscal deficit, and the external sector. In situations of
inflationary pressures there were constant concerns and promoting price
stability became paramount; for this purpose money supply was sought to be
controlled only within the limits permitted by the government’s borrowing
requirement (Balachandran 1998). There were no institutional limits set on the
issuance of government securities. The operational device evolved for this
purpose was issue of ad hoc treasury bills, which started as an administrative
convenience in 1956, tended to precipitate an automatic source for financing the
gaps in government finances.11
An interesting analytical debate cropped up during this period between S.B.

Gupta, accusing that RBI’s monetary analysis was devoid of any theoretical basis
and a number of economists defending it in the pages of the Economic and
Political Weekly (Box 4.1). From the current vantage point it appears that this
debate, in some sense, signified the structuralist versus monetarist paradigms of
monetary analysis.
While allocation of credit and its supervision, primarily through administrative

fiats, emerged as a major task for the RBI, the 1970s witnessed macroeconomic
instability and bouts of inflation—from 10 per cent to 25 per cent for three years
in the first half of the 1970s and another bout of 17 per cent to 18 per cent
inflation in the last two years 1979–80 and 1980–1. The sources of price
instability were many. Border hostility with Pakistan in 1971, droughts in 1973
and 1979, oil shocks and breakdown of the Bretton Woods System—all got
manifested. The RBI used the traditional weapons of direct monetary control as
anti-inflation measures and thus succeeded in bringing inflation under control in
different years of the decade. Monetary policy increasingly took the form of
administrative controls on the cost of credit with supporting refinance and other
direct quantitative controls. In the early 1970s, the RBI began using changes in
CRR as an instrument for the first time and then used it frequently. Between
1973 and 1981, CRR was changed 15 times, mostly increases with only three
downward adjustments (Figure 4.1); on three occasions in 1977–8, the system of
incremental CRR was deployed. (p.132)
Box 4.1 Monetary Policy Analysis during the 1970s: The Debate
between S.B. Gupta and Others
Page 15 of 106
At an intellectual level, a debate surfaced in 1976 on the issue of relevance

of the then prevailing monetary policy procedure. The first dissenting note
came from Professor S.B. Gupta with his article advocating in favour of
‘money-multiplier’ approach. Gupta (1976a) argued that, the then prevailing
RBI’s money supply analysis simply sums up its various components, and
hence merely an accounting or ex post analysis. It was accused of being
tautological in nature and was suggested that money supply analysis needs
to be based on some theory of money supply like ‘money-multiplier’
approach.
However, a number of economists rejected Gupta’s analysis as mechanistic,

and unsatisfactory in theory as well useless in practice (Mujumdar 1976),
and claimed that, RBI’s analysis provides an economic explanation of money
supply. Mujumdar (1976) questioned the basic ingredients of ‘money-
multiplier’ approach, namely, stability of the relationship between money
supply and reserve money, controllability of reserve money and endogeneity
of money multiplier.
Shetty et al. (1976) supplemented Mujumdar (1976) in defending RBI’s

money supply analysis and argued that money supply is both an economic
and policy controlled variable. As an economic variable it may be determined
by the behaviour of the public to hold currency and bank deposits, but as a
policy controlled variable it depends on the monetary authority’s perception
about the appropriate level of primary and secondary money.
Subsequently, a categorical statement to this effect was made in the RBI’s

Annual Report for 1983–4,
Reserve money serves as the base for multiple credit and deposit
creation by banks under the fractional reserve system and provides the
wherewithal for an overall growth of liquidity in the system. To the
extent that credit policy focuses on regulating the overall growth of
liquidity the measures, to be effective, have to work towards
moderating the growth of the reserve money base and the
immobilisation of the reserve money already created in the economy.
At this point a reconciliatory note came from Khatkhate (1976). He

emphasized the usefulness of ‘money multiplier framework’ as suggested by
Gupta (1976a), but was critical of him for accusing the RBI being not aware
of it and commented: ‘Gupta is quite right in suggesting this line, but the
difficulty is that it has no connection with the RBI presentation of monetary
data. And what is even worse is that Gupta does no better than the RBI in
proposing his alternative.’
Source: Economic and Political Weekly, various articles, as cited above.
Page 16 of 106
Since statutorily, CRR could not exceed 15 per cent of the net demand and time
liabilities (NDTL) of the scheduled commercial banks (SCBs), faced with a
situation of high liquidity fuelled by automatic monetization of fiscal deficit, the
RBI had to take recourse to incremental CRR (p.133)
in a number of occasions.
Illustratively, on 26 October 1985,
10 per cent of the increase in
NDTL over the level as on 1
November 1983 was imposed.
One-third of additional cash
balance impounded under 10 per
cent incremental CRR as on 31
October 1981 was released.
The RBI was frontally
confronted with these
unenviable developments: Figure 4.1 CRR (per cent) during 1968–
explosive increase in prices; a 85
large portion of bank credit Source: Handbook of Statistics on Indian
being absorbed by deficit Economy, RBI, various issues.
financing by the central and
state governments; and the
government placing increasing pressure on the bank to expand credit flows to
the priority sectors with the prescribed target being raised from 25 per cent to
33 per cent of net bank credit by March 1979; the burden of financing
procurements and stocking of agricultural commodities being passed on to
banks.12 With the socio-political compulsions of public expenditure and
government borrowings and the need for continuing with priority sector
advances, any suggestion to place a ceiling on money supply growth could not
be accepted. The authorities believed thus: ‘Inflation, in other words, is not so
much a monetary as a social phenomenon; and its nemesis has to be sought at a
fundamental level, that is, in changes reflected in the socio-economic
structure’ (Krishnaswamy 1976: 15). Against the backdrop of such a structuralist
view in July 1974, the government promulgated three ordinances on (i)
compulsory deposit scheme on (p.134) additional wage components, (ii)
restrictions on company dividends, and (iii) the compulsory deposit scheme for
income-tax payers.
Such a structuralist view could not be sustained in totality for long as the
economic situation became difficult and, therefore, the period coincided with
certain measures to liberalize imports and deregulate industry beginning with
1978–9. In that context, there was the need for backing up the country’s
reserves and the International Monetary Fund (IMF) was approached in October
1981 for an Extended Fund Facility (EFF) for a sum of US$ 5 billion as ‘a
medium-term facility with precisely this objective in view, namely, of helping
Page 17 of 106
countries to effect some policy changes on the supply side over a medium-
term’ (Narasimham 2002: 126–7). Within the system the rationale for the
philosophy of reform was provided by the Report of the Committee on Trade
Policies (Chairman: Abid Hussain), which noted (Government of India [GoI]
1984: 82), ‘there is a clear nexus between trade policies, industrial policies and
other economic policies. A complete solution cannot be found in the realm of
trade policies alone; rationalisation of other economic policies is also necessary’.
Monetary Targeting with Feedback (1986–97)

The period from 1985 onwards witnessed the adoption of monetary targeting as
an analytical discipline guiding monetary policy. Though the overall monetary
policy framework with monetary targeting as the strategy and price stability as
the primary goal, begun with the recommendations of the Report of the
Committee to Review the Working of the Monetary System (Chairman: S.
Chakravarty; hereafter referred to as Chakravarty Committee Report; RBI
[1985]), seeds of it can be traced earlier, in particular to the financial
programme initiated under the IMF’s EFF which had monetary control as an
important conditionality;13 the Fund programme imposed intermediate ceilings
for total domestic credit and sub-ceilings on net bank credit to government.
Monetary Targeting
The new framework designated by the Chakravarty Committee as ‘monetary
targeting with feedback’ involves a systematic monetary modelling to begin
with. This modelling exercise is to derive the (p.135) estimates of aggregate
money supply and reserve money consistent with the expected increase in
output and the objective of a desired level of inflation. The equilibrating factor
between the monetary expansion derived from the demand route and the supply
route is the change in the price level. The transmission mechanism involved in
achieving the desired results is indeed complex and a plethora of direct and
indirect monetary instruments will have to be deployed to achieve them. The
medium through which policy signals are supplied and response signals are
received is the money market which has multiple components—call money
market, gilt-edged, foreign exchange, and many more.
Analytically, the report marked a departure from the credit planning paradigm of
the earlier period and its skeletal structure can be conceived of a demand for
money, a supply of money, and a monetary targeting rule, whereby the targeted
monetary growth is expressed in terms of a sum of acceptable level of inflation
and desired rate of growth multiplied by the income elasticity of the demand for
money.14 Five building blocks can be discerned to the analytical framework of
the Chakravarty Committee Report (Rangarajan 2009).15 First, price stability
becomes a major concern as monetary policy instruments are more effective in
relation to this objective than other policy instruments. Second, with a
reasonably stable demand function for money (M3), it is perceived that money
plays a predominant role in the dynamics of inflation. Third, there is a
Page 18 of 106
reasonable degree of association between reserve money adjusted for changes

in reserve requirements and money supply (M3), that is, in the form of stability
in money multiplier. Fourth, necessary understanding between the government
and the RBI on the size of net RBI credit to government, which is a major factor
contributing to reserve money expansion, is a prerequisite. Fifth, a role for
interest rates has been created with positive real rates of interest on
government securities and reasonable correspondence with ‘market-determined’
rates for the organized banking system.
In the Indian context, the Chakravarty Committee Report has faced several
criticisms at the academic level. First, questions have been raised on the
operational validity of the monetary targeting framework, such as those relating
to the measurement of anticipated level of output or acceptable inflation rate
(Datta 1986).16 Second, while hailing the Committee’s report as a landmark, it
has been commented (p.136) that, ‘there is danger…that, because of its [that
is, the Report’s] uncritical market orientation, it may prove a disastrous
landslide. There can be no doubt that, in the present context of India’s
development, credit for purposes of government must be obtained at a
subsidised rate and hence from a captive market. It will be right to indicate the
limits of this captive market’ (Dandekar 1986). Third, the analytical framework
of the Committee has also received criticism that, ‘without denying the
analytical utility of the concept of the money multiplier, it may be pointed out
that too much importance need not be attached to variations in reserve money
as being the prime cause of changes in money supply in, speaking in terms of
the monetary system, a relatively less sophisticated economy such as
ours’ (Economic and Political Weekly 1986).
Despite these critiques, in retrospect, the Chakravarty Committee could be

credited with highlighting the most crucial issue of monetary–fiscal nexus in
monetary policy decision-making in India. A major empirical work in support of
the Report came from Rangarajan and Arif (1990), who, in emphasizing the
interrelationships among money, output, and prices, found that that the price
effect of an increase in money supply is stronger than the output effect. It was
also said that since government revenue collections do not keep pace with
government expenditures as nominal incomes rise, the resource gap widens
during a period of continued price increases.
How do we evaluate the Indian experience of monetary targeting? For objective

evaluation, one can compare the intentions and outcome of monetary growth
during this period (Table 4.3). Purely from the point of marksmanship, out of the
13 years of monetary targeting experience, it is during four years that the target
was achieved. In fact, in terms of institutional features, large recourse to
monetization of government deficit perhaps made the condition of accountability
missing from the framework.
Page 19 of 106
In due course, thus, monetary targeting has given its way in favour of multiple
indicators approach to monetary policy in India. It has been aptly noted that
(Mohanty 2010a: 528–9):
With the pace of trade and financial liberalization gaining momentum

following the initiation of structural reforms in the early 1990s, the efficacy
of broad money as an intermediate target of monetary policy came under
question. The Reserve Bank’s Monetary and Credit Policy for the First Half
of 1998–99 observed that financial innovations (p.137)
Page 20 of 106
Table 4.3 Performance of the Monetary Targeting Regime
Year M3 GDP Inflation M3 GDP Inflation
1985–6 Liquidity growth Output growth of Avoid resurgence 16.0 target 4.1 4.8
lower than that the same order of inflation achieved
in 1984–5 as in 1984–5
1986–7 M3 growth to be Output growth The rate of 18.6 4.3 5.1

contained below somewhat higher inflation should
the high annual than in 1985–6 continue to be
average level of kept under check
the previous four
years, that is,
17.5 per cent
1987–8 M3 growth well 5.0 Avoid re- 16.0 target 4.3 10.7
below the emergence of achieved
expansion in inflationary
1986–7, that is, pressures
18.6 per cent
1988–9 M3 growth to be – – 17.8 10.0 5.7

below the
average for the
previous three
years, that is,
16.9 per cent
Page 21 of 106
1989–90 M3 growth to be 4.5 – 19.4 6.9 9.1

contained at a
level lower than
the average of
the last four
years, that is
17.1 per cent
1990–1 To bring about a Around 5.0 – 15.1 target 5.4 12.1

sharp reduction achieved
of M3 growth by
about 4
percentage
points over
previous year
achieved, that is,
15.4 per cent
1991–2 (October) To contain M3 3.0 Max 9.0 19.3 0.8 13.6

growth to 13.0
per cent
1992–3 11.0 per cent – 8.0 15.7 5.3 7.0

(Max) M3 growth
(p.138) 1993–4 Around 12.0 per 5.0 Further 18.4 6.2 10.8
cent M3 growth moderation in
inflation rate
Page 22 of 106
1994–5 (October) 16.0 per cent 5.5 Sharp reduction 22.3 7.8 10.4
(Max) M3 growth in inflation rate
by about 4
percentage
points
1995–6 15.5 per cent 5.5 Around 8.0 13.7 target 7.2 5.0
(Max) M3 growth achieved
1996–7 15.5–16.0 per 6.0 6.0 16.2 7.5 6.9

cent M3 growth
1997–8 15.0–15.5 per 6.5–7.0 5.0–6.0 17.6 5.1 5.3

cent M3 growth
Source: Mohanty and Mitra (1999).
Page 23 of 106
(p.139) emerging in the economy provided some evidence that the dominant
effect on the demand for money in the near future need not necessarily be real
income, as in the past.
Fiscal–Monetary Nexus
As highlighted earlier, this period witnessed a growing awareness of the nexus
between monetary and fiscal policy via the mechanism of automatic
monetization of government deficit. In fact, during the 1980s, there was a
substantial expansion in public debt primarily due to automatic accommodation
to the Central Government by the RBI through the mechanism of ad hoc
Treasury bills. With a dormant secondary market for government bonds, the
monetary management was dominated by rising CRR and SLR prescriptions and
left little room for monetary manoeuvring (Mohan 2009). Nevertheless, once the
framework of flexible monetary targeting with feedback and its implications for
fiscal–monetary coordination were accepted by the government, there were
some positive developments. Illustratively, in the context of appropriately
predicting ‘reserve money’ growth, the government accepted in principle that
the definition of budget deficit should be altered to be equivalent to ‘net RBI
credit to government’ (GoI 1987). After considering the various technicalities, it
was decided that from the 1987–8 budget of the central government, the
increase in net bank credit to the central government would be presented as a
memorandum item alongside the figures of conventional budget deficit. All these
incremental efforts finally culminated into the First Supplemental Agreement
between the RBI and the GoI on 9 September 1994 setting out a system of limits
for creation of ad hoc Treasury bills during the three-year period ending March
1997. Subsequently, a Second Supplemental Agreement was signed between the
RBI and the GoI on 6 March 1997, finalizing complete phasing out of the ad hoc
Treasury bills by converting the outstanding amount into special undated
securities and replacing the system of government borrowing from the RBI by a
system of Ways and Means Advances. All these led to a significant slashing of
the annual growth in net RBI credit to government and also a steady fall in this
monetized deficit as a proportion of M3 (Table 4.4). (p.140)
Page 24 of 106
Table 4.4 Monetary–Fiscal Nexus
Year Net RBI Credit to Rate of Expansion in

Govt as a per cent of Money Supply (M3) Net Bank Credit to Net RBI Credit to Other Banks’
M3
Government Government Investment in
Government
Securities
1985–6 32.4 16.0 15.8 12.6 22.8
1986–7 32.7 18.6 23.5 19.7 31.0
1987–8 32.1 16.0 17.1 13.8 23.1
1988–9 30.8 17.8 14.3 13.1 16.3
1989–90 31.9 19.4 21.4 23.6 17.9
1990–1 33.4 15.1 19.7 20.6 18.1
1991–2 29.7 19.3 12.9 5.8 25.1
1992–3 27.0 14.8 11.4 4.7 21.1
1993–4 23.0 18.4 15.7 0.9 34.5
1994–5 19.2 22.4 9.1 2.2 15.6
1995–6 20.3 13.6 15.9 19.6 12.8
1996–7 17.8 16.2 12.0 2.3 20.5
1997–8 16.5 18.0 14.5 8.8 18.9

Source: Handbook of Statistics on Indian Economy, RBI, various issues.
Page 25 of 106
Monetary Policy Measures

The reductions in monetized deficit made it possible to make a paradigm shift in
the use of monetary policy instruments during this period. With the initiation of
the financial sector reform process, both CRR and SLR started their downward
path since the early 1990s (Figure 4.2).
Towards a Multiple Indicators Approach (1998–2011)

In its monetary policy statement of April 1998, the RBI announced that it would
switch to a multiple indicators approach ‘to widen the range of variables that
could be taken into account for monetary policy purposes rather than rely solely
on a single instrument variable such as growth in broad money (M3)’. This
marked the end of the regime of monetary targeting and a multiple indicators
approach was initiated, which took into account the information content of
variables like money market interest rates, exchange rates, foreign exchange
reserves, credit to government and commercial sector, and (p.141)
the fiscal position of the

government. It was claimed that
these would be closely monitored
and utilized to guide policy
actions.
The multiple-indicators
approach continued to evolve
and was augmented by forward-
looking indicators and a panel
of time series models (Mohanty
2010). The forward-looking
indicators are drawn from the
RBI’s industrial outlook survey,
capacity utilization survey,
professional forecasters’ survey,
and inflation expectations
survey. The assessment from
these indicators and models
feed into the (p.142) Figure 4.2 Movement in CRR and SLR
projection of growth and during 1985–98
inflation. The RBI also gives the
projection for broad money (M3)
Economy, RBI, various issues.
which serves as an important
information variable, so as to
make the resource balance in the economy consistent with the credit needs of
the government and the private sector. Thus, this framework of monetary policy
could be termed as an ‘augmented multiple indicators approach’ (Mohanty
Page 26 of 106
2010a) and with it, ‘the current stance of monetary policy remains anti-
inflationary’ (Mohanty 2011).
Operating Procedure—LAF Operations

Even so, as it is at times perceived, the large panel of indicators can be criticized
as a ‘check list’ approach, without there being a definitive anchor for monetary
policy (Mohanty 2010a). In operational terms, such an anchor has willy-nilly
been settled in the interest rate corridors of the LAF. Pursuant to the
recommendations of the Narasimham Committee on Banking Reforms, the RBI
decided, in principle, to introduce an LAF operated through repo and reverse
repo in order to set a corridor for money market interest rates. Accordingly, in
April 1999, an Interim LAF (ILAF) was introduced pending further upgradation
in technology and legal/procedural changes to facilitate electronic transfer and
settlement.17
Under the LAF, the Reserve Bank sets its policy rates, that is, repo rate and
reverse repo rate and carries out repo/reverse repo operations, thereby
providing a corridor for overnight money market rates.18 The LAF avoids
targeting a particular level of overnight money market rate in view of the
exogenous influences impacting liquidity at the shorter end, namely, volatile
government cash balances and unpredictable foreign exchange flows.
Historically, depending on liquidity conditions, the repo and reverse repo rates
have been changed a number of times (Figure 4.3).
More recently, in May 2011, following the recommendation of the Working

Group to Review the Operating Procedure of Monetary Policy in India
(Chairman: Deepak Mohanty), there have been some significant changes in
monetary policy operating procedure. The following changes deserve special
attention. First, the weighted average overnight call money rate is taken to be
the operating target of monetary policy of the Reserve Bank. Second, instead of
the twin rates of reverse repo and repo rate, there will henceforth be only one
(p.143)
independently varying policy rate

and that will be the repo rate.
Third, the reverse repo rate will
continue to be operative but it will
be pegged at a fixed 100 basis
points below the repo rate. Fourth,
a new Marginal Standing Facility
(MSF) has been instituted from
which the banks can borrow
overnight up to 1 per cent of their
respective NDTL.19 Thus, the
revised corridor will have a fixed Figure 4.3 Repo and Reverse Repo Rates
width of 200 basis points. The repo rate will be in the middle. The reverse repo rate
Page 27 of 106
will be 100 basis points below it and the MSF rate 100 basis points above it. While the
width of the corridor is fixed at 200 basis points, the RBI will have the flexibility to
change the corridor, should monetary conditions so warrant. This transition to a single
independently varying policy rate is expected to more accurately signal the monetary
policy stance (RBI 2011). Thus, the repo rate was placed in the middle of the corridor,
with the reverse repo rate 100 basis points below it and the MSF rate 100 basis points
above it (Figure 4.4).
CRR
As part of the policy of financial Economy, RBI, various issues.
sector liberalization, it was
decided that the extent of
statutory pre-emptions (CRR and SLR) would be reduced. The CRR, which stood
at 15 per cent during July 1989 to (p.144)
October 1992, was reduced to 4.5

per cent of NDTL by June 2003, in
pursuance of the medium-term
goal of finally bringing it down to
the statutory minimum of 3.0 per
cent. The reduction in CRR was, in
particular, facilitated by phasing
out of the automatic monetization
of the government deficit with the
abolition of the earlier practice of
Figure 4.4 The Revised LAF Framework
issuance of ad hoc treasury bills.
As far as the evolution of CRR Source: Mohanty (2011).
during this period is concerned,
three sub-periods may further be
discerned, namely, (i) till October 2004, CRR followed a uniform declining path; (ii)
during the period November 2004 to September 2008, CRR has been on an upward
path to take care of the capital inflows as well as on account of inflationary
considerations; (iii) coinciding with path of Lehman Brothers and the impact of the
global financial crisis in India, CRR has been on a sharp downward path since October
2008 till January 2010; and, finally, (iv) from February 2010, CRR has again been on an
upward trend in order to tackle the latest inflationary spiral (Figure 4.5). Insofar as
SLR was concerned, the rate adjustment had already been done before 2007–8 (Figure
4.2).
Deposit and Lending Rates
The RBI began to deregulate the deposit and lending rates in the early 1990s. At
present, commercial banks have freedom to set domestic (p.145)
Page 28 of 106
term deposit rates of seven days

and above on a uniform basis for
all clients. The RBI, which had
been reluctant to free interest
rates on savings accounts and had
fixed the rates at 3.0/3.50 per cent
per annum until recently,
nevertheless, deregulated the
savings bank deposit rates also
with effect from 25 October 2011,
thus ending the last vestige of the
regulation of rupee interest rates. Figure 4.5 CRR during 1998–2010
However, it has continued to issue Source: Handbook of Statistics on Indian
guidelines on non-resident
deposits from time to time
depending on the evolving
macroeconomic situation.
As for loan rates, banks were also free to fix their lending rates for all classes of
loans, with only small loans below Rs 2 lakh and export credit for which the
ceiling rates were prescribed to be linked to the PLR being exceptions. In order
to instil transparency, banks were required to announce their benchmark prime
lending rates (BPLRs), reflecting some kind of actual average costs and also
their range of effective lending rates. When the RBI observed some serious
drawbacks and absence of transparency in the implementation of the BPLR
regime, it has replaced it by a system of base rate for loan rate and, along with
it, has abolished the system of preferential rates for small loans. Interest rate
issues are discussed in the next section.
(p.146) Forex Inflows and Monetary Policy

The way fiscal–monetary nexus tended to complicate monetary policy in the
earlier period, in this period foreign capital flows posed considerable challenges
to monetary policy. Although capital flows to any capital-scarce country is
welcome, sudden surges can complicate macroeconomic management and
create financial risks. Apart from determining the nature and durability of
capital inflows, on the macroeconomic front, often the economy is confronted
with a concern that the surge will lead to an appreciation of the exchange rate
that would undermine competitiveness of the tradable sector. On the financial
stability front, the main worry is that large capital inflows may lead to excessive
foreign currency exposure and this could fuel domestic credit booms and asset
bubbles (Ostry et al. 2010). Furthermore, investors in search of high returns
often borrow in a low-interest rate currency, such as the US dollar, and invest in
high-yielding currencies, such as the rupee, so as to earn the interest differential
as well as the possibility of rupee appreciation—a phenomenon known as ‘carry
trade’.
Page 29 of 106
A key macro complication in this regard comes from what has come to be known
as impossible trinity—the impossibility of attaining monetary policy
independence, perfect capital mobility, and flexible exchange rate. Thus,
depending on the subjective as well as objective conditions of the economy,
policymakers resort to a combination of policies involving exchange rate
appreciation, reducing domestic interest rate, prudential measures, sterilization,
reserve accumulation, tighter fiscal policy, and capital controls. The story of
handling capital inflows by Indian policymakers is beyond the scope of the
present chapter and hence what follows below is a synoptic account of the
monetary policy measures to handle capital inflows.
The Indian economy has been receiving large and volatile capital flows since
1993–4; it touched the peak during 2007–8 when net capital flows rose as high
as 8.6 per cent of GDP (Table 4.5). More recently, capital inflows came back to
emerging market economies (EMEs) in general and India in particular in a
global system flush with liquidity, low interest rates ruling in advanced
economies, and the prospects of robust growth in EMEs (Subbarao 2010).
While active management of the capital account, tighter prudential restrictions

on access of financial intermediaries to external (p.147)
Page 30 of 106
Table 4.5 India’s Balance of Payments—Capital Account (as a per cent of GDP at Current Market Prices)
Net Capital Foreign Investment Debt Flows Others Net Overall BoP
Flows Net [Net Surplus
Net Gross Direct (in Portfolio (in
(+)/Deficit
India) India)
(−)]
1990–1 2.2 0.0 0.0 0.0 0.0 2.2 0.0 −0.8
1991–2 1.5 0.1 0.1 0.1 0.0 1.7 −0.2 1.1
1992–3 1.6 0.2 0.2 0.1 0.1 1.0 0.4 −0.1
1993–4 3.2 1.5 1.7 0.2 1.4 1.1 0.6 3.1
1994–5 2.6 1.5 1.8 0.4 1.4 1.0 0.1 1.8
1995–6 1.2 1.4 1.6 0.6 1.0 1.0 −1.2 −0.3
1996–7 3.1 1.6 2.0 0.7 1.3 2.1 −0.6 1.8
1997–8 2.4 1.3 2.3 0.9 1.4 1.4 −0.3 1.1
1998–9 2.0 0.6 1.4 0.6 0.8 1.3 0.2 1.0
1999–2000 2.3 1.2 2.7 0.5 2.2 0.7 0.5 1.4
2000–1 1.9 1.5 3.8 0.9 3.0 1.7 −1.2 1.3
2001–2 1.8 1.7 3.2 1.3 1.9 0.3 −0.2 2.5
2002–3 2.1 1.2 2.8 1.0 1.7 −0.2 1.1 3.3
2003–4 2.8 2.6 5.4 0.7 4.7 −0.1 0.3 5.2
2004–5 3.9 2.1 6.5 0.8 5.6 1.4 0.4 3.6
Page 31 of 106
Net Capital Foreign Investment Debt Flows Others Net Overall BoP
Flows Net [Net Surplus
Net Gross Direct (in Portfolio (in
(+)/Deficit
India) India)
(−)]
2005–6 3.0 2.6 9.2 1.1 8.2 1.3 −0.8 1.8
2006–7 4.8 3.1 14.0 2.4 11.5 3.0 −1.4 3.8
2007–8 8.6 5.0 22.0 2.8 18.9 3.3 0.3 7.5
2008–9 0.5 1.7 13.3 2.9 10.4 1.0 −2.2 −1.7
2009–10 4.1 4.9 15.3 2.9 12.3 1.2 −2.0 1.0

Source: Handbook of Statistics on Indian Economy, RBI, 2010 and other issues
Notes: 1. From 2004–5, GDP with Base Year 2004–5 is used.
2. Debt flows include external assistance, external commercial borrowings, short-term borrowings, and non-resident deposits.
3. ‘Others’ includes banking capital excluding non-resident deposits, rupee debt service, and other capital and foreign investment
abroad.
Page 32 of 106
borrowings, flexibility in exchange rate movements, all have been parts of the strategy
to handle these inflows, sterilization of interventions in the foreign exchange market
through multiple instruments, including CRR and issuances under the MSS, were key
components of the policy metric (Mohan and Kapur 2009).20 Furthermore, during
periods of reversal, liquidity is injected through cuts in CRR and unwinding of the
MSS. An interesting innovation in the Indian context is MSS (Box 4.2). (p.148)
Box 4.2 Market Stabilization Scheme
An Internal RBI Working Group on Instruments of Sterilization was formed in

2003. The Committee while considering various options for sterilizing
foreign exchange inflows noted that,
In view of the finite stock of government securities available with the

Reserve Bank for sterilisation, particularly, …the Group considered
whether the Government could issue a special variety of bills/bonds for
sterilisation purposes. Unlike in the case of central bank securities
where the cost of sterilisation is borne indirectly by the fisc given the
consolidated balance sheet approach as discussed earlier, the cost of
issuance of such instruments by the Government would be directly and
transparently borne by the fisc. To operationalise such a new
instrument of sterilisation and ensure fiscal transparency, the Group
recommends that the Government may consider setting up a Market
Stabilisation Fund (MSF) to be created in the Public Account. This
Fund could issue new instruments called Market Stabilisation Bills/
Bonds (MSBs) for mopping up enduring surplus liquidity from the
system over and above the amount that could be absorbed under the
day to day repo operations of LAF. … The amounts raised would be
credited to the Market Stabilisation Fund (MSF)… The maturity,
amount, and timing of issue of MSBs may be decided by the Reserve
Bank in consultation with the Government depending, inter alia, on the
expected duration and quantum of capital inflows, and the extent of
sterilisation of such inflows. (RBI 2003)
Following this recommendations, the RBI has proposed to the GoI to

authorize issuance of existing debt instruments, namely, treasury bills and
dated securities up to a specified ceiling to be mutually agreed upon
between the Government and the RBI by way of a Memorandum of
Understanding (MoU) under the MSS. Subsequently, MSS was introduced by
way of an agreement between the government and the RBI in early 2004.
Under the scheme, RBI issues bonds on behalf of the government and the
money raised under bonds is impounded in a separate account with RBI. The
money does not go into the government account.
Page 33 of 106
The bills/bonds issued under MSS would have all the attributes of the
existing Treasury Bills and dated securities. The bills and securities will be
issued by way of auctions to be conducted by the RBI. The RBI will decide
and notify the amount, tenure and timing of issuance of such treasury bills
and dated securities. Whenever such securities are issued by the RBI for the
purpose of market stabilisation and sterilisation, a press release at the time
of issue would indicate such purpose. For the present, the total outstanding
obligations of the government by way of bills/securities thus issued under the
MSS from time to time would not exceed Rs 60,000 crore. Subsequently, this
limit has been revised a number of times to keep pace with the existing
trends in capital inflows.
Source: Annual Report, RBI, various issues.
(p.149) At the current juncture during 2010–11, monetary policy continues to

be operating through variety of instruments, such as, OMO, LAF, and also
unwinding (including desequestering) of balances under MSS to maintain
appropriate liquidity in the system, and CRR.
Impact of Global Financial Crisis in India and Response of Monetary Policy21

No account of monetary policy at the current juncture is complete without a
discussion on its role in dealing with the fallout of the global financial crisis. The
Indian economy had almost negligible exposure to toxic assets that are
associated with the US sub-prime crisis and hence the direct effect of the sub-
prime crisis on Indian banks/financial sector was almost negligible (Mohan
2009a). Besides, Indian banks had limited exposure to complex derivatives and
other prudential policies put in place. Naturally, the initial impact of the sub-
prime crisis on the Indian economy was quite muted. Interestingly, following the
low interest rate regime in the US since August 2007, there was a massive jump
in net capital inflows. The RBI had to sterilize the liquidity impact of large
foreign exchange purchases through a series of increases in the CRR and
issuances under the MSS.
Nevertheless, following the fall of Lehman Brothers, the Indian market was hit.
It happened in a number of ways. Illustratively, the cheaper source of funds for
Indian firms dried up globally. This increased the demand for both domestic
liquidity and foreign exchange as the funds borrowed needed to be converted
into dollar payments (Aziz et al. 2008). Besides, when the Indian money market
became tight, these firms redeemed their investments in mutual funds to finance
their own funding needs, setting off a wave of redemptions for mutual funds. The
sell-off was particularly damaging for non-banking financial companies (NBFCs)
and real estate companies, for whom mutual funds are the only source of debt
financing. There were also adverse effects on the real economy reflected in
Page 34 of 106
reduced GDP growth and saving and investment ratios, though partially and
temporarily.
For containing the contagion, the monetary policy response was guided by three
objectives: ‘first, to maintain a comfortable rupee liquidity position; second, to
augment foreign exchange liquidity; and third, to maintain a policy framework
that would keep credit (p.150) delivery on track so as to arrest the moderation
in growth’ (Subbarao 2009). Consequently, the RBI’s policy stance of monetary
tightening was reversed. The policy packages included both conventional and
unconventional measures. On the conventional side, the policy interest rates
were reduced aggressively and rapidly, and refinance facilities for export credit
was liberalized. Measures aimed at managing forex liquidity included an upward
adjustment of the interest rate ceiling on the foreign currency deposits by non-
resident Indians, substantially relaxing the external commercial borrowings
(ECB) regime for corporates, and allowing NBFCs and housing finance
companies access to foreign borrowing. On the unconventional front, a rupee–
dollar swap facility for Indian banks was introduced to give them comfort in
managing their short-term foreign funding requirements. This apart, an
exclusive refinance window as also a special purpose vehicle for supporting
NBFCs, and expanding the lendable resources available to apex finance
institutions for refinancing credit extended to small industries, housing, and
exports, was introduced.
Performance
In order to evaluate the monetary policy outcome, a comparisons between the
actual outturn vis-à-vis indicative projection yields that the performance of the
recent period has been fairly impressive (Table 4.6). This is not to be interpreted
in an absolute sense—and one can find some instances when the actual inflation
outturn has exceeded the initial indicative projections.
Changing Contours of Banking Policy in India

Yester Years and the Periodization22
The perimeter of Indian banking sector is vast; it comprises, apart from
commercial banks, a sizable cooperative banking sector and, till recently, a
significant set of development finance institutions.23 In the present chapter, our
focus is confined to only commercial banks, which would constitute more than
three-fourths of the banking sector at any point of time under study, measured
by the size of their operations. Insofar as two terminal points of the time period
is concerned, we, as in the last section, confine our attention to 1951–2010. (p.
151)
Page 35 of 106
Table 4.6 Actuals vis-à-vis Indicative Projections of Monetary Policy
Indicative Projections Actual growth (in %age) Inflation
Year Real GDP M3 (% Scheduled WPI Real GDP M3 Scheduled WPI CPI-IW
(% Growth) Commercial Banks Commercial Banks
Growth)
Aggregat Non-food Inflation Aggregat Non-food
e Deposit Credit (% (%) e Deposit Credit
Growth)
1997–8 6.5–7.0 15.0–15.5 – – 5.0–6.0 4.1 18.0 18.4 15.1 4.5 8.3
1998–9 6.5–7.0 – – – 5.0 6.2 19.4 19.3 13.0 5.3 8.9
1999– 6.0–7.0 15.5–16.0 16.5% 18.0 5.0 7.4 14.6 13.9 16.5 6.5 4.8
2000
2000–1 6.5–7.0 15.0 15.5% 16.0 4.5 4.0 16.8 18.4 14.9 5.5 2.5
2001–2 6.0–6.5 14.5 14.5% 16.0–17.0 5.0 5.2 14.1 14.6 13.6 1.6 5.2
2002–3 6.0–6.5 14.0 Rs 15.0–15.5 4.0 3.8 14.7 16.1 26.9 6.1 4.1
154,000
cr
2003–4 6.0 14.0 Rs 15.5–16.0 5.0–5.5 8.4 16.7 17.5 18.4 4.9 3.5
179,000
cr
2004–5 6.5–7.0 14.0 Rs 16.0–16.5 5.0 8.3 12.0 13.0 31.6 4.2 4.2
218,000
cr
Page 36 of 106
Indicative Projections Actual growth (in %age) Inflation
Year Real GDP M3 (% Scheduled WPI Real GDP M3 Scheduled WPI CPI-IW
(% Growth) Commercial Banks Commercial Banks
Growth)
Aggregat Non-food Inflation Aggregat Non-food
e Deposit Credit (% (%) e Deposit Credit
Growth)
2005–6 7.0 14.5 Rs 19.0 5.0–5.5 9.3 21.1 24.0 38.4 5.2 5.3
260,000
cr
2006–7 7.5–8.0 15.0 Rs 20.0 5.0–5.5 9.4 21.7 23.8 28.5 6.7 6.7
330,000
cr
2007–8 8.5 17.0–17.5 Rs 24.0–25.0 4.0–4.5 9.6 21.4 22.4 23.0 7.7 7.9
490,000
cr
2008–9 8.0–8.5 17.0 Rs 20.0 4.0–4.5 5.1 19.3 19.9 17.8 0.8 8.0
550,000
cr
2009–10 6.0 17.0 18.00 % 20.0 4.0 7.7 16.8 17.2 18.9 11.0 14.9
Source: Compiled from RBI’s Monetary and Credit Policies, various issues.
Note: Data on indicative projection are as published in different issues of RBI’s Annual Monetary Policy Statements and the actuals are
worked by using the latest available data.
Page 37 of 106
(p.152) However, for the sake of continuity and in order to set the context of what
follows below is a quick run-down of the pre-1951 banking.
Banking business had been known in India since antiquity. Economic history of
India is full of evidence on ‘when the British began establishing their
administrative supremacy over the whole sub-continent, there was an extensive
network of Indian banking houses connecting all cities and towns which were
commercially important’ (Bagchi 1987: 31). But, the actual antecedents of
modern banking in India belong to the evolution of the State Bank of India (SBI).
Its origins date back to the first decade of the nineteenth century when the Bank
of Calcutta was established in 1806 and later received its charter as the
Presidency Bank of Bengal in 1809. It was the first British joint-stock bank,
followed by the Bank of Bombay in 1840 and the Bank of Madras in 1843. All
were government-sponsored and set up under the respective Presidency Bank
Acts incorporated under charters from the respective provincial governments.
The passage of the Paper Currency Act of 1861 established a government
monopoly of note issue through the Presidency Banks as agents of the
government. The three Presidency Banks were amalgamated by statute of 1920
into the Imperial Bank of India in 1921 as a going joint-stock bank.
With the establishment of the RBI in April 1934, the Imperial Bank of India Act
was amended in that year to withdraw its function as banker to the government.
Also, unlike in the past, the bank was allowed to engage directly in foreign
exchange business. In the RBI’s formative years, there was no separate law
governing the banking companies. The Indian Companies Act of 1913 was
applied to banking and non-banking companies alike. Of course, it had a few
provisions relating to joint-stock banks. The Report of the Central Banking
Enquiry Committee (1931) emphasized the need for enacting a special Banks Act
covering the organization, management, audit, and liquidation of banks.
Immediately after the RBI was set up, the first attempt at banking legislation
was made with the passing of the Indian Companies (Amendment) Act, 1936,
which defined the term ‘banking’ and conferred the special status for ‘scheduled
banks’—a feature which has continued till date. The war years saw a
phenomenal growth of banking in India in terms of new banks and new offices
and deposit expansion, but the corresponding avenues for lending were limited.
In spite of rapid growth of banking very often with inadequate capital, the
attention of the authorities was drawn to renewing their (p.153) efforts for a
regular Banks Act. A Banking Companies Bill, bringing the exchange banks
within its important provisions and designed to be a comprehensive banking
legislation, was moved in the Legislative Assembly in April 1945, but it lapsed
after the fresh Assembly elections were announced in October 1945. The
stresses and strains faced by the Indian banking system during the immediate
post-War years were compounded by the post-Partition travails, particularly in
West Bengal and the Punjab, the provinces which suffered the most out of the
impact of the country’s partition.24
Page 38 of 106
Despite the turmoil faced, the period saw significant efforts to put in place
statutory provisions for banking governance, which finally culminated in the
enactment of the Banking Companies Act, 1949. The act tightened the provisions
relating to minimum capital requirements and cash reserves, and certain
discipline regarding loans and advances. Immediately after the enactment of this
act, it was found that the provisions relating to amalgamation and liquidation of
banks were found to be insufficient and, therefore, an amendment was effected
in 1950. The amending law also contained an important provision extending the
RBI’s powers of licensing to the opening of foreign branches. A major
development of the immediate post-Independence period was the nationalization
of the RBI, effective January 1949.
Given this backdrop, we now turn to the structure, conduct, and policy
developments relating to the Indian banking during 1951–2010. Insofar the
periodization of the banking developments is concerned, in line with major
regime shift, we follow a three-period classification: (i) 1951–68, which was a
period of consolidation, (ii) 1969–91, or the post-nationalization period, and (iii)
1992–2010, which marked the financial liberalization phase.
A Phase of Banking Consolidation: 1951–68

At the time of Independence, in terms of ownership, Indian banking was
essentially in the private sector. The ownership structure was also skewed with
five large banks and some other smaller commercial banks (which were
essentially regional in nature).25 The RBI took up the task of consolidation and
strengthening of the banking system after 1950 and initiated multi-layered
actions. Towards this end, the new Banking Companies Act 1949 had to be
amended on as many as 10 occasions between 1950 and 1967 (Balachandran
1998).
(p.154) The multi-layered processes of consolidation and strengthening

involved actions such as: (i) execution of a wide set of measures of supervision
and control over banking companies including control over managements, board
memberships, and voting rights; and (ii) varied attempts at amalgamations,
mergers, transfers, reconstructions, and even liquidations and winding up of
fragile banks. The process of consolidation through amalgamation was slow until
1960 because it had to be voluntary. The failure of two major banks in 1960
brought home the inherent risks involved in allowing sub-standard banks to
continue to function. Hence, an amendment to the banking law was enacted that
year which facilitating compulsory reconstruction and amalgamation of banks
considered to be unviable and reluctant to enter into voluntary merger
arrangements. This was the phase when efforts were made to reorganize 54
state-associated banks in the princely states. As a result, between 1960 and
December 1969, there were 48 compulsory mergers, apart from 20 voluntary
amalgamations, 17 mergers with the SBI, and 125 transfers of assets and
liabilities, thus involving 210 banks. These various measures of consolidation
Page 39 of 106
drastically reduced the number of banks from 566 in 1951 to 292 in 1961 and,
finally, to 89 in 1969. The process brought an end to what had come to be known
as non-scheduled banks that did not have capital and reserves above prescribed
limits and which could not satisfy the central bank that their business was run
on sound lines—the conditions which qualified the banks to be put on the Second
Schedule to the Reserve Bank of India Act, 1935 (Table 4.7).
In furthering the objectives of regional and functional spread of banking, the

social orientation of commercial banking was conceived in the founding law of
the RBI. The RBI was entrusted with the responsibility of enlarging the supply of
agricultural finance through cooperative institutions or through SCBs. Until the
early 1950s, the cooperative movement was considered appropriate for this
purpose. On the basis of the recommendations of the Rural Banking Enquiry
Committee (1950) for involving commercial banks in rural credit, the then
Imperial Bank of India agreed to open 114 offices in rural and semi-urban areas
(against 274 branches recommended) but could open only 63 branches in five
years from July 1951. It was, therefore, thought that without state intervention,
banking facilities could not be extended to such areas. Hence, the Imperial Bank
of India was brought under public ownership as the new SBI from July 1955 with
(p.155)
Page 40 of 106
Table 4.7 Amalgamation of Commercial Banks: 1954–66
Year Compulsory Amalgamation Voluntary Amalgamation Banks otherwise Ceased to Function
No. of Paid-up Deposits No. of Paid-up Deposits No. of Paid-up Deposits

Banks Capital Banks Capital Banks Capital
1954 – – – – – – 17 25 88
1955 – – – – – – 11 23 20
1956 – – – – – – 6 11 47
1957 – – – 1 5 115 10 19 23
1958 – – – 4 56 523 10 15 63
1959 – – – 4 4 33 20 26 110
1960 – – – 2 1 3 15 34 40
1961 30 198 1,722 – – – 9 17 142
1962 1 1 6 3 20 122 22 55 134
1963 1 1 7 2 3 16 15 34 781
1964 9 36 438 7 23 147 63 55 569
1965 4 13 54 5 3 39 24 59 501
1966 – – – – – – 7 19 453
Source: RBI (2008).
Page 41 of 106
(p.156)
Page 42 of 106
Table 4.8 Evolution of Commercial Banking: 1951–69
1951 1956 1961 1969
No. of Commercial Banks 566 423 292 89
Scheduled Commercial 92 89 82 73
Banks
Non-scheduled 474 334 210 16

Commercial Banks
No. of Offices in India 4,151 4,067 5,012 8,262
Population per Office (in 87 98 88 64

′000)
Bank Deposits (as % of 10.5 11.9 13.2 13.7

GDP)
Source: Ajit and Bangar (1997).
Page 43 of 106
the central bank of the country holding 92 per cent of its shares and with a statutory
responsibility to establish at least 400 additional branches within a five-year period; it
fulfilled these and other branch expansion targets it set for itself. In September 1959,
major state-associated banks of princely states were taken over and vested with the
SBI as subsidiaries finally numbering seven.
How did the structure of banking system evolve during this period? The extent
of bank failures and amalgamation during those days can be gauged from the
fact that as against 566 SCBs operating in 1951, only 89 survived till 1969, the
rest going into liquidation or amalgamation in between (Table 4.8).
Initiation of Regular Social Control over Banks

Many perceived weaknesses of the commercial banking system, such as poor
population coverage of bank branches, deposits, and credit and urban
concentration, vast sectoral credit gaps, excess control over banks by industrial
and commercial interests, and unduly poor capital base, came to be aired in
political circles suggesting the need for reorientation of the banking system.
This led to a series of steps during 1965–9 which has been described as ‘social
control’ over commercial banks. First, the credit authorization scheme (1965)
was introduced which required scheduled banks to obtain prior authorization for
granting fresh credit limits of Rs 1 crore or over to any single party so as to
align credit policy more closely with the FYP objectives. Second, a social control
scheme was initiated in 1968 with the objectives of achieving a wider spread of
bank credit, preventing (p.157) its misuse, directing a larger volume of credit
to priority sectors. Third, commercial bank boards were reconstituted statutorily
with a majority representation to informal sectors. The process of integrating
credit allocation with their system of indicative planning became the basis of this
experiment.
1968–91: Bank Nationalization and Social Control

Apart from large number of bank failures and amalgamations, the banking
sector as it stood in the mid-1960s had a number of flaws. It had an extremely
skewed ownership structure with 49 per cent of the shares of the leading banks
being held by 3 per cent of the shareholders, and 36 per cent of the shares
owned by 1 per cent of the shareholders in 1965 (Torri 1975). Besides, deposits
and credit growth was not substantial to take care of quantum and distributive
aspect of bank finance. A major exponent of the policy of bank nationalization
has succinctly put it (Raj 1974: 308):
If the dimensions of the problem introduced by market imperfection in the

allocation of resources were fully recognised, and the objectives of the
development programme kept in mind, one would have expected less
hesitation being shown in nationalising all commercial banks in the
country and in using them directly for a more optimal distribution of
finance in the economy. For, there are important reasons why banking
enterprises seeking to maximise their profits would not venture out into
Page 44 of 106
areas and sectors of activity to which high priority needs to be attached

from a larger social and economic point of view.
The socio-political undercurrents of the second half of the 1960s were thus one
of disenchantment with the functioning of the commercial banking system even
after the initiation of social control over banks. Accordingly, effective 19 July
1969, 14 major Indian scheduled banks, having public deposits of Rs 50 crore or
over, were nationalized.26
The chronology of events during this period established social control over
banks and the major landmarks were as follows:
• 1968: National Credit Council (NCC) was set up in February 1968 to assist
the RBI and the government to allocate credit according to plan priorities.
(p.158) • 1969: 14 banks with deposits of over Rs 50 crore were

nationalized.
• 1969: The lead bank scheme was introduced with a view to mobilizing
deposits and also for stepping up lending to the weaker sections.
• 1972: Concept of priority sector was formalized. Specific targets were set
out in November 1974 for public sector banks (PSBs) and in November 1978
for private sector banks. Subsequently, the Differential Rate of Interest (DRI)
Scheme was instituted to cater to the needs of the weaker sections of the
society and for their upliftment.
• 1973: A minimum lending rate was prescribed on all loans, except for the
priority sector. The district credit plans were initiated.
• 1975: Banks were required to place all borrowers with aggregate credit
limit from the banking system in excess of Rs 10 lakh on the first method of
lending, whereby 25 per cent of the working capital gap, that is, the
difference between current assets and current liabilities, excluding bank
finance, was required to be funded from long-term sources. Besides, a new
type of commercial bank, namely, regional rural bank (RRB), came to be
established in underbanked districts of the country as an institution
combining local feel and familiarity with modern banking methods.
• 1976: The maximum rate for bank loans was prescribed in addition to the
minimum lending rates.
• 1980: The contribution from borrowers towards working capital out of their
long-term sources was placed in the second method of lending, that is, not
less than 25 per cent of the current assets required for the estimated level of
production, which would give a minimum current ratio of 1.33:1 (as against
25 per cent of working capital gap stipulated under the norms prescribed in
1975).
Page 45 of 106
• 1980: Six banks with demand and time liabilities greater than Rs 200 crore
as on 14 March 1980 were nationalized on 15 April 1980.
• 1988: Service area approach was introduced, modifying the lead bank
scheme.
(p.159) Impact
If we take the objectives of bank nationalization as well as the setting up of
RRBs as wider territorial and regional spread of the banks’ branch network,
larger mobilization of financial savings through bank deposits, and reorientation
of credit deployment in favour of small producers and the disadvantaged classes,
how did these impact banking activities and the structure? Towards this end, let
us take a look at various outcome indicators.
Extension of Banking across Different Dimensions:
These institutional developments have brought, along with SBI and its
subsidiaries, commercial banks with over 90 per cent of deposits into public
ownership (Table 4.9). This is also reflected in the deposits–GDP ratio over the
period 1951–90, which went up from around 12 per cent in 1968–9 to a little less
than 40 per cent in 1990–1 (Figure 4.6).
Second, a series of policy initiatives have brought about many other structural
changes, such as the fast growth of bank branches, branches spreading to rural,
semi-urban, and underdeveloped regions, and a higher proportion of bank credit
being extended to agriculture, small-scale industries, and other defined priority
sectors. By the end of March 1990, over 46,000 bank branches (or 77 per cent)
had been located in rural and semi-urban areas (Table 4.10).
Third, an equally sharp change has occurred in the sectoral distribution of bank
credit, with the share of agriculture, small-scale
Table 4.9 Growth and Structure of Commercial Banks in India,

1969–90
Variable 1969 1980 1990
No. of all Commercial Banks 89 276 290
RRBs – 194 196
SCBs including RRBs 73 273 287
Non-SCBs 16 3 2
Share in Bank Deposits (in %age)
PSBs 84.5 91.9 90.8
Foreign Banks 9.2 2.9 5.0
Page 46 of 106
Variable 1969 1980 1990
Private Banks 6.3 5.2 4.1

Source: Statistical Tables Relating to Banks in India, RBI, various
issues.
(p.160) industries, and other

informal sectors rising
significantly from less than 10 per
cent in March 1968 to about 40
per cent in March 1990 (Table
4.11); the share of medium- and
large-scale industry has
correspondingly declined from
about 60 per cent to 37 per cent
during the period. Moreover, if we
take loans from commercial banks
to agricultural and small-scale Figure 4.6 Increasing Trends in Credit
industries, one gets a picture of and Deposits (as percentage of GDP)
sharp increases in the initial years Source: Handbook of Statistics on Indian
but slowing down the tempo Economy, RBI, various issues.
thereafter (Figure 4.7).
Another dimension of banking
spread is the state-wise distribution of bank offices as well as state-wise pattern
of population per branch offices. At this point, a contrarian view may be raised.
It may be argued, for example, that since the GDP pattern between states is not
equitable, why do we need to ensure equitable distribution of banks? After all, a
state with higher GDP will need more banks to finance it. Such argument stems
from a notion which views finance not as a cause but essentially as an effect of
economic development The moment we view finance as a cause (or perhaps both
as a cause as well as an effect) of economic growth and development, ensuring
availability of financial services becomes an imperative based on the principles
of supply-leading. From this standpoint, substantial progress may be (p.161)
Page 47 of 106
Table 4.10 Distribution of SCB Offices
Year (June No. of Offices* % to Total

end)
Rural Semi- Urban Metropolit Total Rural Semi- Urban Metropolit Total
urban an urban an
1969 1,833 3,342 1,584 1,503 8,262 22.2 40.5 19.2 18.2 100.0
1980 15,105 8,122 5,178 4,014 32,419 46.6 25.1 16.0 12.4 100.0
1990 34,791 11,324 8,042 5,595 59,752 58.2 19.0 13.5 a9.4 100.0
Source: Banking Statistics, RBI, various issues.
Note: * Coverage of centres has changed over time based on population census classifications.
Page 48 of 106
(p.162)
Table 4.11 Distribution of Advances of SCBs by Sectors (as

percentage of total advances)
Sector March 1968 March 1980 March 1990
Agriculture 2.2 14.5 15.9
Industry 67.5 47.9 48.7
Small Scale Industries 7.9 12.2 11.5
Commerce 19.2 28.5 22.2
Personal 3.7 4.8 6.4
Others 7.4 4.3 6.8
Total Advances 100.0 100.0 100.0

Source: Banking Statistics, RBI, various issues.
traced in state-wise distribution of

bank office as well as population
per branch office (Table 4.12).
Growing Financialization:
An interesting trend about the

pattern of financial
intermediation emerges from
the flow of funds accounts of
the Indian economy, which
locates financial flows within six
Figure 4.7 Outstanding Credit of SCBs
sectors of the economy, namely,
against Agriculture and Small-scale
households, corporates, rest of
Industries
the world, government, banks,
and other financial institutions. Source: Banking Statistics, RBI, various
Various ratios may be derived issues.
from these sub-component-wise
financial flows. For example,
(p.163)
Page 49 of 106
Table 4.12 Population per Bank Office by Region and State
Region/State No. of Offices Population per Office (2000s)
Dec. 1972 Dec. 1981 Mar. 1991 Dec. 1972 Dec. 1981 Mar. 1991
Northern 2,396 6,138 9,426 26 13 11

Region
Haryana 321 857 1,280 31 15 13
Himachal Pradesh 122 400 736 28 11 7
Jammu and 128 529 786 36 11 10

Kashmir
Punjab 721 1,644 2,178 19 10 9
Rajasthan 637 1,724 3,105 40 20 14
Chandigarh 37 88 137 7 5 5
Delhi 430 896 1,204 9 7 8
North-Eastern 202 831 1,870 97 30 17

Region
Arunachal 5 22 68 94 29 13
Pradesh
Assam 152 548 1,236 96 33 18
Manipur 7 39 84 153 36 22
Meghalaya 17 63 158 60 21 11
Page 50 of 106
Mizoram 1 12 73 332 41 9
Nagaland 6 42 71 86 18 17
Tripura 14 105 180 111 20 15
Eastern Region 1,625 6,207 11,362 76 24 16
Bihar 574 2,701 4,906 98 26 18
Odisha 217 1,114 2,103 101 24 15
Sikkim 5 29 63 14
West Bengal 830 2,375 4,303 53 23 16
Andaman and 4 12 21 29 16 13
Nicobar Islands
Central Region 2,171 6,878 13,005 60 24 16
Madhya Pradesh 728 2,360 4,414 57 22 15
Uttar Pradesh 1,443 4,518 8,591 61 25 16
Western Region 3,223 6,412 9,526 24 15 13
Goa 127 248 263 6 4 4
Gujarat 1,297 2,388 3,471 21 14 12
Maharashtra 1,795 3,771 5,775 28 17 14
Page 51 of 106
Dadra and Nagar 4 5 7 19 21 20

Haveli
Southern 5,033 11,469 16,535 27 14 12

Region
Andhra Pradesh 1,047 2,923 4,703 42 18 14
Karnataka 1,422 2,914 4,407 21 13 10
Kerala 947 2,401 2,912 23 11 10
Tamil Nadu 1,588 3,172 4,434 26 15 13
Lakshadweep 4 5 8 8 8 6
Puducherry 25 54 71 19 11 11
All India 14,650 37,935 61,724 37 18 14

Source: Statistical Tables Relating to Banks in India, RBI, various issues.
Page 52 of 106
(p.164) finance ratio, defined as the financial flows from all sectors apart from the
financial intermediaries as a proportion to national income, captures the extent of
financialization of the economy. These ratios indicate growing financialization as well
as intermediation tendencies of the Indian economy during this period of social control
over banks (Figure 4.8). (p.165)
Figure 4.8 Growing Financialization of

the Indian Economy: 1955–6 to 1990–1
Page 53 of 106
(p.166) Increased Savings: Source: Compiled from data on Flow of

The growing financialization is Funds Accounts, RBI (2000).
also reflected in the savings Notes: (1) Finance Ratio = Ratio of
trends of the Indian economy. Primary Issues (that is, financial
Following the nationalization of flows from all sectors other than
major banks and extensive banks and other financial
branch network, savings in institutions) to National Income; (2)
general and financial savings in Financial Interrelations Ratio = Ratio
particular went up sharply of Total Financial Flows to Net
during the 1970s and 1980s and Domestic Capital Formation; (3) New
within financial saving, the Issue Ratio = Ratio of Primary
share of bank deposits Financial Flows to Net Domestic
increased substantially (Figure Capital Formation; (4) Intermediation
4.9). In fact, in the savings Ratio = Ratio of Secondary (that is,
behaviour of the Indian financial flows from banks and other
economy, population per bank financial institutions) Issue to
office often Primary Issues.
(p.167) emerged as a major

explanatory variable indicating
that extension of bank network
tended to have played a major role
in the increased saving of the
country (Athukorala and Sen
2004).
Figure 4.9 Growing Influence of Bank

Deposits and Rising Savings
Page 54 of 106
Making a Dent on Poverty: Notes: Net Deposits = Deposits –

Advances.
Bank nationalization in general
and bank branch expansion in
particular have made a dent on
the poverty level in the
economy. This has come from a number of channels. First, there have been
significant structural changes in the deployment of commercial bank credit via
purposeful action on three planes, namely, rigorous control on the pre-emption
of credit by medium and large-scale industries, prescription of policies and
instruments for directing credit in favour of the designated priority areas, and in
development of a framework of instruments and institutions strongly favouring
such structural changes (Shetty 1978). Furthermore, using state-level data, it
has been shown that that rural branch expansion in India was associated with
significant reductions in rural poverty (Burgess et al. 2005). In addition, during
1970–90, bank borrowing among rural labour households was higher in states
that saw more rapid rural branch expansion; it has also been shown that the
social banking experiment in India has increased access of lower caste and tribal
households to bank loans (Burgess and Pande 2005).27 Besides, the 1:4 licensing
policy (operative between 1977 and 1990) favouring rural and under-banked
areas has caused the commercial banks to open more bank branches in less
financially developed states and it seemed to have helped increase and equalize
bank branch presence across and within Indian states and reductions in rural
poverty were linked to increased savings mobilization and credit provision in
rural areas. Taken together, these findings suggest that the central bank’s
licensing policy enabled the development of an extensive rural branch network,
and that this, in turn, allowed rural households to accumulate more capital and
to obtain loans for longer-term productive investments.28
Is Growth Finance-led?:
Finally, while the spread of banking and bank nationalization have ensured more
equity in distribution of credit and poverty eradication, what was its impact on
growth? Towards this, we have already seen that the social banking experiment
can be associated with increase in savings. Evidence seems to suggest that
financial sector was not only instrumental in promoting (p.168)
Page 55 of 106
Table 4.13 Major Sources of Industrial Finance (as percentage of GDP)
Period Bank Credit Development Finance Capital Market Total

Institutions
1970s 1.8 0.3 0.1 2.2
1980s 2.7 0.7 0.6 4.0
1990s 2.6 1.0 1.2 4.8

Source: Mohan (2009).
Page 56 of 106
aggregate investment and output, but also in the steady shift toward industry that has
characterized India’s development—in this while the operative channel could be one of
‘debt accumulation’ rather than improvements in total factor productivity, the
contribution of finance went beyond the passive support of fiscal policy (Bell and
Rousseau 2001).29 More importantly, a close look into the proportion of major sources
of industrial finance establishes the primacy of bank credit as the most important
source (Table 4.13).
Broad Trends:
How do we conclude these broad trends? As we see further, while the model of
social-control in banking development came under severe critique later years, its
contribution to economic development, growth, saving, poverty eradication, and
equity is undeniable. Moreover, to brand the whole social banking experiment as
one of subsumed fiscal costs may be misleading. It is instructive to quote from
two commentators (Bell and Rousseau 2001: 173), who despite their
reservations against state intervention in banking and finance, concluded in the
Indian case that ‘Financial development can promote economic growth and
structural change even in an environment in which both industrial investment
and financial activities are highly regulated.… For India, at least, it appears that
a particular form of financial development, whatever its flaws, has played an
important role in the industrialization process.’
Financial Liberalization Era: 1992–201130

By the end of the 1980s, it became apparent that while the existing banking
structure has attained a number of policy goals on equity front, the performance
of the Indian banking sector was not that (p.169) impressive on the efficiency
front. Has the progress of commercial banking brought with it growing problems
of deterioration in the quality of loan portfolios resulting in sizable non-
performing assets, declines in productivity and profitability, and serious
management weaknesses? Illustratively, the net profit margin of SCBs was a
meagre 0.12 per cent in 1970s, 0.11 per cent in the 1980s, and a negative 0.07
per cent in early 1990s (Ajit and Bangar 1997). This apart, due to non-disclosure
of bad debts, the financial health of the banking sector may not have been very
transparent.
Notwithstanding the adverse outcome in profitability, efficiency, and asset

quality in the Indian banking system, causal links are often not clear and
differing views have been taken with regard to its diagnosis.
Illustratively, it has been held that even as the post-nationalization policies for
commercial banks were underway, many efforts were made to examine their
functioning, restructuring, enhancing productivity, efficiency and profitability,
and improving customer service in banks but in retrospect it is found that many
of their substantive recommendations remained unimplemented or implemented
Page 57 of 106
half-heartedly.31 As a result, the deterioration in the working of commercial

banks persisted.
On the other hand, the rationale for financial liberalization has also been drawn
in the ‘financial repression’ hypothesis, wherein one of the reasons for the poor
growth performance of a developing economy is traced in administratively
determined very low real interest rates which discouraged savings and
encouraged inefficient use of capital (McKinnon 1973; Shaw 1973).32
The financial repression hypothesis is, by no means, the established wisdom in

this area. It has also been argued that market structure influences the way in
which banking sector policies affect financial deepening and that asymmetric
information may lead to monopolistic lending behaviour by individual banks
(Stiglitz and Greenwald 2003). Moreover, experiences with financial
liberalization, however, did not always produce desirable results and in case of a
number of economies financial liberalization tended to be systematically related
to banking fragility affecting financial sector development adversely (Demirguc-
Kunt and Detragiache 1998; Kaminsky and Reinhart 1999).
In line with differing arguments and counter-arguments, a view may be taken

that this period was marked by twin forces of liberalization (p.170) and efforts
towards ensuring financial stability. Illustratively, while reductions in statutory
pre-emptions via reduction in CRR and SLR can be seen as liberalizing
measures, introduction of prudential norms on banking can be viewed as a
measure ensuring financial stability. The relative position of these two forces is
of course a matter of opinion. The dominant view in this context is echoed by
Williamson (1999) as:
When we speak of financial sector reform, we have in mind two distinct but
complementary types of change.… First, we mean liberalization of the
sector: putting the private sector rather than the government in charge of
determining who gets credit and at what price. Second, we mean
establishing a system of prudential supervision designed to restrain the
private actors so that we can be reasonably sure that their decisions will
also be broadly in the general social interest. Liberalization without
supportive arrangements for proper supervision can easily lead to anti-
social behavior by bankers, of the forms referred to as ‘looting and
gambling’.33
How do we characterize the Indian financial sector reform? Following Reddy

(2000), five elements of Indian financial sector reforms may be highlighted.34
First, cautious and proper sequencing of various measures such as the gradual
introduction of prudential norms has been its hallmark. Second, there were
mutually reinforcing measures, for example, combining reduction in refinance
with reduction in the CRR that could improve bank profitability. Third,
Page 58 of 106
complementarities between reforms in banking sector and changes in fiscal,

external, and monetary policies have been accepted. This is most visible in terms
of coordination with government; for example, recapitalization of government-
owned banks coupled with prudential regulation; decisive fiscal–monetary
coordination with the abolition of ad hoc treasury bills and its replacement with
a system of ways and means advances for also the central government coupled
with reforms in debt markets. Fourth, developing financial infrastructure has
been an integral part; for example, establishment of Board for Financial
Supervision, or legal amendment to the RBI Act on NBFCs. Fifth, initiatives were
taken to nurture, develop, and integrate money, debt, and forex markets in such
a way that all major banks had an opportunity to develop skills, participate, and
benefit.
(p.171) Contours of Financial Sector Reforms

The foundation of the financial sector reforms in India came from two official
reports, namely, the Report of the Committee on Financial System (Chairman: M.
Narasimham; RBI, 1991; hereafter referred to as Narasimham Committee I) and
the Report of the Committee on Banking Sector Reforms (Chairman: M.
Narasimham; Government of India, 1998; hereafter referred to as Narasimham
Committee II). While Narasimham Committee I was primarily devoted to giving
operational freedom to the commercial banking sector, Narasimham II was
devoted to prudential norms and other stability considerations (Box 4.3).
Outcome
Where are the outcomes of these recommendations? Towards an assessment, let
us take a quick run-down of the key elements, such as interest rate
liberalization, entry deregulation, credit policies, and prudential regulation and
supervision. All recommendations excepting three or so have been accepted and
implemented.
Deregulation of Interest Rates:
The RBI began deregulating the deposit and lending rates in the early 1990s,
with commercial banks getting full freedom to set domestic term deposit rates of
seven days and above on a uniform basis for all clients. As stated above, even
the last vestige of controls on rupee interest rates in the form of prescribing the
rates on savings accounts has been dispensed with. Of course, non-resident
deposit rates remain under control. Banks were also freed from regulating their
lending rates; initially they had become free to fix their lending rates for all
classes of loans, with only small loans below Rs 2 lakh and export credit for
which the ceiling rates are prescribed to be linked to the PLR being exceptions.
However, with the introduction of Base Rate system for loan pricing, even the
preferential rate arrangement for small loans has been dispensed with from
April 2010.
Page 59 of 106
In tandem with easy liquidity conditions and reflective of the RBI’s policy
preference for a softer interest rate regime, there was a gradual softening of the
interest rates across the board in the 1990s. While (p.172) (p.173)
bank lending rates have been

relatively rigid in the first half of
2000s, it has followed a downward
trend thereafter (Figure 4.10).
Figure 4.10 Nominal Interest Rates in

India
Note: In case of a range of deposit
rates, the mid-point is taken as a
representative rate.
Box 4.3 Recommendations of Narasimham Committee Reports I and

II
The Narasimham Committee Report I of 1991 gave the following major

recommendations:
• Reduction in the SLR and CRR: The committee recommended the

reduction of the higher proportion of the SLR and the CRR. SLR was
recommended to reduce from 38.5 per cent to 25 per cent and CRR from
15 per cent to 3 to 5 per cent.
• Phasing out of Directed Credit Programme (Not accepted)
• Interest Rate Determination: The committee recommended eliminating

administrative controls on interest rate and phasing out the concessional
interest rates for the priority sector.
• Structural Reorganizations of the Banking Sector: The committee

recommended that the actual numbers of public sector banks need to be
reduced. While three to four big banks could be developed as
international banks, eight to ten banks having nationwide presence should
Page 60 of 106
concentrate on the national and universal banking services. Local banks

should concentrate on region-specific banking. The RRBs should focus on
agriculture and rural financing. (Not accepted)
• Establishment of the ARF Tribunal: The committee recommended the

establishment of an Asset Reconstruction Fund (ARF). This fund could
take over the proportion of the bad and doubtful debts from the banks and
financial institutions and help banks to get rid of bad debts.
• Removal of Dual Control: The dual control of the RBI and the Banking
Division of the Ministry of Finance (GoI) could be done away and the RBI
should be the only main agency to regulate banking in India.
• Banking Autonomy: In order to pursue competitiveness and efficiency,

banks must enjoy operational autonomy.
The major recommendations of Narasimham Committee Report II of 1998

were as follows:
• Strengthening Banks in India: It recommended the merger of strong

banks which will have ‘multiplier effect’ on the industry.
• Narrow Banking: For successful rehabilitation of the weak banks with

high non-performing assets, the committee recommended the concept of
‘narrow banking’, whereby weak banks will be allowed to place their
funds only in short term and risk free assets like government securities.
(Not accepted)
• Capital Adequacy Ratio: In order to improve the inherent strength of the

Indian banking system, the committee recommended that the prescribed
capital adequacy norms should be increased.
• Bank Management: A review of functions of bank boards is needed to

adopt professional corporate strategy.
• Review of Banking Laws: The committee considered that there was an

urgent need for reviewing and amending main laws governing the Indian
banking industry.
Sources: RBI (1991) and GoI (1998).
Figure 4.10 does not tell the full story of the behaviour of interest rates. Over the
years, there has been significant change in the structure of interest rate
determination in India (Box 4.4).
The inter-temporal behaviour of the BPLRs has been found to be downwardly

sticky and asymmetric. Illustratively, it has been observed that during the
monetary policy tightening phase (March 2004 to September 2008), while banks
Page 61 of 106
were often quick in raising lending rates during an upturn in the interest rate
cycle, they were slow to bring down the interest rate in the downturn of the
interest rate cycle (Table 4.14). Accordingly, the Working Group on Benchmark
Prime Lending Rate noted, ‘the extant benchmark prime lending rate (BPLR)
system has fallen short of expectations in its original intent of enhancing
transparency in lending rates charged by banks and needs to be modified’ (RBI
2009) and saw merit in introducing a system of Base Rate to replace the existing
BPLR system.
From another standpoint, the greater policy concern is that the real interest
rates for borrowers could have actually been increasing. In (p.174) fact, they
have risen much more than the increase in interest rates for depositors. Mohan
(2002) has shown that if real interest rates are calculated as the weighted
average lending rate of SCBs less manufacturing inflation for borrowers and
average cost of time deposits less inflation for depositors (based on the
consumer price index for industrial workers), then there has been a marked rise
in the real lending (p.175)
Page 62 of 106
Table 4.14 Movements in Monetary Policy Instruments and BPLRs (changes in basis points)
Phase CRR Repo Rate Reverse Repo Benchmark Prime Lending Rate
Rate
Public Sector Private Banks Foreign Banks
Banks
Monetary 450 300 150 300 to 325 225 to 375 100 to (−)150
Tightening Phase:
Mar. 2004 – Sept.
2008
Monetary Easing (−)400 (−)425 (−)275 (−)150 to (−)275 (−)100 to (−)125 (−)50 to (−)100
Phase: Sept.
2008– May 2009
Source: RBI (2009).
Page 63 of 106
rates.35 This has effectively meant that banks have not fully passed on the benefits of
the reduction in deposit rates to borrowers.
Box 4.4 Evolution of Lending Rate Structure in India
September The structure of lending rates was rationalized into six size-
1990: wise slabs. Of these, banks were free to set interest rates
on loans of over Rs 2 lakh with minimum lending rates
prescribed by the Reserve Bank.
April 1992: Slabs compressed into four.
April 1993: Slabs compressed into three.
October Lending rates for loans with credit limits of over Rs 2 lakh
1994: deregulated. Banks were required to declare their PLRs.
February Banks allowed to prescribe separate PLRs and spreads over

1997: PLRs, both for loan and cash credit components.
October For term loans of three years and above, separate Prime
1997: Term Lending Rates (PTLRs) were required to be
announced by banks.
April 1998: PLR converted as a ceiling rate on loans up to Rs 2 lakh.
April 1999: Tenor-linked Prime Lending Rates (TPLRs) introduced.
October Banks were given flexibility to charge interest rates without

1999: reference to the PLR in respect of certain categories of
loans/credit.
April 2000: Banks allowed to charge fixed/floating rate on their lending

for credit limit of over Rs 2 lakh.
April 2001: The PLR ceased to be the floor rate for loans above Rs 2
lakh. Banks allowed to lend at sub-PLR rate for loans above
Rs 2 lakh.
April 2002: Dissemination of range of interest rates through the

Reserve Bank’s website was introduced.
April 2003: Benchmark PLR (BPLR) system introduced and tenor-linked

PLRs discontinued.
February Draft circular on Base Rate placed on RBI website for

2010: obtaining comments/suggestions from public/stakeholders.
April 2010: Base Rate system of loan pricing introduced effective 1 July
2010. Rupee lending rate structure completely deregulated.
Page 64 of 106
Source: Mohanty (2010b).
Deregulation of Bank Operations:
The RBI began to rationalize the sector-specific directed lending programme in

the early 1990s. Three developments are noteworthy. First, most credit controls
have been gradually phased out in the early 1990s. Second, the list of borrowers
eligible for loans under the priority sector has been considerably expanded.36
Finally, interest rates on priority sector lending had been rationalized; they were
linked to PLRs. Besides, after a long gap, in 1993 the RBI allowed new banks in
the private sector.37 The branch licensing policy was further liberalized whereby
banks are permitted to rationalize their existing branches or open specialized
branches. Currently, while public sector banks occupy nearly three-fourths of the
aggregate assets, private sector bank’s stood at near one-fifth (Table 4.15).
Prudential Regulations:
The cornerstone of the strategy of strengthening financial stability was the

institution of prudential norms relating to income recognition, asset
classification, and provisioning requirements and incentive-based regulation
through the prescription of capital to risk-weighted assets ratio. This had been
supplemented by asset-liability management and risk management systems.
Over (p.176)
Page 65 of 106
Table 4.15 Shares of Bank Groups in Banking Aggregates (as of end March 2010) (in per cent)
Share(s) in Public Private Foreign Total
Aggregate Assets 73.7 19.1 7.2 100.0
Deposits 77.7 17.3 5.0 100.0
Investments 70.1 20.6 9.3 100.0
Government Securities 73.8 17.6 8.6 100.0
Loans and Advances 77.2 18.1 4.7 100.0

Source: Report on Trend and Progress of Banking in India, RBI, 2009–10.
Page 66 of 106
the period, the guidelines had only been tightened to bring them in line with the best
international practices.
At the core of prudential norms is the issue of adequacy of capital in relation to
the risks of banking assets. The RBI had prescribed banks capital to risk-
weighted assets ratio (CRAR) in 1992–3. The CRAR stipulations had been
gradually increased, especially in the case of domestic banks, from 4.0 per cent
during 1992–3 to 9 per cent in 1999–2000. The improvement in the profitability
of the banking system has been reinforced by an improvement in its health. The
CRAR of the banking system, as in end March 2010, worked out to 13.6 per cent
of assets, far above the stipulated 9 per cent (Figure 4.11).
An equally important issue of the Indian banking sector is the asset quality.
Banks were earlier instructed to rate their loan portfolio on a health code matrix
introduced in 1985. Following the recommendations of the Narasimham
Committee I, the RBI required banks to classify their loan portfolio into
‘standard assets’ (if the accounts are satisfactory) and into ‘non-performing
assets’ (NPAs), if principal/instalment of interest are due after a stipulated time
period. Depending on the time period for which such payments are not received
by the bank, NPAs are further divided into ‘sub-standard assets’, ‘doubtful
assets’, and ‘loss assets’. While incomes are typically recognized on an accrual
basis, no income should be recognized in case of these NPAs. During this period,
NPAs have followed a steadily decreasing path (Figure 4.12).38
The RBI has also repeatedly stressed the need for marking assets to the market
in order to capture true current values. Banks were initially required to mark to
market 30 per cent of their investment portfolio in 1992–3—the proportion was
gradually raised to 75 per cent in 1999–2000. Subsequently, the investment
portfolio is required to be classified (p.177)
Figure 4.11 CRAR of Scheduled

Commercial Banks
Page 67 of 106
(p.178) into ‘held to

maturity’ (HTM), ‘available for
sale’ (AFS) (at least annual
revaluation), and ‘held for
trading’ (HFT) (at least monthly
revaluation) in accordance with
Generally Accepted Accounting
Principles (GAAP). While the HTM
component could be held at
historical cost, subject to a cap of
25 per cent of the investment
portfolio, the balance has to be Figure 4.12 Declining Non-performing
‘marked to market’ (MTM) at Assets of the Indian Banking Sector
prescribed frequencies.
Balance Sheet Indicators:
Economy, RBI, various issues
During the 1990s, the
proportion of deposit growth in
GDP began to plateau out as the push effect of wider banking began to be
countered by the pull effect of financial innovations (Bhaumik and Mukherjee
2003; Sarkar 2004). The ratio of credit to output, an indicator of financial
development, continued to climb suggesting that banks remained ‘special’ as
sources of finance in the Indian economy. Since the early 1990s, the Indian
commercial banking sector experienced healthy growth in deposits; the growth
experience of bank advances was, however, not too spectacular (Figure 4.13).
(p.179) Illustratively, while it

is true that the share of bank
credit had not appreciably
increased despite the reduction
in statutory pre-emptions, this
was against the backdrop of the
weakening of credit demand in
the latter half of the 1990s. The
situation changed after the
1990s when banks were
accorded the freedom to align
their credit allocation in
consonance with their portfolio
decisions. Besides, factors like Figure 4.13 Banking Indicators: Credit,
growing indirect securitization Deposits, and Investments
of bank credit and banks’ Source: Handbook of Statistics on Indian
investments in non-SLR Economy, RBI, various issues.
investment could have been
responsible.
Page 68 of 106
Finally, despite the reduction in SLR, the share of government paper in the bank
portfolio has been on a rising trend till 2004–5. There was, however, a major
shift in the rationale of such investment. Unlike till the mid-1990s when gilt
investment was largely on account of high SLR requirements prescribed by the
central bank, during the latter half of the 1990s, the persistent preference for
government paper reflected lack of alternative avenues of investments with the
weakening of domestic credit demand (Sarkar 2004). The decision of the
banking system to park funds in government paper allowed them to earn
attractive returns in a scenario of falling interest rates during the downturn in
economic activity in the latter half of the 1990s. Besides, investments in
government paper allowed banks to avoid the problems of adverse selection,
which are usual, in economic slowdowns. This was reflected in the fact that the
fresh accretion to NPAs has been marginal in recent years notwithstanding the
economic slowdown.
In this context, Banerjee et al. (2005) found some evidence of under-lending and
concluded: ‘Credit in India does not necessarily seem to flow to the people who
have the greatest use for it’. In their opinion, fear of being prosecuted for a
defaulted loan by loan officers in a bank could explain part of this under-lending.
Profitability/Productivity:
What has been the impact of all these to banks’ bottom lines? There is very little
doubt that the profitability of the banking system improved during the 1990s.
Net profits of the SCBs climbed steadily, notwithstanding a narrowing of spreads
and higher provisions for non-performing loans (Koeva 2003). Besides, there had
been distinctive productivity improvements in Indian banking (Mohan 2006).
Illustratively, at 1993–4 prices, profits per employee improved to Rs 1.5 lakh in
2004 from Rs 0.2 lakh in 1992.
(p.180) How was this increase in profitability possible? While a priori

competitive forces during a period of financial sector reforms could drive the
profits down, they could also result in making a bank more cost-conscious. In
fact, in the Indian case, the improvement in profitability was primarily due to a
combined effect of larger trading incomes and a curtailment in operating
expenses, including the wage bill.39
In fact, an analysis of various accounting measures suggests a significant

improvement in the efficiency/productivity of the Indian banking sector in the
post-reform period, although the degree of improvement varied across the bank
groups. The performance, especially of public sector banks, worsened in the
initial years of reforms as eight public sector banks suffered net losses in 1992–3
and six in 1993–4 (see Table 4.16).
Page 69 of 106
Thereafter, the performance improved gradually, especially beginning 2001–2

with intermediation cost declining significantly in the last few years, reflecting
the impact of intensifying competitive pressures. Despite this, however, the
profitability of banks improved as was reflected in the return on assets (Table
4.17).
Ownership Effect:
The concept of public ownership often evokes strong reactions. While to an

exponent of the ‘financial repression’ hypothesis, the notion of public ownership
in banks is an anathema, to a believer of social control, dilution of public
ownership is often
Page 70 of 106
Table 4.16 Profitability Indicators in the Initial Reform Period
Year (April– March) No. of Profit- making No. of Loss- making Overall Profit/Loss Return on Assets of Return on Assets of
SCBs SCBs (−) Rs Crore SCBs PSBs
1992–3 59 (15) 14 (12) −4,150 −1.08 −0.99
1993–4 60 (15) 14 (12) −3,625 −0.85 −1.15
1994–5 73 (19) 13 (8) 2,154 0.41 0.25
1995–6 80 (19) 14 (8) 939 0.16 −0.07
1996–7 92 (24) 8 (3) 4,504 0.67 0.57
1997–8 92 (25) 11 (2) 6,502 0.82 0.77

Source: RBI (2008).
Notes: SCBs: Scheduled Commercial Banks; PSBs: Public Sector Banks; figures in parentheses indicate number of public sector banks.
Page 71 of 106
(p.181)
Page 72 of 106
Table 4.17 Select Productivity Indicators of Commercial Banks in India (in %)
Year Public Sector Banks Private Banks Foreign Banks All Commercial
Banks
Operating Cost to 1991–2 2.60 2.97 2.26 2.59

Assets
1998–9 2.65 2.04 3.39 2.65
2006–7 1.77 2.06 2.78 1.91
Cost to Income Ratio 1991–2 58.41 58.96 30.91 55.30
1998–9 65.94 58.96 56.61 64.26
2006–7 50.58 52.17 44.64 50.15
Labour Cost per Unit 1991–2 2.36 2.86 1.08 2.30

of Earning Assets
1998–9 2.58 1.30 1.37 2.35
2006–7 1.32 0.84 1.56 1.23
Non-labour Cost per 1991–2 1.04 1.17 2.18 1.12

Unit of Earning
1998–9 0.98 1.36 3.27 1.20
Assets
2006–7 0.73 1.60 2.36 1.03
Intermediation Cost 1991–2 5.77 6.13 13.28 6.24
1998–9 3.96 4.03 6.32 4.19
2006–7 3.20 3.61 5.50 3.43
Net Interest Margin 1991–2 3.22 4.01 3.90 3.30

(Spread)
Page 73 of 106
Year Public Sector Banks Private Banks Foreign Banks All Commercial
Banks
1998–9 2.81 2.11 3.52 2.79
2006–7 2.65 2.45 3.74 2.69
Other Income (Non- 1991–2 10.74 9.62 22.72 11.82

interest) to Total
1998–9 11.91 12.25 19.35 12.67
Income
2006–7 11.04 17.86 27.80 14.09
Business per 1991–2 45.15 33.48 199.47 46.66

Employee (Rs Lakh)
1998–9 105.78 193.95 504.81 117.72
2006–7 470.99 694.07 995.09 521.94
Business per branch 1991–2 8.93 4.87 149.96 9.12

(Rs Crore)
1998–9 20.90 25.24 349.04 22.75
2006–7 66.83 133.16 1,004.10 79.39
Return on Assets 1991–2 0.28 0.57 1.56 0.39
1998–9 0.42 0.67 1.01 0.50
2006–7 0.83 0.87 1.65 0.90
Return on Equity 1991–2 11.02 26.77 42.26 14.77
1998–9 7.78 11.70 10.96 8.59
2006–7 14.86 12.81 13.86 14.24

Source: RBI (2008).
Page 74 of 106
seen as shedding societal concerns on the part of the banks. How far is performance
sensitive to ownership question?
Table 4.17 is instructive in this regard. Productivity indicators varied quite a lot
across bank-groups. Illustratively, intermediation (p.182) cost in public sector
banks is distinctly less than both private and foreign banks—the same is true for
return on equity as well. Thus, the often assumed efficiency hierarchy of foreign
and private banks being better than public sector banks suffers from over-
simplified popular misbeliefs.
There is a large literature on Indian banking that examines whether the public
sector banks are less efficient than their private sector counterparts.40 Existing
empirical evidence indicates that the ownership effect in Indian banking is
rather weak. Illustratively, in estimating efficiency and productivity of banks it
was found that while banks have improved their performance during 1986 to
2000 in terms of both efficiency and productivity, foreign banks have been the
worst performers throughout the period as compared with state owned and
private domestic banks (Sensarma 2006). On the basis of profit measures it has
been concluded that public banks have been able to bridge the difference with
private banks and hence the role of competition is more important than that of
ownership (Bhaumik and Dimova 2004).
Interestingly, it is observed that the improvement in profitability has been fairly

broadbased cutting across bank groups. If we define ‘government-owned
PSBs’41 as the set of select PSBs which were fully government-owned at end-
March 2002, and ‘Divested PSBs’ as the set of select PSBs, which had accessed
capital market and consequently, had a lowered government holding,42 then an
important highlight of the entire process has been the sharp improvement in the
performance of fully government-owned public sector banks as well (Sarkar et
al. 1998). This suggests that the issue of ownership is not as strong a factor in
bank performance as is often made out to be. However, it has been observed that
as far as the ability of commercial banks to insulate their portfolios from the
impact a contractionary monetary policy is concerned, the behaviour of the
banks is weakly sensitive with respect to ownership (Ray 2008).
Quantum Jump in Secondary Market Transactions:
While studying the growth of the Indian financial system in recent years, what
stands out is the mindboggling size of turnover in secondary markets in every
segment of the system (Table 4.18). Several regularities may be noted in this
connection. First, in the commodities markets, futures trading may be helpful in
some instances but because of the dominance of the speculator-financial
interests in futures, genuine (p.183) price discovery for the farmer is found to
be very difficult. Besides, on account of the limited amounts of physical
deliveries including the inadequacy of enabling warehouses, risk management is
impossible of achievement. Secondly, the practice of permitting futures trading
in individual stocks has also been questioned. Illustratively, Mehta (2005) has
Page 75 of 106
pointedly brought out how in equity derivatives, trades are allowed to be cash
settled and not delivery settled, and went on to say:
In the absence of physical delivery, the system simply flushes out all trades
at the end of the month when the contract expires. There is no logical
conclusion to the futures trade. On the last day, cash is exchanged and the
one-way traffic of buy does not have any speed-breaker of sale
transactions. The continuous balancing of buy and sell does not happen
and the populist view gets further propagated as the buyer does not have
any obligation to take delivery.
Distributional Issues and Financial Inclusion:
A major critique of the financial liberalization period comes from issues relating
to distributional goals and the incidence of growing financial exclusion. Has
financial liberalization given a fillip to productivity, efficiency, and solvency of
the banking sector but at the cost of distributive justice? It is interesting to note
that the Report of the Committee on Financial Inclusion (Chairman: C.
Rangarajan; NABARD 2008: 115) observed thus:
The financial system in India has grown rapidly in the last three decades
and more. The functional and geographical coverage of the system is truly
impressive. Nevertheless, data do show that there is exclusion and that
poorer sections of the society have not been able to access adequately
financial services from the organized financial system. There is an
imperative need to modify the credit and financial services delivery system
to achieve greater inclusion.
Another official committee, namely, the Committee on Financial Sector Reforms

(Chairman: Raghuram Rajan; GoI 2009: 49), noted, perhaps from a different
perspective:
Financial sector policies in India have long been driven by the objective of
increasing financial inclusion, but the goal of universal inclusion is still a
distant dream. The network of cooperative banks to provide credit to
agriculture, the nationalization of banks in 1969, the creation of an
elaborate framework of priority sector lending with mandated targets were
all elements of a state-led approach to meet the credit (p.184)
Page 76 of 106
Table 4.18 Secondary Market Turnover in Financial and Commodities Markets
(Amount in Rs crore)
Market Segments/ 2002–3 2003–4 2004–5 2005–6 2006–7 2007–8 2008–9 2009–10 2010–11 2011–12
Year
1 Government 15,44,37 25,18,32 26,92,12 25,59,26 35,78,03 56,02,60 62,54,51 89,86,71 6970,23 72,52,08
Securities Market 6 2 6 0 7 2 9 9 6 0
(62.9) (91.4) (83.0) (69.3) (83.3) (112.3) (111.1) (138.7) (89.4) (80.8)
2 Forex Market 6,58,035 23,18,53 40,42,43 52,39,67 80,23,07 1,27,26, 1,69,37, 1,42,11, 19,16,01 22,19,96
1 5 4 8 832 489 486 53 12
(26.8) (84.2) (124.7) (141.9) (186.8) (255.2) (300.8) (219.4) (245.8) (247.4)
3 Total Stock 13,74,40 37,44,84 42,21,95 72,09,89 1,03,16, 1,84,62, 1,48,71, 2,31,71, 3,39,18, 3,56,29,
Market Turnover 3 1 2 2 750 681 781 922 597 595
(I+ II)
(56.0) (135.9) (130.2) (195.2) (240.2) (370.2) (264.1) (357.7) (435.1) (397.0)
I Capital Derivati 4,39,863 21,30,61 25,47,05 48,24,25 73,56,27 1,30,90, 1,10,10, 1,76,63, 2,92,48, 3,13,49,
Market ves 2 3 1 1 478 482 665 221 732
(NSE)
Cash 6,17,989 10,99,53 11,40,07 15,69,55 19,45,28 35,51,03 27,49,45 41,29,21 35,65,19 28,03,88
5 2 8 7 8 0 4 5 9
Total 10,57,85 32,30,14 36,87,12 63,93,80 93,01,55 1,66,41, 1,37,59, 2,17,92, 3,28,13, 3,41,53,
2 7 5 9 8 516 932 879 416 621
(43.1) (117.3) (113.7) (173.1) (216.6) (333.7) (244.4) (336.4) (420.9) (380.5)
Page 77 of 106
Market Segments/ 2002–3 2003–4 2004–5 2005–6 2006–7 2007–8 2008–9 2009–10 2010–11 2011–12
Year
II Capital Derivati 2,478 12,074 16,112 9 59,007 2,42,308 11,775 234 154 8,08,476
Market ves
(BSE)
Cash 3,14,073 5,02,620 5,18,715 8,16,074 9,56,185 15,78,85 11,00,07 13,78,80 11,05,02 6,67,498
6 4 9 7
Total 3,16,551 5,14,694 5,34,827 8,16,083 10,15,19 18,21,16 11,11,84 13,79,04 11,05,18 14,75,97
2 5 9 3 1 4
(12.9) (18.7) (16.5) (22.1) (23.6) (36.5) (19.7) (21.3) (14.2) (16.4)
III Total Derivatives 4,42,341 21,42,68 25,63,16 48,24,26 74,15,27 1,33,32, 1,10,22, 1,76,63, 2,92,48, 3,21,58,
Turnover 6 5 0 8 786 257 899 375 208
(BSE+NSE)
(18.0) (77.8) (79.1) (130.6) (172.7) (267.3) (195.8) (272.7) (375.2) (358.3)
4 Commodities 66,500 1,29,400 5,71,759 21,34,00 36,76,92 40,65,98 52,48,95 77,64,75 1,19,48, 1,81,26,
Market 0 7 9 7 4 942 104
(2.7) (4.7) (17.6) (57.8) (85.6) (81.5) (93.2) (119.9) (153.3) (202.0)
GDP at market 24,54,56 27,54,62 32,42,20 36,93,36 42,94,70 49,87,09 56,30,06 64,77,82 77,95,31 89,74,94
prices 1 1 9 9 6 0 3 7 4 7
Memo Item:
Page 78 of 106
Market Segments/ 2002–3 2003–4 2004–5 2005–6 2006–7 2007–8 2008–9 2009–10 2010–11 2011–12
Year
Open Interest at 2,194 7,188 21,052 38,470 38,670 48,900 57,705 9,7978 1,01,816 89,048
the end for
derivative
contracts traded
on NSE
Source: NSO, Rakshitra and other Publications of CCIL, SEBI Bulletin, NSE NEWS, and FMC website.
Note: Figures in brackets represent per cent to GDP at current market prices.
Page 79 of 106
(p.185) (p.186) needs of large sections of the Indian population who had no
access to institutional finance.… Its success has been mixed, and has been
showing diminishing returns.
What are the symptoms of financial exclusion? Analyses of certain indicators of

banking penetration of SCBs in the country, including RRBs, amply testify to the
rural–urban divide existing in their operations/business (Thorat 2009). The
average population served per branch office is an important indicator of banking
penetration; while the population per branch has decreased for urban areas, the
same has increased for rural areas, indicating that branch expansion has not
kept pace with the population increase in the rural areas (Table 4.19).
The share of agriculture in total bank credit had steadily increased under the
impulse of bank nationalization and reached 18 per cent towards the end of the
1980s, but thereafter the achievement has been reversed and agriculture’s
credit share has dipped to less than 10 per cent in the late 1990s—a ratio that
had prevailed in the early 1970s (see Figure 4.14). Even the number of farm loan
accounts with SCBs has declined in absolute terms from 27.74 million in March
1992 to 20.84 million in March 2003 (Shetty 2004).43
Yet another indication of financial exclusion is to be seen in the neglect of small

and marginal farmers or small borrowers in general. Following bank
nationalization and for the next two decades, there was an upsurge in small
borrowal accounts nursed in the lending programmes of SCBs. Thus, between
December 1992 and March 1992, the additional bank accounts of SCBs were
essentially in the form of small borrowal accounts with Rs 10,000 or less credit
limit or with Rs 25,000 or less credit limit as defined in different periods; such
small accounts had constituted as much as 93 per cent to 94 per cent of the total
additional loan accounts. However, beginning 1990s, there was a sudden shift of
focus in the banks’ operations, moving away from small borrowal accounts.
Between March 1992 and March 2001,
Table 4.19 Average Population per Branch Office
1991 2001 2005
Population per Branch 13,711 15,209 15,680
Population per Rural Branch 13,462 15,667 16,650
Population per Urban Branch 14,484 14,137 13,619

Source: Thorat (2009).
(p.187)
Page 80 of 106
for instance, there was an

absolute decline of as much as
25.3 million small borrwoal
accounts with credit limits of Rs
25,000 or above. Even in the next
period between March 2001 and
March 2005, while there has
occurred an addition of 24.79
million in total loan accounts,
small borrowal accounts had
experienced an absolute fall of
0.49 million until March 2004. The Figure 4.14 Credit to Agriculture and SSI
year 2004–5 was the first year of Sector (as percentage to total credit)
farm credit doubling, when there
Source: Banking Statistics, RBI, various
was an increase of 1.97 million
accounts of small loans but issues.
thereafter the small loan accounts Note: SSI: Small-scale industry.
generally followed a zigzag
pattern of declines and increases
in successive years.
Besides, a more revealing
aspect relates to the unusually sharp decline in the share of small borrowers in
the total bank credit outstanding. This share in amount has reached such a puny
level as 1.2 per cent of the aggregate, it was about 25 per cent at the end of the
1980s.
As for small and marginal farmers, between 1991–2 and 2003, their share in
total operational holdings increased from 81 per cent to 86 per cent and
correspondingly their share in the operated area increased from 34 per cent to
44 per cent. However, their share in the number of credit accounts decreased
from 77 per cent to 69 per cent and in amount of credit disbursed decreased
from 54 per cent to 48 per cent. In contrast, for semi-medium and above
farmers, the share of credit increased while their share of area declined (see
Table 4.20). (p.188)
Page 81 of 106
Table 4.20 Land-size-wise Distribution of Agricultural Credit Flow from SCBs
Category Share in Operational Share in Operated Area Share in Number of Agricultural Share in Agricultural Credit
Holdings Credit Accounts Disbursed
1991–2 2003 1991–2 2003 1991–2 2002–3 2006–7 1991–2 2002–3 2006–7
Marginal 62.8 69.7 15.6 22.6 45.4 38.9 41.6 28.8 22.1 24.7
Small 17.8 16.3 18.7 20.9 31.4 30.2 27.9 24.9 25.5 22.9
Semi+ 19.4 14.1 65.7 56.5 23.2 30.9 30.5 46.3 52.4 52.4
Source: Handbook of Statistics on Indian Economy, RBI, 2008; Some Aspects of Operational Land Holdings in India,
National Sample Survey Organisation (NSSO), various rounds. Reproduced from Report of the Task Force on Credit
Related Issues of Farmers (Chairman: Umesh Chandra Sarangi) submitted to the Ministry of Agriculture, Government
of India in June 2010.
Notes: 1. Semi+ denotes Semi-medium and above. 2. Land holding data are reported in hectares (ha) where Marginal (<1.00 ha), Small
(1.00–1.99 ha) and Semi+ (2.00 and above). 3. Credit data across land size given by land-size are up to 2.5 acres, 2.5–5.0 acres, and
above 5 acres, which approximately resemble Marginal, Small, and Semi+, respectively.
Page 82 of 106
(p.189)
For the small-scale industry (SSI) sector, less than 5 per cent of the small-scale
units enjoyed any bank finance; in the case of unregistered units which
dominate, it had been just about 3.1 per cent. As per the estimates of the
National Commission for Enterprises in the Unorganised Sector (NCEUS) only
an estimated 5.3 per cent out of 58 million units in March 2007 with investment
of Rs 25 lakh or less have had any institutional credit; about 55 million (about 95
per cent) did not enjoy any such facility.
A more serious dimension of financial exclusion is revealed by the NSSO in the

situation assessment survey on ‘Indebtedness of Farmer Households’ (2003). As
per NSSO data, 45.9 million farmer households in the country (51.4 per cent),
out of a total of 89.3 million farmer households do not access credit, either from
institutional or non-institutional sources. Only 27 per cent of total farm
households are indebted to formal sources (of which one-third also borrow from
informal sources). Thus, 73 per cent of farm households do not have access to
formal credit sources. The farm households not accessing credit from formal
sources as a proportion to total farm households is especially high at 95.9 per
cent in the north-eastern region (see Table 4.21).
These numbers are quite glaring and call for immediate action. Some of the
recent initiatives by the government and the RBI in respect of achieving better
financial inclusion appear innovative. First, though initially dithering, the
authorities have recognized the acute institutional vacuum existing in rural and
semi-urban areas and directed SCBs to open at least 25 per cent of the new bank
branches in unbanked rural centres. Secondly, with a view to strengthening the
institutional set up, the RBI’s January 2011 guideline allowed banks to resort to
‘Agency Banking’, that is, to engage the services of Business Correspondents
(BCs) with cash dealing powers and those of Business Facilitators (BFs) as
agents without cash handling powers. Of late, even for-profit companies have
been allowed to participate as BCs. Thirdly, based on the recommendations of
the Usha Thorat Committee on Lead Bank Scheme (August 2009), the proposals
to revitalize the scheme have been accepted whereby the processes of ‘financial
inclusion’ to be achieved with state- and district-level credit plans are to be
dovetailed into the processes involved in achieving the objectives of ‘inclusive
growth’ with the help of state and district-level development plans. These steps
are expected in particular to strengthen the entire rural financial architecture.
(p.190)
Page 83 of 106
Table 4.21 Extent of Financial Exclusion amongst Farm Households: Region-wise
No. of Farmer Households (HH) in Lakh
Region Total Farm Indebted % to total Non- % to total Indebted to % to total Excluded by % to total
HHs HHs HHs indebted HHs Formal HHs Formal HHs
HHs Sources Sources
Northern 109.46 56.26 51.0 53.20 48.6 27.423 25.0 82.04 75.0
North 35.40 7.04 19.9 28.36 80.1 1.448 4.1 33.95 95.9
Eastern
Eastern 210.61 84.22 40.0 126.39 60.0 39.467 18.7 171.14 81.3
Central 271.33 113.04 41.6 158.29 58.4 60.814 22.4 210.52 77.6
Western 103.66 55.74 53.7 47.92 46.3 45.586 44.0 58.07 56.0
Southern 161.56 117.45 72.7 44.11 27.3 69.072 42.8 92.49 57.3
Group of 1.48 0.49 33.1 0.99 66.9 0.150 10.1 1.33 89.9
UTs
All India 893.50 434.24 48.6 459.26 51.4 243.960 27.3 649.54 72.7
NE, C & E 517.34 204.30 39.5 313.04 60.5 101.730 19.7 415.61 80.3
Regions*
Share to All 57.90 47.10 68.20 41.700 64.00

India (%)
Source: NABARD (2008): 30.
Note: * NE = North-Eastern Region, C = Central Region, E = Eastern Region.
Page 84 of 106
(p.191) In addition, the banks in their allotted districts have been asked to
open ‘no-frills’ loan accounts, issuing kisan credit cards and general credit
cards. At the end of June 2012, 147.94 million such no-frills accounts have been
opened by the banking system. Finally, SCBs and RRBs have been encouraged to
promote microcredit through formation and credit linkage of self-help groups
(SHGs).44
Considering the enormity of financial exclusion and the vastness of area to be

covered, quality of success achieved in fulfilling the institutional goals and goals
of financial inclusion have to be carefully assessed. A College of Agricultural
Banking (CAB), Pune, study has reported that most Customer Service Points
(CSPs) of BCs are not positioned as effective extensions of the banking system to
offer a larger suite of products and services; they focus on completing
transactions on behalf of their bank partners and do not offer a wide array of
banking services. Also, most CSPs report operational constraints, such as
delayed remuneration, liquidity problems, and technology failures; their
earnings form CSP work are less than half of what they expect in most cases.
These observations are further corroborated by a statement issued by K.C.

Chakrabarty (2013: 14), a Deputy Governor of RBI:
We are trying to use BCs to take banking to the people’s doorsteps. The BC
model is aimed at reducing the transaction costs of banking services as the
cost of regular bank employees is very high, making it difficult to provide
low cost banking services to the unbaked poor. However, banks do not
seem willing to pay reasonably to these people from the unorganised
sector. The poor BCs are paid so low that people accept this job only if they
do not have any other option and at the very first opportunity, leave the
BC’s work. The BC needs to be paid reasonably and also supported
through appropriate ICT enabled infrastructure. How do we integrate the
BC model with the overall delivery model of the banking services is
another challenge for making Financial Inclusion a reality.
The RBI officials themselves have thus been critical of the quality of financial
inclusion achieved so far. To quote no less a person than the RBI Governor, D.
Subbarao (RBI Bulletin, August 2012), whose observations in this respect are
indeed an eye-opener:
The general impression I got is that frontline branch managers treat ‘no
frills’ accounts as a ‘nuisance’ and low income households as an intrusion
into their time and their business. This is disappointing to say the least…
(p.192) I am also conscious that the bulk of our effort so far has been
from the supply-side—opening branches, appointing BCs and opening
Page 85 of 106
accounts that remain largely inoperative. If this is all that happens, the
effort is both futile and wasteful…
It is difficult to conclude the evolution of monetary and banking policy over a

long 60-year period for the Indian economy. Missing the trees for the woods
could be a common limitation of a chapter such as this. If one says that
monetary and banking policies like any other wings of economic policy tended to
follow the zeitgeist or spirit of time, one may be stating the obvious without
being analytical or informative.
Nevertheless, at the risk of broad generalization, movement from pre-

nationalization era to a structuralist strategy and then to monetary targeting
and finally to a complex multiple indicators approach in the sphere of monetary
policy in some sense captures the spirit of evolution of the Indian economy. In
this locomotion, monetary policy has traversed a long but not necessarily a
linear path. But in terms of the desired outcomes of growth and inflation, on the
average, the overall direction of the path seems to be one of reasonable
progress.45
Coming to banking, the initial days of bank failures and the philosophy of
planned economic development gave rise to bank nationalization. During the
1970s and 1980s, banking network spread under an overall state interventionist
strategy. This tremendous spread of bank network gave rise to increasing
financialization of the economy, leading to higher savings, investment, and
growth along with a dent on poverty eradication. The initiation of economic
liberalization strategy in the Indian economy since the 1990s had a fairly
significant element of financial liberalization comprising both freeing of
government control over the functioning of banks as well as imposition of
prudential regulation on banks. While this strategy has made the banks more
efficient, viable, and stable, issues relating to financial inclusion seem to be
indicating that specialized policies and intervention are still needed to carry
forward the mantle of provision of finance among the larger sections of the
society. In fact, the objective of ‘financial inclusion’ has still remained a distant
goal.
Thus, in terms of a broad brush, monetary and banking policies have moved on
in search of their quest for confronting newer and more daunting challenges.
The chapter covers developments in monetary policy and banking in India till
about 2010. While updating it in terms of all the recent developments could be
illusive, for the sake of completeness this appendix gives a synoptic account of
the recent developments—needless to say, the treatment is highly selective. This
postscript concludes that while in case of monetary policy there has been a
regime shift in the form of adopting inflation targeting, the changes in the broad
Page 86 of 106
banking structure have been mostly incremental in nature and many of them are
in their initial announcement phase.
Monetary Policy
Over the last two decades, in a large number of countries inflation targeting has
emerged as a monetary policy paradigm. What started with New Zealand in
1989 soon spread to the United Kingdom and a host of Asian countries like
Thailand and the Philippines. The global bandwagon of inflation targeting has
made an entrance to the Indian policy arena in recent times.46
Interestingly, till mid-2013 the widely held view inside the RBI was against
adoption of inflation targeting. Illustratively, D. Subbarao, former RBI governor,
had strongly opposed inflation targeting indicating that ‘[i]t is neither feasible
nor advisable in India’. In a 2011 speech, Subbarao pointed out: ‘In an emerging
economy like ours, it is not practical for the central bank to focus exclusively on
inflation oblivious of the larger development context. The Reserve Bank cannot
escape from the difficult challenge of weighing the growth-inflation trade off in
determining its monetary policy stance’ (Subbarao 2011).
However, at the same time, over the last few years, a number of policy
documents have spoken in favour of inflation targeting, such as the 2008 Report
of the Committee on Financial Sector Reform (Chairman: Raghuram Rajan) as
well as the 2013 Financial Sector Legislative Reforms Commission (FSLRC)
spoke in favour of it. Once Raghuram Rajan took over as RBI governor, he seems
to have succeeded in coordinating a change of views within the RBI in favour of
the appropriateness of inflation targeting.47 This is reflected in the report of the
RBI-appointed Expert Committee to Revise and Strengthen the Monetary Policy
Framework (Chairman: Urjit Patel) (p.194) which recommended: ‘Inflation
should be the nominal anchor for the monetary policy framework’.
All these culminated into the signing of a contract between between the
President of India (acting through the Ministry of Finance) and the RBI in
February 2015, wherein it was explicitly mentioned that (a) the RBI will aim to
bring inflation below 6 per cent by January 2016; and (b) the target for 2016–17
and for all subsequent years shall be 4 per cent with a band of +/– 2 per cent is
an interesting development in this arena. In the First Bi-monthly Monetary
Policy Statement, 2015–16, issued on 7 April 2015, it was stated categorically:
‘The Monetary Policy Framework Agreement signed by the Government of India
and the Reserve Bank in February 2015 will shape the stance of monetary policy
in 2015–16 and succeeding years’. Thus, Indian monetary policy entered into
new regime of inflation targeting.
Is this policy shift good or bad for the economy? While policy counterfactuals are
difficult to establish, it may suffice to say that there is a large body of literature
that questions adoption of inflation targeting in a country like India. We can do
Page 87 of 106
no better than draw attention to the studies reviewing the Urjit Patel Committee
Report by three eminent scholars in the Economic and Political Weekly
(Chandrasekhar 2014; Correa 2014; Nachane 2014) broadly summing up that
‘the Report of the RBI remains stuck in new consensus macroeconomics and
disregards international experience, making its recommendations risky for
India’s economy’ and simultaneously quote from a subsequent editorial of the
same journal:
In the Indian case one can cite a number of reasons why the adoption of
inflation targeting as a monetary policy framework could be inappropriate.
First, the monetary policymaker cannot escape the reality of an inflation–
output trade-off in the short run. India’s central bank is compelled to take
care of multiple objectives. In India, the exchange rate and portfolio flows
have shared the centre stage with growth in the formulation of monetary
policy. After all, despite the so-called impossible trinity, the Indian and
Chinese experiences both amply illustrate that a country can achieve non-
corner solutions, whereby the central bank can have a combination of
some monetary policy independence coupled with limited capital account
convertibility and partially-managed exchange rates. Second, the Indian
framework on inflation targeting is couched in terms of overall CPI
inflation, but the presence (p.195) of substantial inflation in food and fuel
makes inflation in India less amenable to monetary policy actions; the
proposed inflation targeting framework does not talk of some sort of ‘core
inflation’ that is free from all such influences of external factors/
administered prices. Third, in a country where any announcement of a fall
in monetary policy rates is invariably followed by moral suasion of
commercial banks to cut lending rates, the efficacy of monetary
transmission is seriously in question and hence one is never sure of the
effectiveness of inflation targeting. Finally, as the new framework does not
talk of the composition of the Monetary Policy Committee (MPC) that is to
oversee targeting, one does not have sufficient clarity as to how it will
function. Would the Governor of the RBI have veto power? Will there be
two representatives from the Ministry of Finance? Will the voting be
published by names of the MPC members? All such questions remain
unanswered. (EPW 2015: 8)
Banking Developments
While almost all of the reform measures in the banking arena are a continuation
of the earlier programmes but with greater gusto and hype and with the same
bureaucratic target-setting methods, without being supported by the necessary
institutional and infrastructural preparations, there have been some noticeable
incremental additions. Some of these deserved to be flagged.
Page 88 of 106
Licensing of New Banks

In 2010, in the context of the alleged inefficiencies in the performances of the
public sector banks and the consequential demand for more private banks, the
RBI brought out a Discussion Paper for licensing of new banks in the private
sector. It was followed up by issuing draft guidelines and the final guidelines in
February 2013 that required the promoters and promoter groups of applicants
controlled by residents / resident entities to have to satisfy ‘fit and proper’
criteria and they should have an initial minimum paid-up capital of Rs 500 crore.
Non-resident shareholding in a new private sector bank should not exceed 40
per cent of the voting equity for the first five years and no non-resident
shareholder will be permitted to hold 5 per cent or more of paid-up voting
equity. The business plan of the bank should be realistic and viable and should
address how it proposes to achieve (p.196) financial inclusion; it has to comply
with priority sector targets and sub-targets.
There were 26 applications received for new bank licences by 1 July 2013 and
finally in-principle approval was granted in April 2014 to two private sector
banks with universal banking licences—IDFC and Bandhan Microfinance.
Differentiated Banks
Creation of specialized banks has been in the policy discussion forums for some
time. In 2007, there were discussions on starting differentiated banks—small
banks and payment banks—but it was then not considered opportune to
introduce such banks and the existing banking structure was considered as
sufficiently well-equipped to handle their expected tasks. Subsequently, in
August 2013, a Discussion Paper, ‘Banking Structure in India—The Way
Forward’, was issued by the RBI to explore the licensing of banks, banking
models, and to suggest a transition path for some banks. Later the RBI set up a
committee on Comprehensive Financial Services for Small Businesses and Low-
income Households, which submitted its report in January 2014 and
recommended, amongst other things, the setting up of a system of two
differentiated banks. Accordingly, the RBI issued guidelines in November 2014
to licence small-scale finance banks and payment banks.
The basic design of a small bank remains full-service bank that combines all the
three banking services: deposits, credit, and payments. But they will be
differentiated on the dimension of size and sectoral target segments. They may
have to concentrate on promoting saving vehicles and bank credit for small
borrowers. The objective of payments banks are to further financial inclusion by
nurturing small savings accounts and offering remittance services for migrant
and low-income households in particular; they will not lend. While no licence has
been actually issued so far for any differentiated bank (as of May 2015), there is
already a long list of as many as 72 applications for small banks licence and 41
applications for payment banks licence. While the emergence of ICT-enabled48
transactions may have introduced some added scope for these types of banks, a
Page 89 of 106
moot question would still be whether they would be self-sustaining after fulfilling
the banking norms.
(p.197) Further Impetus to Financial Inclusion

Financial inclusion is another area that has attracted attention in recent times.
The RBI has operated two phases of a financial inclusion plan. Phase I consisted
of a three-year plan (April 2010 to March 2013) which covered 74,414 unbanked
villages with populations of more than 2,000 persons; these were identified and
allotted to various banks. All these unbanked villages have been covered. It is
claimed that, ‘about 7,400 rural branches had been opened during the three-
year period contrast to an absolute reduction of 1,300 rural branches during the
previous two decades’ (Pant Joshi 2013). In Phase II (April 2013 to March 2016),
the roadmap was to provide banking outlets in unbanked villages with
populations of less than 2,000 persons; accordingly 490,000 unbanked villages
were identified and allotted to banks. As per the progress reported up to March
2014, 183,993 unbanked villages were covered comprising 7,761 branches,
163,187 BCs and 13,045 through other modes.
These targets appear mindboggling, when there are not enough brick and
mortar bank branches to supervise the operations; the RBI had prescribed that
banks should open more brick and mortar branches in unbanked villages such
that there is at least one branch supporting up to 8–10 BCs at a reasonable
distance of 2–3 km. Critical evaluations of the entire financial inclusion plan
have shown serious misgivings regarding the approach, unrealistic targets, and
the use of BCs not found equal to the tasks before them (EPW Research
Foundation 2014: 235–41).
Prime Minister’s Jan-Dhan Yojana

Superimposed on the same institutional structure is the PM’s Jan-Dhan Yojana. It
is not the objective which is being questioned but the haste and mindboggling
bureaucratic targets with which the programme is being imposed on the banking
system, particularly in the context of the presence of limited rural bank
branches and inadequate BCs. The plan envisages universal access to banking
facilities with at least one basic banking account for every household, financial
literacy, and access to credit, insurance, and pension facility. The overdraft
facility up to Rs 5,000 is available for only one account per household, preferably
a lady of the household. The beneficiaries will get a RuPay Debit (p.198) Card
having inbuilt insurance cover of Rs 1 lakh. The plan envisages all direct benefit
transfers (DBTs) for various subsidies and other government benefits.
Data collated by the government from banks and state-level banking committees
(SLBCs) as of 15 April 2015 suggests that while the number of accounts stood at
around 15 crore, the deposit balance in accounts was little less than Rs 16
Page 90 of 106
thousand crore. Interestingly, almost 8.5 crore accounts were with zero
balances.
Comprehensive Regulatory Reforms in the Financial Regulatory Architecture

The FSLRC has given a holistic look at the Indian financial sector and proposed
a sector-neutral Indian Financial Code to replace financial sector legal structure,
splitting the regulation between the RBI and a new unified financial agency that
will oversee the remaining financial sector and would subsume the legal and
regulatory structure of Securities and Exchange Board of India (SEBI),
Insurance Regulatory and Development Authority (IRDA), Pension Fund
Regulatory and Development Authority (PFRDA) and some functions of the
Forward Markets Commission (FMC). In some sense, the FSLRC has given rise
to a serious schism between the bureaucracy and the financial system led by the
RBI. The RBI has held out publicly many concerns regarding the Commission’s
recommendations. The RBI’s concerns relate to the proposed regulatory
architecture (the RBI to manage the rupee value but the control over the inward
capital flows particularly debt flows given to another agency), the proposal to
create Financial Sector Appellate Tribunal (FSAT) as a judicial oversight over
the regulatory functions, and the nature of the Indian financial code—all will
involve considerable tension before they reach a final shape.
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Notes:
(*) This chapter presents the authors’ personal views. The authors wish to thank
R. Krishnaswamy, Rema K. Nair, Bipin K. Deokar, Vishakha G. Tilak, Shruti J.
Pandey, and K. Srinivasan—all from EPW Research Foundation, who have
provided extensive support in the preparation of this chapter, as well as Edwin
Prabu for his comments on an earlier draft of this chapter.
Page 100 of 106
(1.) Available at http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm, last

accessed in December 2010.
(2.) This view on money and monetary policy stems from a fairly standard
monetarist/neoclassical paradigm; see Patnaik (2009, 2011) for an alternative
view on many of the standard issues in monetary economics.
(3.) After all, a bank keeps only a fraction of the deposit it receives and lends
rest of the money, so that if all depositors approach the bank to withdraw their
deposit, there will be a run on the bank.
(4.) The state of Andhra Pradesh was divided into two states—Andhra Pradesh
and Telangana—in June 2014. The data in the present chapter refers to the state
before division.
(5.) There are a number of authoritative accounts of monetary policy in India;

see, for example, Jadhav (2000), Joshi and Little (1994), Mohan (2007),
Rangarajan (1997), RBI (2008), and Reddy (2009) for synoptic views.
(6.) For example, until 1986 in the US, the Federal Reserve System had the
power under ‘Regulation Q’ to set maximum interest rates that banks could pay
on savings deposits.
(7.) Selective credit control was operated through one, or a combination, of the
techniques of (i) minimum margin for lending against the value of specified
securities, (ii) ceiling on the level of credit, and (iii) minimum rate of interest on
advances. While the first two measures sought to control the quantum of credit,
the third had a bearing on the cost of credit.
(8.) It is pertinent to note that the preamble to the Reserve Bank of India Act of
1934 mentions the objectives as: ‘to regulate the issue of bank notes and
keeping of reserves with a view to securing monetary stability in India and
generally to operate the currency and credit system of the country to its
advantage…’.
(9.) Available at http://planningcommission.nic.in/plans/planrel/fiveyr/

index9.html.
(10.) The RBI’s Annual Report for 1964–5 had noted: ‘During the financial year
1964–65, industrial production showed a deceleration, the index rising by only
6.4 per cent as compared to the rise of 9.1 per cent in 1963–64.… As a result,
the average annual rate of growth for the four years of the Third Plan worked
out to 7.6 per cent as against the target of an annual increase of 11 per cent
envisaged for the Third Plan period’ (p. 3).
Page 101 of 106
(11.) Besides, it is widely held that the optimistic assumption of the Department
of Agriculture, Government of India fed into an expansionary indicative
monetary growth (Joshi and Little 1994).
(12.) The persistence of inflation was so explosive that it inspired a group of

economists led by V.K.R.V. Rao to submit a memorandum to the Prime Minister
on behalf of 140 economist signatories in March 1974 suggesting a ceiling on
money supply expansion so as to contain inflation. B.R. Brahmananda and C.N.
Vakil followed up the memorandum with a grand scheme christened
SEMIBOMBLA (Scheme of the Economists for Monetary Mobilisation through
Bond-Medallions and Blocked Assets; March 1974).
(13.) For example, the scheme of offering higher yields close to market-related
rates as suggested by the Committee was already implemented in 1983 and
1984. More significantly, some definite indications of starting to use monetary
targeting as an integral part of the monetary policy framework and, in that
context, to employ reserve money—money multiplier processes, were discernible
in policy pronouncements of 1982–3 and thereafter. An analytical predecessor
can be found in a study titled ‘Reserve Money: Concepts and Policy Implications
for India’ by C. Rangarajan and Anoop Singh in Reserve Bank of India Occasional
Papers, June 1984. Thus, many elements of the Chakravarty policy framework,
such as working estimates of aggregate deposits and bank credit, M3 targeting,
streamlining of the limits and procedures under the Credit Authorisation
Scheme (CAS), and the rationalization of the operation of selective credit
controls—were already implemented during 1982 to 1985, much before the
formal acceptance of the Committee’s recommendations in 1986–7.
(14.) That is, where , is the target for monetary expansion,

is the acceptable rise in price, is the anticipated real output growth, and
eM,Y is the income elasticity of demand for money.
(15.) Also see Tarpore (1987).
(16.) It is pertinent to quote,
The question that immediately arises is that, despite the smoothening out
of seasonal factors in the Indian economy, estimates of anticipated changes
in the output have to be made quickly and for every quarter. Who could
anticipate in early 1979 that the GNP in 1979–80 would fall by 4.8 per
cent?… A more difficult question arises in regard to the ‘acceptable
inflation rates’. This, in the Committee’s words, is aimed at ‘reflecting
changes in relative prices necessary to attract resources to growth
sectors’ (paragraph 9.88). This sounds perfect, but is it possible to discover
a unique general inflation rate which will ensure the attainment of a
Page 102 of 106
targeted change in the relative prices, except under very strict and
therefore very unrealistic assumptions. (Datta 1986)
(17.) The transition from ILAF to a full-fledged LAF began in June 2000 and was
undertaken in three stages: (i) in the first stage, beginning 5 June 2000, LAF was
formally introduced and the additional CLF and level II support to PDs was
replaced by variable rate repo auctions with same day settlement; (ii) in the
second stage, beginning May 2001, CLF and level I liquidity support for banks
and PDs was also replaced by variable rate repo auctions.
(18.) From 29 October 2004, the nomenclature had been interchanged as per
international usages.
(19.) The rate of interest on amount accessed from this facility will be 100 basis
points above the repo rate.
(20.) It may be pertinent to note what former RBI Governor Bimal Jalan said
about India’s exchange rate regime,
RBI does not have a fixed target for the exchange rate which it tries to
defend or pursue over time; RBI is prepared to intervene in the market to
dampen excessive volatility as and when necessary; RBI’s purchases or
sales of foreign currency are undertaken through a number of banks and
are generally discrete and smooth; and market operations and exchange
rate movement should, in principle, be transaction-oriented rather than
purely speculative in nature. (Jalan 2003)
More recent econometric research found that in line with the RBI’s own public stance,
exchange rate movements do not constitute a systematically important determinant of
its monetary policy conduct over the entire sample period (Hutchison et al. 2010).
(21.) Monetary policy is only an arm through which the fallout of the global
financial crisis has been tackled. Fiscal and trade policy too have played a
significant role. See Mohan (2009a) and Subbarao (2009) for detailed discussion
on the menu of policies undertaken in this regard.
(22.) See Bagchi (1987, 1989, and 1997) for a detailed analyses of this period.
(23.) Apart from this, there is a small but critically important segment of NBFCs.
(24.) During 1947–51, 205 banks went out of business; of them 83 were in West
Bengal and 24 in Punjab. Even so in the post-war period, bank failures were
fewer than in the war years, but the bulk of the failed banks during 1945 to 1951
were relatively bigger banks (Bagchi 1987).
(25.) In addition to the Imperial Bank, there were five big banks, each holding
public deposits aggregating Rs 100 crore and more, namely, Central Bank of
Page 103 of 106
India Ltd., Punjab National Bank Ltd., Bank of India Ltd., Bank of Baroda Ltd.,
and United Commercial Bank Ltd; see RBI (2008) for details.
(26.) As in case of any such major policy change, there were multiplicity of views
on the efficacy and desirability of nationalization of banks in India. While K.N.
Raj supported it, another authoritative recommendation for bank nationalization
was made by R.K. Hazari (who later became the Deputy Governor of the RBI) in
his study on monopoly controls in the Indian industry (Hazari 1966). P.R.
Brahmananda argued against it and went on to say in a column in Financial
Express in 1967 that, ‘bank nationalisation was like using a sledge-hammer to
strike a nail in to a wall’ (Brahmananda 2000). Admittedly, there were political
elements in bank nationalization; see Desai (2009); Patel (2002); and Torri (1975)
on the political elements in bank nationalization.
(27.) To quote:
Between 1970 and 1978, and after 1990, both rural and urban poverty
declines were pronounced in more financially developed states. Between
1978 and 1990, however, the relationship differs by poverty measure.
Urban poverty and a state’s initial financial development are largely
uncorrelated. In contrast, between 1983 and 1990, rural poverty
reductions are more pronounced in states with lower initial financial
development. The graph for rural poverty is thus the inverse of that for
rural branch expansion. (Burgess and Pande 2005: 787)
(28.) See Kochar (2011) for contrary evidence. Using a data set spanning 1983–
93 for Uttar Pradesh, Kochar finds that the number of rural banks had a larger
effect on the per capita expenditure of the non-poor than on the poor and that, of
the two main components of the social banking policy, it is the spread in the
number of banks that most affected households; lending constraints, which
required banks to lend for agricultural purposes, had minimal effects.
(29.) Interestingly, RBI (2001) found a bidirectional causality between finance

and growth in India.
(30.) There are two dimensions of financial liberalization: (i) domestic financial
sector deregulation and (ii) opening of the capital account. This section
discusses the first aspect.
(31.) Mention may be made to James Raj Committee (RBI 1978), Banking
Commission (GoI 1972), PEP Committee (RBI 1977), and Varadachary Working
Group (IBA 1977).
(32.) A typical application of the financial repression hypothesis can be found in

Fry (1981), who went on say: ‘Economic policymakers in India, particularly the
monetary authorities, appear to have become more and more suspicious of
Page 104 of 106
market forces and market signals over the past two decades’ (p. 1), and ‘The use
of key instruments of macroeconomic policy for sectoral or selective policies
through differential interest rates, tax treatment…seems to have made the
Indian economy rather more vulnerable to exogenous shocks’ (p. 1). Cho and
Khatkhate (1989), on the contrary, observed: ‘One of the most important lessons
to be drawn from financial liberalisation across countries is that price stability
and, more broadly, macro-economic stability, is the linchpin of successful
liberalisation, not the deregulation of interest rates per se, especially when the
countries undergoing financial reforms have shallow financial markets’ (p.
1111).
(33.) It is interesting to note despite such twin track approach to financial sector
reforms, advanced countries suffered the financial crisis in 2007, the description
of which could be close to ‘looting and gambling’. It is also interesting to note
that Professor Williamson, the author of the Washington Consensus, regretted
the neglect of income distribution as an important objective in his scheme of
economic reforms; see Williamson (2003).
(34.) See Ahluwalia (1999), Mohan (2009), Rangarajan (2009), Reddy (2000), and
Sen and Vaidya (1997) on the broad contours of Indian financial liberalization.
(35.) Mohan (2002) calculated the real interest rate for borrowers and lenders
separately for two separate periods, namely, period I: 1990–1 through 1995–6,
and period II: 1996–7 to 2001–2. He found that while the real interest rate has
increased for depositors from (−)0.3 per cent in period I to 1.9 per in period II,
the same has gone up much sharply for borrowers from 6.5 per cent in period I
to 12.5 per cent in period II.
(36.) In case banks were not able to meet priority sector lending targets, they
were allowed to place the money under the Rural Infrastructure Development
Fund (RIDF) or the Small Industrial Development Bank of India (SIDBI),
depending on whether the shortfall in priority sector is in agriculture or in small-
scale industry target, respectively.
(37.) Banks such as the UTI Bank (present name, Axis Bank), IndusInd Bank,
ICICI Bank, Global Trust Bank, and HDFC Bank came into being at this point.
(38.) Strict provisioning norms had been specified in case of the various
categories of NPAs, namely, sub-standard assets (10 per cent), doubtful assets
(100 per cent of unsecured portion and 20–50 per cent of the balance depending
on the time profile), and loss assets (100 per cent). In addition, a nominal 0.25
per cent had to be provided for standard assets (since increased to 0.40 per cent
in the October 2005 monetary policy).
(39.) The macroeconomic environment in which banks operate changed

dramatically in the 1990s.
Page 105 of 106
(40.) See Sarkar et al. (1998) on the ownership question of Indian banking.
(41.) These included Bank of Maharashtra, Central Bank of India, Punjab and
Sind Bank, UCO Bank, and United Bank of India.
(42.) These included State Bank of India (December 1993 and October 1996),
Oriental Bank of Commerce (October 1994), Bank of Baroda (December 1996),
Bank of India (February 1997), and State Bank of Bikaner and Jaipur (November
1997), with the date of going public in brackets.
(43.) One of the reasons highlighted in this context is the introduction of Basel
norms; for example, it has been noted that, ‘while it is a bit early to pass
judgment on the success of these new prudential regulations in terms of the
long-term stability and growth of the country’s banking sector in the context of
the newly opened up financial sector, one can duly have some reservations
regarding the possible contractionary effects with changing composition of the
priority credit itself’ (Ghosh and Sen 2005: 1178).
(44.) As at the end of March 2011, 4.79 million SHGs had a loan outstanding of
Rs 31,221 crore. In addition, there were 2,315 private microfinance institutions
which had loans outstanding of Rs 13,731 crore. NABARD has claimed that
through the SHG–bank linkage programme, more than million households were
associated with the banking agencies.
(45.) Illustratively, real GDP growth, on an average, has improved successively

from 4.6 per cent in the decade prior to the monetary targeting period to 5.5 per
cent in the monetary targeting period and further to 7.1 per cent in the multiple
indicators phase; on the inflation front, while headline WPI inflation, on an
average, increased during the monetary targeting regime (alongside significant
increase in fiscal deficit), under the multiple indicators approach, inflation fell
significantly (Mohanty 2010a).
(46.) There is a large literature on inflation targeting in which an independent

central banker is responsible for delivering a low and stable inflation and is
often accountable directly to the legislature (Walsh 2009).
(47.) Interestingly, the earlier four successive RBI governors—Bimal Jalan, C.

Rangarajan, Y.V. Reddy, and D. Subbarao—have all held the view that India
cannot be at this stage an inflation-targeting country.
(48.) ICT refers to information and communications technology.
Page 106 of 106
On Macroeconomics of Fiscal Policy

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001

Surajit Das
DOI:10.1093/acprof:oso/9780199458950.003.0005

The deficit financed government expenditure multiplier is stronger than the tax-
financed government expenditure multiplier, ceteris paribus, in enhancing
aggregate level of activity and employment in a demand constrained situation.
The fiscal deficit does not necessarily cause crowding-out of private investment.
It does not necessarily cause demand-pull inflation either. The sustainability of
public debt is also not necessarily a matter of deep concern. The higher foreign
indebtedness as a consequence of financing a larger fiscal deficit is also not
inevitable. In fact, expansionary fiscal policy broadens the size of the market. It
seems that the real basis of the opposition of fiscal deficit by the businessmen
and the industrial leaders is political.
Keywords: macroeconomic policy, fiscal policy, crowding-out, public debt, fiscal deficit, inflation,
unemployment
The discussion on macroeconomics of fiscal policy has been centred on the

arguments and counter-arguments about the pros and cons of fiscal deficit and
public debt. Fiscal deficit is a flow variable, which is defined as the gap between
the government’s aggregate expenditure and its revenue receipts within a
specific time period (say, a year); whereas, public debt is an accumulated stock
of government liabilities accrued over a longer period of time in the process of
financing the fiscal deficit of various years. This area of economics has attracted
the attention of many economists because, among other things, it is precisely
also the area of fiscal–monetary interface. What proportion of national income
should be collected as tax? Should or not the government expenditure as
proportion of GDP be increased? What should be the optimum fiscal deficit to
Page 1 of 31
GDP ratio? All these are political decisions of the government in power and they
are also dependent on past trends that vary from country to country. The
economic theory cannot determine the optimum level of fiscal deficit to GDP
ratio for any particular economy.
The Keynes–Kahn multiplier analysis suggests that an increase in the

government expenditure causes the aggregate level of activity to increase more
than the initial increase in the level of government expenditure. It also suggests
that the higher tax–GDP ratio reduces the effectiveness (value) of the multiplier,
which is defined as the ratio of increase in the aggregate level of activity to
increase in the autonomous expenditure. Therefore, in the context of a demand-
constrained economy, more government expenditure and less tax revenue would
boost effective demand in order to enhance growth and to generate (p.214)
more employment. By this logic, the larger fiscal deficit may actually turn out to
be beneficial for the health of a demand-constrained economy saddled with the
problem of persistence of large-scale involuntary unemployment.
Using standard notations, the ex post national income identity for an open
economy can be stated as: ; or,
; or, for simplicity, in case of a closed economy (or
an open economy with zero current account deficit/surplus), .1
Therefore, the fiscal deficit always finances itself in the sense that it always
generates an equal amount of private savings over private investment in the ex
post situation. In case of an open economy, fiscal deficit always generates an
equal amount of extra net import plus private savings over private investment.
In a full employment, supply-constrained situation, where output adjustment is
not possible anymore (given technology), the price adjustment takes place.
Following Kaleckian argument, through redistribution of aggregate income
against the wage earners and in favour of the capitalists in an inflationary
situation, an additional amount of savings, equal to the difference between ex
ante savings and investment, gets generated. Since the savings out of profits are
a larger proportion compared to savings out of wages, the overall saving rate in
the economy goes up. This phenomenon is known as ‘forced savings’ in the
literature on economics because in the process of mobilizing more savings in the
economy, the workers are forced to consume less through reduction in their real
purchasing power. Under a demand-constrained situation, the output adjustment
takes place through the Keynes–Kahn multiplier until aggregate supply expands
to match the increased demand for it at any given level of prices. Moreover, the
deficit-financed government expenditure multiplier would always be stronger
than the tax-financed government expenditure multiplier in enhancing aggregate
level of activity and employment because tax is a leakage of multiplier.
However, there are concerns expressed by many economists that the larger
fiscal deficit would necessarily be harmful for the health of the economy. It is
believed by many that fiscal deficit necessarily causes crowding-out of private
Page 2 of 31
investment by raising the rate of interest in the economy. As a result, the overall
level of employment may even come down and growth of level of activity may get
affected. It is also argued that the fiscal deficit necessarily causes inflation and
(p.215) hence, it is detrimental. There are concerns expressed also about the
sustainability of public debt and its effect on the next generation of population.
It is argued that in case of rising public debt, the ‘unproductive interest
payment’ component of government expenditure will also increase over time for
any given effective interest rate for debt servicing, which, in turn, would narrow
down the ‘fiscal space’ for other important components of government
expenditures, given the rule-based budgeting. If the fiscal deficit is financed by
external borrowing, there is a risk of higher foreign indebtedness. Although
Indian public debt is primarily domestic in nature, this is a general concern
which may be relevant for other economies.
The idea of ‘sound finance’ is being propagated all over the world because of
these concerns. In India, too, ‘Fiscal Responsibility and Budget Management
(FRBM)’ legislation has been passed in 2003 to keep our fiscal deficit restricted
within 6 per cent of GDP—3 per cent for the centre and 3 per cent for the states,
following the Maastricht Treaty of the European Union of 1992, which talked
about limiting the fiscal deficit within 3 per cent of GDP. In fact, in India, the
combined (centre and states) fiscal deficit was brought down to 4 per cent of
GDP in 2007–8. It went up again following the pay revision and ‘financial crisis’.
However, some economists argued that while during crisis the ratio may go up,
it should be brought down following ‘counter cyclical fiscal tactics’. Some
economists also argued that the deficit limit should vary from state to state,
given differences in the economic scenarios of the states in Indian context.
However, all of them argue in favour of a ‘rule-based budgeting’—an average
rule over medium-term and an average across states. The process of ‘fiscal
prudence’ started right after the oil price shock of early 1970s following the
heyday of Keynesianism since the Second World War. The Thatcher–Reagan era
of 1980s not only implemented (in the UK and the US, respectively) the agenda
of ‘republican fiscal conservatism’ influenced by ‘monetarism’ but also
propagated them all over the world. However, the Fund–Bank–US Treasury
advocated ‘fiscal discipline’, particularly in the context of developing countries,
was first formally articulated in what was called the ‘Washington consensus’2 of
1989 (Williamson 2004).
This chapter begins by discussing the effect of fiscal deficit on the interest rate
and the so-called crowding-out effect on private investment. It is followed by a
section that concentrates on the issue of (p.216) inflation due to expansionary
fiscal policy, following which we discuss the whole issue about the sustainability
of government debt. The last section concludes with some notes on some aspects
of the political economy.
Page 3 of 31
Fiscal Deficit and Crowding out

Whenever there is a consideration of expansionary fiscal policy, it is always
argued that there is an essential trade-off between deficit-financed public
expenditure and private investment because there is a limited pool of aggregate
investible resources available in an economy. Or, in other words, being
‘privileged borrower’, if the government takes away larger proportion from this
limited pool for financing its fiscal deficit by borrowing from the domestic credit
market, a smaller proportion would be left for the private sector borrowing.
Now, if the availability of loanable fund for financing private investment, after
financing fiscal deficit, becomes too limited relative to the aggregate private
demand for such funds, the interest rate necessarily increases. Since private
investment is sensitive to cost of borrowing, this rise in interest rate causes
crowding-out of private investment. It is widely believed that, as a result of this,
the aggregate (government and non-government) level of activity and (given
technology) the level of employment may even come down. It is also argued that
since the rate of interest stands for the terms on which finance can be obtained
for private investment, it equates the aggregate private demand for credit and
the availability of loanable fund for private borrowing. However, at any given
rate of interest, these two could be equal, irrespective of the level of the public
borrowing and that of the private investment demand. Hence, in the real world,
there is no inevitability of crowding-out of private investment because of rise in
the fiscal deficit financed by market borrowing.
The whole idea of crowding out comes from the ‘treasury view’ (Kahn 1978) or
the ‘fixed-pool-of-savings view’, which assumes that there is a fixed amount of
aggregate savings available in an economy. According to this view, the aggregate
private investment would be equal to that fixed pool of savings less the
government borrowing. These two are equated by the interest rate, that is, if the
public sector borrowing increases, the availability of loanable fund for the
private sector comes down, the interest rate necessarily increases and causes
(p.217) crowding out of private investment in order to maintain the ex post
saving–investment equality. However, the dependence of savings on income was
never recognized by this view. If the aggregate level of activity goes up, the
aggregate saving, being a positive function of aggregate income, would also rise.
As Patnaik (2009: 1) says, ‘corresponding to the increase in government
borrowing, there must be an equivalent increase in the excess of private savings
over private investment’. But then, why is the theory propounded as if the level
of income is given? This is because there is an underlying assumption that the
economy is at full employment which determines the fixed pool of savings. The
possibility of forced savings under full employment situation through price
adjustment is also ruled out. In today’s world, existence of large-scale
involuntary unemployment is an undeniable fact. Therefore, it is inappropriate to
use theories assuming full employment (directly or indirectly) to draw policy
conclusions. If there is an increase in the autonomous investment demand,
Page 4 of 31
output adjustment is perfectly possible through Keynes–Kahn multiplier in the

context of a demand-constrained economy. Even in a full employment situation,
aggregate investment would always generate its equal amount of savings in ex
post situation through price adjustment and forced savings as opposed to the
fixed-pool-of-savings view.
The treasury view claims that aggregate savings determines the level of
investment in an economy. However, according to the Keynesian school of
thought, investment always generates its equal amount of savings to maintain ex
post savings–investment identity. In a demand-constrained economy, for any
given distribution of income, an increase in investment raises the output and
employment through Keynes–Kahn multiplier. While discussing some aspects of
the development of Keynes’s discovery, Richard Kahn (1978: 545, 548) stated
that ‘investment creates the necessary voluntary saving, quite irrespective of the
extent to which it is financed by the banks.… when, as the present time, there is
plenty of surplus labour and equipment—an increase in investment results in an
equal increase in savings’. Even in full employment situation when output
adjustment is not possible any more, given technology, the price adjustment
takes place and the aggregate income gets redistributed in favour of profits. As
a result, the aggregate saving rises through this redistribution of income and
‘forced savings’. Therefore, it is investment which determines savings and not
the other way round. Savings cannot precede (p.218) investment because
savings cannot be generated unless income is earned and income in the form of
wages, salaries, rent, profit, and other factor payments cannot accrue unless
investment takes place. Keynes made a distinction between the concepts of
‘savings’ and ‘finance’ and defined finance as the credit required in the interval
between planning and execution of some investment project, which has nothing
to do with saving. He argued that ‘the investment market can become congested
through shortage of cash (finance). It can never become congested through
shortage of saving’ (Keynes 1937: 669). He also argued that ‘the rate of interest
is not the “price” which brings into equilibrium the demand for resources to
invest with the readiness to abstain from present consumption (i.e. savings) and
it (the rate of interest) is the “price” which equilibrates the desire to hold wealth
in the form of cash with the available quantity of cash’ (Keynes 1936: 168).
Keynes assumed an exogenous supply of money as one of the three ‘ultimate

independent variables’ (Keynes 1930). Keynes did not talk about endogenous
money directly. However, according to Joan Robinson (1970: 507),
[I]n the orthodox system that he (Keynes) had to attack, the rate of
interest, confused with the rate of return on investment, was the
regulating mechanism which caused savings to be invested and secured
equilibrium with full employment. He had to make every possible
concession to this point of view in order to get a hearing. It would have
been much simpler to start by assuming a constant rate of interest and a
Page 5 of 31
perfectly elastic supply of money. But then his whole case would have been
dismissed as a misunderstanding of the orthodox position. He was obliged
to accept the presumptions of his critics in order to explode them from
within.
One of the major theoretical advancements in the literature of economics has

been the development of the theory of money supply endogeneity. As opposed to
the simplistic neoclassical notion that money supply grows strictly through
central bank initiatives, that is, through exogenous processes, according to the
post-Keynesian school of thought, the demand for money or credit is the basic
determinant of both money supply and credit availability. Economists such as H.
Minsky, Nicholas Kaldor, Kahn, Robinson, and Basil Moore, amongst others, have
argued that money supply is endogenously determined and that the interest rate
happens to be (directly (p.219) or indirectly) policy determined. As post-
Keynesian literature has developed, it has also become clear that there are
actually two distinct theories of money supply endogeneity within this tradition
(Pollin 1991). One perspective, known as accommodative money supply
endogeneity, argues that when banks and other intermediaries hold insufficient
reserves, central banks must necessarily accommodate their needs. According to
the other view, even if the central bank chooses to restrict the growth of non-
borrowed reserves, additional reserves are generated within the financial
structure itself. The latter perspective is referred to as structural endogeneity.
Both approaches share a common starting point: the idea that the rate of money
supply growth and, more importantly, credit availability are fundamentally
determined by demand-side pressures within financial markets.
According to Minsky, the interest rate is administered by the central bank ‘to
keep interest rates at a given level, the central bank must be willing to supply
reserves to commercial banks, in response to commercial banks’ demands,
without limit at a fixed rediscount rate. Therefore, the rediscount rate seems the
appropriate tool of central bank policy’ (Minsky 1957b: 883). The monetary
authority controls the nominal rate of interest and given any rate of inflation, it
also influences the real rate. In fact, Romer (2000) has argued, while discussing
his Investment–Savings/Monetary–Policy (IS/MP) model, it would be more
realistic to assume that the central banks actually target the real interest rate
(which affects the commodity market equilibrium, that is, the IS curve) through
frequent re-examinations of the choice of nominal rates as the monetary
response function of the central banks for targeting inflation and it is a vastly
better description of how central banks behave than the assumption that they
follow a money supply rule. The contribution of Kaldor, in his 1958 report to the
Radcliffe Committee, is commonly regarded as one of the origins of post-
Keynesian monetary theory. Kaldor’s criticisms of orthodox monetary thought in
general and that of Milton Friedman in particular are well known. They have
Page 6 of 31
served well the purposes of post-Keynesians in developing an alternative

approach to Friedman’s monetarism. He wrote:
I would give more emphasis to the proposition that in a World where

money consists of financial claims which come into existence as part of the
process of bank lending, changes in the ‘money supply’ and changes (p.
220) in the ‘velocity of circulation’ are to a large extent substitutes for one
another and depend also on how widely or narrowly the ‘money supply’ is
defined. (Kaldor 1978: Chapter 1 and Appendix II)
In the Memorandum to the Radcliffe Committee, Kahn claimed that ‘the velocity
of circulation of money should be regarded as a purely passive factor’ (Kahn
1958: 147). He rejects the causality inherent in the Chicago Quantity Theory of
Money—that MV determines PT, where M is aggregate money supply
exogenously determined by the central bank, V is the constant velocity of
circulation of money, and PT is nominal value of transactions in which P is the
average price level and T is the aggregate volume of transaction—arguing that
‘it is an effect and not a cause’.
Robinson related the creation of money to bank credit, which is then linked
directly to the aggregate demand for money in the economy. She argued that a
great part of the work of the Chicago-based monetarists led by Friedman
consists in historical investigations of the relationship between changes in the
supply of money and national income in the US. She opined that ‘the correlations
to be explained could be set out in quantity theory terms if the equation were
read right-handed…. But the tradition of Chicago consists in reading the
equation from left to right’ (Robinson 1970: 510). She also argued that post hoc
ergo propter hoc, which means ‘after this, therefore because (on account) of
this’—is a logical fallacy (of the questionable cause variety) which states, ‘since
that event followed this one, that event must have been caused by this one’.
There is no automatic mechanism to translate the increased stock of money as
higher purchasing power of the people unless businesses invest (create demand
for credit) and people receive factor incomes or earn wages.
Endogenous money is central to post-Keynesian macroeconomic theory. It links

the real and monetary sides of the economy through the role played by
commercial banks in meeting the requests of households, farms, and the State to
finance expenditures. This view stems primarily from the Keynesian observation
that, in historical time, savings can never precede investment. Banks are
therefore integral to the production process and are not merely financial
intermediaries. They do not lend pre-existing funds (savings), and they cannot
create money without a pre-existing demand from economic agents. Moore
(1988) has also made significant contribution in devel (p.221) opment of the
theory of money supply, which is demand-determined and credit-led. Moore
argued that along with the variability in the value of the money multiplier and in
Page 7 of 31
the velocity of circulation of money, the high-powered base is also endogenous.

‘Our monetary policy is based on the theory that the Federal Reserve controls
the money supply by altering the monetary base. But, actually growing credit
demands lead to bank lending. This expands deposits and increases the money
supply, forcing the Fed [Federal Reserve] to provide required reserves’ (Moore
1981: 43). Even if, in case, there is a shortage in supply of credit relative to its
demand at any given interest rate, the central bank has to accommodate the
demand for credit to keep its credibility as central bank and in the interest rate
—money supply plane, ‘the money supply may be regarded as horizontal’ (Moore
1998: 173). Moore has also argued that the interest rate is an exogenous policy
variable. Among others, Thomas Palley has also made some significant
advancement and argued ‘in the IS-LM model endogenous money flattens the
LM’ (Palley 2002: 152). It is obvious that both money supply and the interest
rate cannot be determined exogenously simultaneously.
Let us consider the usual IS-LM framework of Hicks (1937), where the left panel
describes the commodity market equilibrium and the right panel depicts the
money market (see Figure 5.1). In the left panel we measure interest rate r
along the vertical and aggregate income along the horizontal axis. For any IS
(I0S0) curve, we would get an equilibrium point (E0) at interest rate r*. With the
shift in IS curve
(p.222) from I0S0 to I1S1, the

level of income might change
(from to ) in the new
equilibrium E1, but the interest
rate may remain the same at Or*
and the LM curve might just be
horizontal. If we measure rate of
interest along the vertical axis and
Figure 5.1 Money Supply Endogeneity
the demand for money along the
and Horizontal LM Curve
horizontal axis in the right panel,
we get usual negatively sloped Source: Author’s own compilation.
demand for money function like
. The supply of money would
adjust in such a way that we get an equilibrium point e0 corresponding to
amount of money and Or* interest rate. Now, if the demand for money function shifts
rightward to, say, , then we may get another equilibrium point such as e1
corresponding to amount of money and same interest rate Or*. This shows that
the money market could always be in equilibrium at any given interest rate (r*). In the
interest rate-income plane, correspondingly, we would get a horizontal LM schedule as
shown in the left graph of Figure 5.1. Hence, any rise in aggregate demand does not
necessarily firm up the interest rates.
Empirically we do not get any necessary positive relationship between fiscal
deficit to GDP ratio and the real interest rate (Das 2004). Fiscal deficit could be
financed either by borrowing from abroad or by borrowing from the domestic
Page 8 of 31
market (from banks, insurance companies, mutual funds, provident funds, or

individuals) or by borrowing from the central bank—known as monetization.
Although, the direct purchase of government securities by the Reserve Bank of
India (RBI) has been stopped in India since 1996–7, yet, through its open market
operation (OMO), the RBI can buy government bonds from the commercial
banks in the secondary market. Some economists argue that the statutory
liquidity ratio (SLR) ensures purchase of government securities by the
commercial banks. However, the commercial banks are seen to hold government
security way above the SLR norms in India.3 Hence, SLR cannot be a binding
constraint in any sense.
Whenever the government spends more than it taxes, extra demand is generated
in the economy. In turn, this generates extra output in a demand-constrained
situation and generates equal amount of excess private savings in a closed
economy. As a result, extra loanable fund is generated in the banking system.
Even if the entire amount of fiscal deficit is financed through borrowing from the
commercial banks, that extra amount of loanable fund gets replaced with risk-
free government bonds. The availability of loanable fund in the banking system
remains the same and does not get reduced (Ranlett 1969). (p.223)
Therefore, there is no theoretical

basis to believe that larger fiscal
deficit necessarily causes
crowding out of private
investment through rise in interest
rates by squeezing the availability
of available resources for the
private sector. Following the
Mundell–Fleming analysis of an
open economy with free capital
flows, even if we consider the case
of so called ‘impossible trinity’, Figure 5.2 Movement of Prime Lending
that is, an open capital account Rate Bank/Repo Rate in India: 1993–4 to
and flexible exchange rate make 2008–9
the aggregate money supply out of
control of the central bank, money
Economy, RBI.
being demand-determined and
Notes: Data on lending rates relates
credit-led, the interest rate would
anyway be determined by the to five major public sector banks up
central bank. True, the domestic to the year 2003–4. For subsequent
interest rate cannot be years, the data relates to five major
determined independently without banks. We have taken bank rate up to
considerations of prevailing 2003–4 and repo rate thereafter.
international interest rates. Annual average Bank/Repo rates are
However, the point is that the
calculated as the simple average of
interest rate is not determined by
monthly rates. For average lending
any demand–supply mechanism, it
rates, we have considered the mid-
Page 9 of 31
is determined exogenously. The interest rate is policy-determined and at any given

interest rate the demand for money and the supply of money would be equal in ex post
situation. Therefore, accusing fiscal deficit for increase in interest (p.224) rate is
baseless. The central bank may raise the domestic interest rate in order to control
inflation or to attract foreign investment, which, in turn, may reduce aggregate private
investment. However, that has nothing to do with the fiscal deficit to GDP ratio. In fact,
in the Indian context, there are empirical evidences for the ‘crowding-in’ phenomenon,
that is, increase in public investment actually causes a rise in the private investment as
well (Mundle et al. 2010). If we look at the movements of administered interest (repo/
bank) rates and the average prime lending rate (PLR) of commercial banks and term
lending institutions, we observe amazingly high correlation between the two (as can be
seen from Figure 5.2). If the PLR is largely determined by the policy rates, it is
pointless to make fiscal deficit responsible for higher interest rate and ‘crowding-out’.
It is just a matter of monetary policy. The following section discusses inflationary fear
resulting from an expansionary fiscal stance.
Fiscal Deficit and Inflation point of the range of the minimum
The fiscal deficit is said to be lending rates.
the best summary indicator to
measure the expansionary
impact of government budget
on the aggregate demand.
However, it is worth mentioning here that the use of fiscal deficit to measure the
expansionary impact of public sector budget implies that a rupee of every type of
government expenditure will have an equivalent expansionary impact on
demand, and that a rupee of every type of government revenue will have an
equivalent deflationary impact or curtailment of private demand exactly by one
rupee (Chelliah 1993). Also, the same deficit could have differential impact in
raising the aggregate demand depending on the levels of government
expenditure and taxation. However, we can make a general statement that a
fiscal deficit generates additional demand in the economy, and under a demand-
constrained situation an expansionary fiscal policy generates larger employment
opportunities and growth of level of activities. However, many economists
express their concern about the possibility of demand-pull inflation due to
additional demand generation. There is, however, absolutely no cause to believe
that there would be only price adjustment and no output adjustment at all due to
larger fiscal deficit. In the presence of large-scale unemployment and unutilized
capacity, it is more likely that there would be output (p.225) adjustments
through various rounds of Keynes–Kahn multiplier. Kahn argued that
when there is a considerable surplus of unused plant and labour—supply is

highly elastic, and a substantial increase in output would involve only a
small rise in prices. The object of the policy is to promote output and
employment by raising the demand for goods. What I should like to
emphasize is that it is quite beside the point to regard a rise in the level of
prices as the objective of economic policy. (Kahn 1933: 169)4
Page 10 of 31
It is argued that if the fiscal deficit is financed through market borrowing,

crowding-out would take place. On the other hand, if the fiscal deficit is
monetized, it would cause inflation through increase in the stock of high-
powered money. Patnaik (2001: 1161) argued that:
[T]he proposition that when the fiscal deficit is monetised it affects not the
interest rates but only prices relative to money wages is doubly wrong:
there is no necessary reason why it should at all affect prices, and there is
no necessary reason why it should not at all affect the interest rates. A
fiscal deficit financed by market borrowing as opposed to monetisation
causes a rise in interest rates rather than in prices in terms of the wage-
unit is also doubly wrong: there is no necessary reason why it should at all
affect the interest rates, and there is no necessary reason why it should not
at all affect prices.
Let us briefly discuss the underlying macroeconomic theory of demand-pull

inflation.
Contemporary monetary theory is characterized by the predominance of the

monetarist thesis in the version elaborated by the new classical economics to
which the general acceptance of two propositions attests: (i) inflation is a
monetary phenomenon and, therefore, the result of excessive money creation
and (ii) for this reason, the pursuit of price stability is the fundamental task of
the monetary authorities, who are considered capable of controlling the quantity
of money (Bertocco 2001). The classical quantity theory of money talks about the
neutrality of money in the sense that the change in money supply affects the
price level only—leaving the real variables unaffected. However, it also
presumes that the increase in stock of money essentially translates into greater
purchasing power of people. Monetarism implicitly assumes a unique level of
activity determined by either full employment or natural rate of unemployment.
In its modern version, people have argued that money may have some effects on
real (p.226) variables in the short run, but in the long run it is completely
neutral. Given endogeniety of money, however, money cannot be in excess supply
relative to the demand for it. But, the possibility of demand-pull inflation is still
emphasized in a situation where the demand for money itself increases due to
‘overheating’ of the economy caused—for instance, either by larger government
spending or by higher level of private investment.
The trade-off between inflation and unemployment was first pointed out by A.W.
Phillips (1958). The Phillips Curve is an inverse relationship between the rate of
unemployment and the rate of increase in money wages. The original argument
was based on wage-bargain hypothesis. In an empirical enquiry, Robert Lucas
(1973) talked about the Phillips Curve, positively sloped labour supply curve, and
the employment–inflation trade-off and argued in favour of inflation targeting.
The so called ‘new consensus’ in monetary economics and monetary policy
Page 11 of 31
(following the lecture of Laurence Meyer in 2001) also tells us nothing but
inflation targeting. The Report of the Committee to Review the Working of the
Monetary System under the Chairmanship of Sukhamay Chakravarty in 1985
also emphasized the need for inflation targeting in India. It pointed out that a
higher level of activity can be achieved only at the cost of a fairly high inflation
rate. The higher the rate of unemployment, the lower is the rate of wage
inflation; higher levels of employment can be maintained only at the cost of
higher inflation. However, the assumption of a positively sloped labour supply
curve implies that the aggregate level of employment could be increased only if
the workers are offered higher wage rates on an average. Again, this very
proposition would be valid only under a situation where there are no workers
ready to work more at the existing wage rate. However, for economies operating
well below full employment level, there are a large number of workers looking
for jobs at the existing wage rate but there are not enough jobs to absorb all of
them or almost all of them. In such a situation, the labour supply curve would be
perfectly elastic or horizontal and the demand for labour alone would determine
the equilibrium level of employment in the economy because of unlimited supply
of labour at any ongoing wage rate. In a non-full employment situation, there
might very well be output adjustment with increase in aggregate demand
without necessarily creating an inflationary pressure in the economy. The
parallel shift of Phillips Curve is also possible.
(p.227) This postulate of Phillips was attacked by the monetarist school, mainly
by Friedman (1968) and Edmund Phelps (1967). Friedman and Phelps argued
that the simple Phillips Curve would shift over time as workers became used to
and began to expect continuing inflation. They have concluded that the notion of
a long run trade-off between inflation and unemployment was illusory although
Phillips’s own data covered a period nearly a century (1861–1957). The
Friedman–Phelps proposition was that if rate of growth of money supply remains
the same, in the long run the economy will move to the natural rate of
unemployment (NRU), irrespective of the rate of change of wages and the
inflation rate. Thus, they argued that while there may be a short-run trade-off
between inflation and unemployment, there is no long-run trade-off. In its
simplest version monetarism was a revival of the quantity theory and the
classical long run ‘neutrality of money’ (Lucas 1995). In the long run, it was
argued, the real variables would settle at their equilibrium values and the level
of output would be independent of the level of money supply. The only effect of
money supply, through the quantity equation, would be on the level of prices.
Central banks, by controlling the growth of money supply can, therefore,
determine the rate of inflation in the long run.
Friedman’s criticism was based on the following grounds. First, workers and
firms are concerned with the real wage rather the money wage. Second, any
long-term commitments involving employers and employees take into account
not only the current observable prices but also the prices expected to prevail
Page 12 of 31
during the entire time frame of such commitments. Any unanticipated rise in
nominal aggregate demand will lead to an initial increase in output and
employment. This leads to a rise in product prices faster than rise in money
wages. The demand for labour is a function of actual real wage since employers
can perceive inflation correctly and the supply of labour is a function of expected
real wage because workers do not have perfect information about the future rise
in prices. As long as the actual price level is higher than the expected level, any
rise in money wage will be considered to be the same as a rise in real wage
(Sircar 2000). This will bring about an increased supply of labour, at the given
real wage. Since there is a fall in ex post real wage on the part of the employers
and a rise in ex ante real wage on the part of the employees, a rising demand for
labour will be matched by an increased supply of labour, reducing the level of
unemployment. However, this, according to Friedman, (p.228) is only a
temporary phenomenon. In the long run, expectations will catch up with reality
and workers will come to anticipate correctly the extent of price rise and the
labour supply will fall (unless the illusion is perpetuated). This will push up real
wage, thereby reducing the level of employment and the economy will move
back to its earlier level. However, in the later version, Friedman (1976)
incorporated imperfect information on the part of both employers and
employees. Both the parties take time to adjust to a change in the general price
level. In the short run, according to this monetarist explanation, one can think of
a Phillips Curve drawn for an anticipated rate of inflation. As expectations
regarding the price rise change, the short-run Phillips Curve shifts upward
adjusting to a new rate of inflation. In the long run, when price rise is
anticipated fully, the economy comes to the NRU and at this rate the Phillips
Curve becomes vertical, that is, independent of rate of inflation.
Therefore, according to Friedman,
[T]he level of employment can be increased beyond what is given by the

NRU, but only if the workers do not anticipate inflation. And even in such a
case, it can be maintained at this level only if expectations are adaptive
and not rational, and then too only at the expense of accelerating inflation.
The presumption underlying all this is that a given amount of labour is
supplied only if a particular real wage is expected to be obtained; if the
expected real wage is lower, then only a smaller amount of labour would be
supplied. In third world economies saddled with massive labour reserve
this is patently untrue; even when real wages secularly decline, without
there necessarily being any divergence between the expected and the
actual real wage, the labour supply never starts drying up. (Patnaik 2003:
1)
The monetarist argument is based on the assumption of voluntary and/or

frictional or search unemployment, which, in turn, is based on the
microeconomic foundation where all the agents are capable of making
Page 13 of 31
constrained choice. It is basically a supply-side argument treating

unemployment as a matter of individual choice. However, the Keynesian
economics tells us that the incidence of involuntary unemployment arises due to
the exclusion of opportunity to find work in an economy where resources may
remain unemployed due to lack of effective demand. The Keynesian explanation
of involuntary unemployment recognizes the distinction between individual and
collective choice while explaining the absence of choice in the labour market.
Workers (p.229) will resist a money wage cut to protect their relative position
and this makes the general level of wages sluggish in downward direction.
First, there is no need of a higher wage rate for increasing the supply of labour
in the presence of a huge ocean of reserve army of labour because at the
existing wage rate many people are already willing to work but are sitting idle.
Moreover, even if the wage rate gets higher, for any reason, a proportionate rise
in product prices is not necessary in a demand-constrained situation because a
higher wage and a higher level of employment will increase the size of the
market by creating extra demand and there will also be quantity adjustment
through Keynes–Kahn multiplier. Eisner (1989), while explaining the US
experience of the 1980s, argued that the ‘real’ budget deficits, that is, nominal
deficits adjusted for changes in the price level and interest rates have been
positively related to output and employment growth and do not have any effect
on inflation. There is absolutely no reason to believe that there would,
necessarily, be a trade-off between unemployment and inflation, neither in short
run nor in the long run, particularly in the context of developing countries such
as India, which are saddled with involuntary unemployment. Blinder and Solow
(1973: 320) argued that ‘there are still good theoretical reasons to believe in the
efficacy of fiscal policy in an economy with unemployed resources’.
However, the functioning of most of the central banks is highly influenced by

monetarism in determining either money supply or short-run interest rates. How
much can the broad money supply be influenced by changing the cash reserve
ratio (CRR) or changing the reserve money is a matter of separate debate given
the flexibility of money multiplier and velocity of circulation of money. Moreover,
in an era of credit card and electronic exchange, even a token or a coupon may
play the role of money. Hence, central banks generally prefer to control inflation
using an interest rate instrument following the ‘Taylor rule’ (Taylor 1993).
However, a hundred years ago, Wicksell proposed, ‘if prices rise, the rate of
interest is to be raised; and if prices fall, the rate of interest is to be lowered;
and the rate of interest is henceforth to be maintained at its new level until a
further movement in prices calls for a further change in one direction or the
other’ (Wicksell 1898: 189). The widely popular Taylor rule tells us that the
nominal interest rate should be tinkered depending on the inflation and output
gaps. If inflation rises above the targeted level or (p.230) if real GDP rises
Page 14 of 31
above the trend GDP, the central bank should raise the interest rate through
repo/bank/discount rate, that is,
where r is nominal interest rate and r* is equilibrium or natural rate of interest; p is the
rate of inflation and p* is the targeted rate of inflation; Y is the level of output and Y* is
the output compatible with NRU; and x is an arbitrary constant such that 0 < x < 1. In
essence, according to the Taylor rule, if output growth is higher than the historical
linear trend or if inflation is higher, the interest rate should be raised and vice versa
(Taylor 1999). Weights (simplest x = 1/2 in Taylor’s original paper) may vary depending
on the situation and choices of the policymakers; however, the direction should be as
mentioned earlier. Clearly, this policy rule is thought of either in the context of a closed
economy or it is formulated without having any consideration of the direction of the
net flows of foreign capital. Secondly, instead of targeting money supply, Taylor’s rule
targets the interest rates and, by doing so, it tries to influence aggregate demand for
money along the demand for money function. Thirdly, this rule assumes that inflation is
always demand-pull in nature and it excludes cost-push inflation. Most importantly, in
the name of inflation targeting, it discourages growth in the level of activities beyond a
certain level by increasing the interest rates and reducing the aggregate demand via
reduction in domestic investment.
In this context, it is important to note here that the monetarist neoclassical
synthesis claims that the higher fiscal deficit to GDP ratio puts inflationary
pressure as well as causes crowding-out of private investment. However,
following monetarism (Taylor’s rule), an increase in the rate of interest must
reduce inflation through crowding-out of private investment demand. Again, if
inflation takes place due to excess money supply caused by fiscal deficit, there
should not be any scarcity of ‘loanable funds’ under a situation of ‘ample
liquidity’. In fact, in such a situation, the interest rate should come down by
neoclassical logic and hence there is no possibility of ‘crowding-out’. Even if we
believe in the monetarist neoclassical framework for a moment and assume that
monetized deficit causes inflation and public borrowing causes crowding-out, the
policy of partial borrowing and partial monetization should nullify each other’s
effect. Possibility of inflation (p.231) and crowding-out simultaneously due to
fiscal deficit within the same economy is logically inconsistent. Moreover, if the
domestic liability of government adds to the high-powered money, the net
foreign capital inflow also does the same. Hence, if fiscal deficit is necessarily
inflationary, the same is true for capital inflows.
Patnaik talks about two very different concepts of inflation:
In the first case, all prices, including the money wage rate, increase in
tandem, but the real wage rate remains unchanged; in the second case,
prices increase relative to the nominal wage rate, resulting in a fall in the
real wage rate. These two cases, following Keynes, can be called ‘income
Page 15 of 31
inflation’ and ‘profit inflation’ respectively. The concept of a profit-inflation

is inconceivable within a monetarist paradigm. (Patnaik 2007: 1)
If wages would have increased by the same proportion, then, in terms of wage
units, there would not be any inflation. Inflation becomes fatal only when
inflation takes place without proportionate rise in income. In such a situation,
contractionary fiscal policy or increase in interest rate would aggravate the
situation and would not be able to solve the problem. The nominal inflation rate
may come down through contraction in income but in terms of wage units, it
does not reduce because average income of people also comes down in the
process. Aggregate demand comes down through reduction in investment and
government expenditure but many people lose jobs or face wage cuts or longer
duty hours without payment. There could be structural inflation or inflation due
to international oil price shocks, etc. If monetarists’ measures are followed, it
‘hurts the poor’ even more and increases misery. In a situation of wage
depression and profit inflation, demand-contracting policies to curb inflation
would reduce the average real purchasing power of common masses.
Emphasizing that the quantity of money can never be in excess supply, Robinson
argued: ‘If banks issue more notes than are required for use as a medium of
exchange, the excess returns to them as deposits or in cancellation of
bills’ (Robinson 1970). According to Robinson,
The quantity of notes outstanding is continuously being adjusted to the

requirements of circulation. Since notes yield no interest to their holders,
while a return of notes to a bank means receiving interest payments (on a
deposit) or a saving of interest payments (on a debt) the outstanding
amount of notes cannot exceed the amount that is required for
convenience in circulation. (Robinson 1956: 236)
(p.232) Therefore, the argument by Friedman (1960), ‘too much money

chasing too few goods’, is flawed. There is no automatic mechanism which
necessarily translates increased stock of money to enhanced purchasing power
of people. Even if the demand for money increases due to increase in the
purchasing power of people due to expansionary fiscal policy, in terms of wage
units, inflation does not take place. Moreover, demand-pull inflation does not
necessarily take place due to an increase in demand in a demand-constrained
situation. In the context of a flat labour supply curve, the argument about
employment–inflation trade-off also makes very little sense for an economy
operating well below full employment level.
Sustainability of Public Debt

Apart from other issues about crowding-out and inflation, the very sustainability
of public debt itself is pointed out to be a major cause of concern. It is always
argued that if the expansionary government policy under demand-constrained
situation has to be undertaken through a fiscal deficit, the accumulated
Page 16 of 31
outstanding public debt as a proportion of GDP would not be sustainable in the

long run. The economists of the International Monetary Fund (IMF) and the
World Bank (2004, 2006, 2007) jointly chalked out a ‘debt sustainability
operational framework for low-income countries’. The Thirteenth Finance
Commission of India (2011) has recommended a target of 68 per cent of debt–
GDP ratio for the centre and the state governments, taken together by the end of
2014–15; consequently, it has also been incorporated in the government’s
medium-term fiscal policy framework (Union Budget 2010–11).
Discussions on debt financing from a long-term perspective have followed three

main approaches: (i) solvency criterion of government finances, (ii) Ricardian
equivalence, and (iii) the Domar model (Rakshit 2005). In brief, the solvency of
treasury condition is stated in terms of an infinite time horizon constraint on the
present discounted value of the debt stock in order to identify situations when
people would refuse to lend to the government. The Ricardian equivalence tells
us that there is no difference between the impact of tax- and debt-financed
government expenditure. The debt-financed expenditure of today is nothing but
postponement of tax and hence, putting extra burden of tax on the future
generation. The most widely used framework for debt sustainability, in some
form or the other, is known as (p.233) the Domar equation. The Domar
condition tells us that if the effective nominal interest rate on government’s debt
is lower than the growth rate of nominal GDP, the government debt would be
sustainable. We would discuss these in details one by one.
Hamilton and Flavin (1986) suggested a framework based on the present

discounted value of the debt stock for the empirical testing of the sustainability
of the government borrowing. They argued that ‘the deficit series must soon
turn to surplus’ (Hamilton and Flavin 1986: 818). According to Buiter and Patel
(1992: 175), the meaning of the solvency constraint is ‘in a finite horizon
economy with a finite terminal date T, the solvency constraint is the requirement
that public debt in the last period be non-positive’. Following the neoclassical
solvency approach, they observed that the relevant criterion for the non-ponzi
game5 condition on public debt is to judge it by comparing the growth rate of
public debt relative to GDP with real interest rate. The transversality condition
for public solvency is basically equivalent to the inter-temporal budget
constraint that public debt should be non-positive at the close of a finite period
of time. This infinite horizon constraint (Rajaraman and Mukhopadhyay 2005) is
stated in discounted terms for the debt stock D, i being the nominal effective
interest rate on the debt stock, for all t > t0:
Page 17 of 31
The solvency requires that the public debt in the (finite) last period be non-
positive. As argued by Rakshit (2005), the answer of how long a government can
go on borrowing in order to fill the budgetary gap is ‘so long as the public is
willing to lend’. Now, there is no reason why people would not lend to the
government because of its insolvency as defined above. The individuals or
commercial banks or insurance companies know that there is no default risk for
loans extended to the government so long as others do not simultaneously seek
to sell off the government bonds in the future. Holding government bonds is as
good as holding money and there is no reason to believe that the faith in
government bond would be reduced or the risk of holding government bonds
would increase due to extra government borrowing as long as people have faith
on a piece of paper, without any use-value, (p.234) guaranteed by government
called ‘money’. Since, in infinite time horizon no individual bond holder is going
to survive, as argued by Rakshit (2005), it is difficult to believe that for increase
in government debt as some proportion to GDP they would be necessarily worse
off in holding their assets in terms of government bonds. If not, until all of them
want to sell off the government papers simultaneously, there should not be any
problem. In fact, in reality, at any given prices for government securities, the
demand for government bonds also rises with increase in supply of government
bonds. Thus, the so-called solvency condition6 is not helpful in assessing long-
term viability of a budgetary programme.
Robert Barro (1974: 1116) argued that ‘fiscal effects involving changes in the
relative amounts of tax and debt finance for a given amount of public
expenditure would have no effect on aggregate demand, interest rates and
capital formation’. The term, Ricardian equivalence theorem, was introduced to
macroeconomists by James Buchanan (1976). He talked about Barro’s paper and
mentioned that ‘the thrust of Barro’s argument supports the Ricardian theorem
to the effect that taxation and public debt issue exert basically equivalent
effects’ (Buchanan 1976: 336). Barro further argued that
for a given path of government spending, a deficit-financed cut in current

taxes leads to higher future taxes that have the same present value as the
initial cut. Therefore, the substitution of a budget deficit for current taxes
has no impact on the aggregate demand for goods. In this sense, budget
deficits and taxation have equivalent effects on the economy—hence the
term, ‘Ricardian equivalence theorem’. (Barro 1989: 39)
However, we know that the increase in tax rate is considered to be one of the
leakages of the multiplier—if the tax rate increases in an economy, the value of
multiplier comes down consequently. Therefore, to inject additional effective
demand in a demand-constrained situation, the policy of debt-financed
government expenditure would be more effective in generating growth and
employment. In turn, the tax revenue of government might increase through
higher employment and output. However, in the first place, the government has
Page 18 of 31
to incur deficit and then fill it up by higher revenue and not the other way round.
Therefore, the policy of ‘mobilizing resources first and allocating them’ is very
different from the Keynesian prescription of ‘digging holes and filling them
up’ (Keynes 1936). In a demand-constrained situation, until and unless extra
demand is being injected into the (p.235) economy, the situation is not going to
change. If the government extracts more tax revenue, higher government
expenditure in strategic sectors—for example, infrastructure and so on—may
‘crowd-in’ private investment and can be much more effective particularly in the
context of underdeveloped and developing economies. Government investment
may also ensure more egalitarian distribution of income considering many
welfare aspects as well. However, higher government expenditure through extra
tax would merely recirculate some more proportion of the aggregate effective
demand through government. ‘If the objective is to generate a certain amount of
employment, then a smaller amount of public expenditure will be needed if it is
borrowing-financed than if it is tax-financed’ (Patnaik 2006: 4560).
Domar (1944) argued that public debt to GDP ratio would be stable in the long
run, provided the growth rate in GDP exceeds the effective interest rate on
public debt. If the GDP rises, given any tax rate, the absolute amount of tax will
also rise and can keep the outstanding debt–GDP ratio constant in the long run.
Only if the effective interest rate on outstanding public debt is higher than the
GDP growth rate, the debt–GDP ratio may go up with time through higher
interest payment component as a percentage of GDP. Domar (1944) considered
four scenarios, namely: (i) when national income remains constant, (ii) when
national income increases at a constant absolute rate, (iii) when national income
increases at a constant percentage rate, and (iv) the War model when national
income grows at 2 per cent per annum. The previous understanding was that the
government necessarily has to increase the tax rate to finance increased
spending. Domar successfully argues that for a growing economy, the tax income
of government may very well rise, without any necessary increase in the tax
rate, simply because of the fact that tax is a positive function of income. If
income rises, revenue would also go up in the same proportion for any given tax–
GDP ratio. However, Domar has not considered the role of government
expenditure in raising the level of activity in an economy—in the original
formulation. The GDP growth is assumed to be exogenously given in the sense
that it is independent of the government spending. However, in the same paper,
Domar argued that
deficit financing may have some effect on income. This remark however…
has received a different treatment. Opponents of deficit financing often
disregard it completely, or imply, without any proof, that income will not
rise as fast as the debt.… There is something (p.236) inherently odd
about any economy with a continuous stream of investment expenditures
and a stationary national income’. (Domar 1944: 801, 804)
Page 19 of 31
The ‘Domar condition for debt sustainability’ with discrete time period in its
simplest form can be written as follows (D’Souza 2005):
(1)
where bt is outstanding loan as a proportion of GDP at the end of period t, r is the

nominal effective rate of interest, g is the nominal growth rate of GDP, and dt is the
primary deficit to GDP ratio. If the fiscal deficit to GDP ratio zt = bt – bt−1, we can write
the same equation in the form (Rangarajan and Srivastava (2005):
(2)
The debt sustainability condition is given as follows: the outstanding debt of

period t as ratio of GDP has to be lower than or equal to the outstanding debt as
a percentage of GDP of the previous period. Clearly, if (g − r) increases for both
g and r > 0, from equation 1, bt would not increase for higher dt. Consequently,
the upper limit of fiscal deficit to GDP ratio would also be higher for sustainable
outstanding debt to GDP ratio. Again, higher the bt−1, higher would be the
sustainable level of fiscal deficit. Domar disaggregated the fiscal deficit into two
components: primary deficit and interest payment. Irrespective of any effective
interest rate on the government borrowings, if the total fiscal deficit gets added
to the outstanding debt of the government, then (using same notations as above)
(3)
Where, the growth rate in period t is given by
(p.237) Therefore, b would not rise if
(4)
For example, if the outstanding debt to GDP ratio be 70 per cent and the growth
rate of nominal GDP be 15 per cent, more than 9 per cent (and not 6 per cent)
fiscal deficit to GDP ratio would not cause any increase in the debt GDP ratio.
Clearly, this does not give any fiscal deficit to GDP ratio for ‘debt sustainability’;
it is dependent on the initial level of debt to GDP ratio and the growth rate of
GDP. If b or g increases (for any positive growth rate), the upper limit of z also
Page 20 of 31
increases, due to which the overall debt to GDP ratio would not rise. Moreover,
in this particular model the essential underlying assumption is that the growth
rate of GDP (g) is strictly exogenous in nature in the sense that it is absolutely
independent of government expenditure. However, nominal output would always
grow with increase in government expenditure and in a demand-constrained
situation; in the presence of large-scale persistent involuntary unemployment,
the real output is also expected to grow (via larger capital formation which, of
course, entails lags) with increased government expenditure. If g depends upon
the government expenditure, then at any given level of rate of interest,
equations 3 and 4 cease to remain the determining equations for debt
sustainability.
We would like to argue here that the larger government expenditure would
always enhance the growth rate of nominal GDP. As mentioned earlier, there is
absolutely no reason to believe that under a demand-constrained situation, in
the presence of large-scale of involuntary unemployment, why only price
adjustment would take place and the real output would not grow through
Keynes–Kahn multiplier. Therefore, government expenditure would also
generate growth in real level of activity under such a situation. If one of the
major objectives of fiscal policy is a reduction in the rate of involuntary
unemployment in the economy, the government should spend enough to ensure a
GDP growth which can absorb larger number of workers than the increase in
labour force. For an economy operating well below full employment and full
capacity level of output, the (p.238) target of public policy should be a
reduction in potential output loss, given the technology. The growth rate in
aggregate output has to be greater than the growth in average labour
productivity. However, the policymakers are very often seen to undertake
contractionary fiscal policy, irrespective of the level of aggregate demand in the
economy. They try to bring down the fiscal deficit as a proportion of GDP even by
cutting down many important components of government expenditure. We know
that the value of closed economy balanced budget multiplier is unity (under
certain restrictive assumptions), that is, if the government spends exactly equal
to its revenue earning, then increased government expenditure would give rise
to an increase in the level of activity by exactly same amount. In case of open
economy also, the value of balanced budget multiplier is lower than that in case
of deficit.
For simplicity, let us assume a standard transitive causality in its simplest form
as the following. Autonomous government expenditure causes GDP and, in turn,
GDP causes revenue of the government. The dependence of GDP solely on the
government expenditure may seem to be too simplistic an assumption and
hence, misleading, too. The fact that in a situation where investment is
determined by the growth of income itself, we have the operation of what Lange
(1943) had called the ‘compound multiplier’ and Hicks (1950) had called the
‘super multiplier’. The overall rate of growth is determined by the rate of growth
Page 21 of 31
of the exogenous stimulus (like autonomous government expenditure in this

case) as was emphasized by Kaldor (1970). The GDP being identically equal to
the sum of three components, namely, private expenditure on consumption and
investment, government expenditure, and the current account surplus on
balance of payments (BoP), the determinants of its growth can be analysed by
looking at how these expenditure items behave. Let us assume to start with that
income distribution within the economy is given, and that the consumption to
GDP ratio remains constant over time. Let us also assume that, in the context of
an open economy, the import–GDP ratio also remains constant over time.
However, the export is dependent on the demand from the rest of the world
along with international competitiveness and that is why, change in net export is
also a determinant of GDP growth. If, in a growing economy such as India, an
increase in import (through improvement in international competitiveness) is
accompanied by an increase in export, the net export to GDP ratio (p.239) may,
more or less, remain same over time. Even if the net export to GDP ratio comes
down with growth in GDP (because of increase in imports and no change in
exports), it would have a negative impact on the GDP growth. In that case, the
estimated government expenditure elasticity would be lower than the actual and
not higher. Since the magnitude of private investment is itself determined by the
growth of GDP (induced investment through accelerator principle in a changing
economy), it follows that the independent variable that determines the growth
rate of GDP, in the longer run, is really the growth rate of government
expenditure.
It is possible at aggregate level that the fiscal deficit to GDP ratio may remain
constant or even may decline with an increase in government expenditure. If we
assume that the saving (S), investment (I), and tax (T) are fixed proportions of
income (Y) in the context of balanced trade for simplicity, then the fiscal deficit
must be equal to or, G is equal to Y. or
(where, and
). Therefore, the fiscal deficit is
and the fiscal deficit to GDP ratio is . Now, with an increase in G, the
fiscal deficit to GDP ratio would not increase in case ‘s’ and ‘a’ remain the same.
If, in case of crowding-in, government expenditure induces private investment
and causes ‘a’ to go up, then might actually come down (provided ‘s − a’
still remains positive for stability). Therefore, in this case, rise in G would lead to
a fall in the ratio of fiscal deficit to GDP.
Due to a change in government expenditure as proportion to GDP, the impact on

the fiscal deficit to GDP ratio would ultimately depend on the government
expenditure multiplier and revenue buoyancy (Das 2007). How to improve
government expenditure multiplier and revenue buoyancy is an interesting
question. The revenue elasticity might improve, if not by increasing the tax
rates, through better tax administration, broadening the tax base by targeting
Page 22 of 31
right areas, improving information network, political will, etc. There are a lot of
studies on the effectiveness of government expenditure on growth and
employment generation—productive and non-productive expenditures, etc. For
example, Robert Eisner (1996: 91) argued (both theoretically and empirically)
extensively that ‘this [NAIRU] is a dogma that has undermined meaningful
economic theory and paralysed economic policy. Fiscal policy can work and
correctly measured budget deficits do stimulate the economy. Reinforced by
monetary policy, they can (p.240) significantly increase employment, saving
and investment and economic growth’. In the context of Indian economy also,
there are many empirical studies confirming the effectiveness of government
expenditure (both consumption and investment) on increasing the aggregate
level of activity. For example, one RBI occasional paper empirically ‘finds the
existence of a stable long-run relationship between public sector expenditure
and national income in India and the causality strictly running from the former
to the latter’ (Khundrakpam 2001: 136). Channelizing government spending in
the most effective manner is undoubtedly important. However, the size of total
government expenditure as a proportion to the overall level of activity, the
overall tax to GDP ratio and, hence, the fiscal deficit to GDP ratio are directly or
indirectly politically determined. It has to be politically determined also because
economics has no clear answer vis-à-vis these—there is no optimal government
expenditure or the revenue receipt or the fiscal deficit to GDP ratio in the theory
of economics. According to William Vickery (1996: 189), ‘we are not going to get
out of the economic doldrums as long as we continue to be obsessed with the
unreasoned ideological goal of reducing the so-called deficit. The “deficit” is not
an economic sin but an economic necessity’.
The standard argument that during economic slowdown, fiscal deficit may be
allowed to increase a bit while during time of high growth there should
necessarily be consolidation by expenditure contraction7 is also questionable.
During higher growth the possibility of both multiplier and revenue buoyancy
being higher increases. And, therefore, during economic boom extra government
expenditure may lead to lowering of fiscal deficit to GDP ratio at a higher rate.
Hence, cutting down government expenditure when growth rate of GDP is
higher would not be prudent. For example, between 2003–4 and 2007–8, during
the unprecedented high growth period, the average expenditure multiplier for
the combined central and the state governments and the average revenue
buoyancy during the same period were higher than unity. However, the
government was found to follow a contractionary fiscal path and brought down
the aggregate expenditure as proportion to GDP in spite of improvement in tax
revenue. The entire extra revenue as proportion of GDP has been utilized to
bring down the revenue and fiscal deficit. However, during this period, if
government would have spent more, the fiscal deficit to GDP ratio could have
come down even more steadily and, (p.241) in the process, increased public
spending could have generated more employment opportunities. Even if the
Page 23 of 31
fiscal deficit has to be brought down as a proportion to GDP, the contractionary

fiscal policy would not necessarily help.
This, however, does not mean that there should be expenditure cuts during the
slump. One, targeting the fiscal deficit instead of setting goals for revenue
collection and assessing expenditure requirements is a misdirected policy
resolution. Fiscal deficit should be treated as a residual of expenditure
requirements and revenue possibilities and should not be directly treated as a
policy variable. Otherwise, there is a possibility of containing fiscal deficit by
cutting required government expenditure down instead of containing it by
revenue increase or even more dangerous neo-liberal direction of ‘tax less and
spend even less’. In fact, the decision on the size of the fiscal deficit as
proportion to GDP should not be linked with the growth rate per se; rather it
should be based on the rate of unemployment in the economy.
We have seen from the discussion in the preceding three sections that neither is
there inevitability of inflation nor that of crowding-out due to larger fiscal
deficit; nor is the sustainability of public debt a necessary threat. Rather,
expansionary fiscal stance may actually generate more employment and output
in a demand-constrained situation and in the process it can actually reduce the
fiscal deficit to GDP ratio or the public debt as a proportion to GDP. This is
precisely the Keynesian policy prescription of ‘digging holes and filling them up’.
The point is not to incur unlimited fiscal deficit but to do away with fiscal
conservatism. Policymakers often face the dilemma between incurring little
higher fiscal deficit as proportion to GDP and attracting foreign capital to the
country. The international rating agencies rate countries, among other things, on
the basis of fiscal deficit to GDP ratio and the direction of flows of international
finance capital gets influenced by these ratings. Clearly, the dependence on
inflow of international finance capital (for sustaining the current account deficit
of balance of payment) often constrains the domestic policymakers from
undertaking expansionary fiscal policy independently.
It is a fascinating question why do the businessmen and industrial leaders not

accept gladly the loan-financed government policies of (p.242) full employment
in a demand-constrained situation? Expansionary policies would have broadened
the size of the market for their products too. Kahn (1931) argued that ‘an
increase in government borrowing generates, at any given interest rate and for
any given private investment/net capital exports, an exactly equal amount of
additional savings in private hands, through an increase in output and
employment in a situation of demand constraint’ (cited in Patnaik 2005: 4).
‘Since such savings depend upon post-tax profits (surplus), there must be a rise
in post-tax profits (surplus); and what is more, this rise is some multiple of the
rise in government borrowing’ (Patnaik 2009: 1). Moreover, ‘the loan financed
government spending does not encroach upon profits because it does not involve
any additional taxation’ (Kalecki 1943: 138). Well-known Marxist economist
Page 24 of 31
Michal Kalecki has pointed out in his essay on ‘Political Aspects of Full
Employment’ in 1943 (p. 139) that ‘the social function of the doctrine of “sound
finance” is to make the level of employment dependent on the “state of
confidence” (on which private investment is dependent and therefore should be
carefully maintained)’. According to Patnaik (2012: 1), ‘If the State directly tries
to increase employment through its own expenditure, then that makes the “state
of confidence” of the capitalists irrelevant’. More importantly, ‘under a regime of
permanent full employment, “the sack” would cease to play its role as a
disciplinary measure. The social position of the boss would be undermined and
the self assurance and class consciousness of the working class would
grow’ (Kalecki 1943: 140). The real basis of the opposition is political.
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Notes:
(1.) Y = Income, C = Consumption, I = Investment, G = Government Expenditure,
X = Exports, M = Imports, S = Savings, and T = Tax.
(2.) Although it was initially formulated in the specific context of some of the
Latin American countrie s, yet, it was imposed upon the entire developing world
in the name of structural adjustment programme of International Monetary Fund
(IMF).
(3.) A substantial portion of the arguments in this section is reproduced from

Das (2010).
(4.) In this seminal article, Kahn also opines:
It is quite true that the supply curve of output as a whole slopes upwards.
But that is a quite different thing from saying that the object is to raise
prices. The rise in prices is not an end in itself, and it is not even a means
to an end. It is merely a by-product of a rise in output. (Kahn 1933: 169)
(5.) Ponzi game generally implies continuously servicing past loans out of
current borrowing.
(6.) The transversality condition stems from micro-founded analysis of the

representative consumer’s utility maximization exercise over infinite horizon.
The same is true for recent discussions on Ricardian equivalence in dynamic
overlapping generation and recursive macroeconomic frameworks. This family of
models suffers from extremely restrictive assumptions such as the aggregate
behaviour must be the summation of individual behaviours following from the
philosophy of ‘the whole must be the sum total of the parts’. The scrutiny of
micro-foundation of macroeconomics is outside the scope of the present chapter.
(7.) For example, see Buti et al. (1997).
Page 31 of 31
Intergovernmental Fiscal Transfers in India

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001

Emerging Trends and Realities
Pinaki Chakraborty
DOI:10.1093/acprof:oso/9780199458950.003.0006

This chapter examines the system and nature of federal fiscal transfers in India
within the broad parameters of intergovernmental fiscal relations. It shows that
the transfer system, as evolved over the years, has been able to reduce
expenditure inequality across states only at the margin largely due to the
fragmented transfer system and growing regional inequalities. The chapter also
observes that though at levels the transfer system appears progressive, it shows
regressive sign when one relates with the state-level per capita income over
time.
Keywords: fiscal equalization, fiscal capacity, inter-governmental transfers, federal fiscal transfer,
state level
The federal fiscal transfer mechanisms imply a design of transfer of resources

between different tiers of the government in a particular federation. The
objective of the system of intergovernmental fiscal transfers is to correct both
vertical imbalances and horizontal inequalities in the distribution of federal
resources. The vertical imbalance arises due to the asymmetric assignment of
functional responsibilities and financial powers between different levels of
governments and horizontal inequalities are the existing disparities in the
revenue capacity across the constituent units of federation, which mainly arises
due to the differences in their levels of income. These imbalances are different
across federations and so also the design of transfers. In this chapter we analyse
the design and the changing nature of intergovernmental fiscal transfers in India
Page 1 of 44
and examine whether transfers have succeeded in achieving horizontal equity

across various constituent units within Indian federation.
Institutional mechanism of federal transfers in India revolves around three

institutions, namely, Finance Commission,1 Planning Commission, and various
ministries of the central government. The Finance Commission’s
recommendations, once accepted by (p.249) the Parliament, become
mandatory so that the transfers of funds brought into effect in pursuance of
these recommendations could be said to have a statutory sanction behind them.2
However, given the system of transfers so evolved over the years, substantial
part of the transfer of resources have fallen largely outside the ambit of Finance
Commission and it is the Planning Commission through which larger share of
resources are transferred to the states.3 The Planning Commission transfers are
in the form of plan grants, which have emerged as the single largest component
of grants transferred to the states from the centre.4 The plan grants in recent
years have also become largely discretionary as substantial portion of the plan
grants fall, outside the Gadgil formula (see Chakraborty et al. 2010). These
apart, there are non-statutory discretionary transfers made to the states by
various ministries of the central government in the form of centrally sponsored
schemes (CSS). By nature, CSS grants are conditional, specific purpose grants.5
The CSS grants constituted 50 per cent of the total grants to the states.6 In
recent years, big ticket CSS, namely Mahatma Gandhi National Rural
Employment Guarantee Scheme (MGNREGS), Sarva Shiksha Abhiyan (SSA), and
National Rural Health Mission (NRHM), have become the principal drivers of
resource transfers to the states. All these big ticket CSS transfers also bypass
the state budget and are directly given to panchayats or to various implementing
agencies. As these funds bypass the consolidated fund of the states, it naturally
raises the question of accountability.7
In case of Finance Commission transfers also, it increasingly became skewed

towards tax devolution, which by nature is entitlement to all the states.
Increasing share of tax devolution in total transfers through Finance
Commission, in turn, left little scope for fiscal equalization grants to play its role
in equalizing fiscal capacities across states. The Twelfth Finance Commission
has emphasized the need for a greater role of equalization grants in the scheme
of transfers to correct for cost disabilities and redistributive consideration that
are not adequately addressed through tax devolution.8 The Thirteenth Finance
Commission has also provided a large number of conditional specific purpose
grants directed mainly towards improving fiscal balance and efficiency of
government spending (see Chakraborty 2010; Rao 2010) with some implicit
equalizing content.
This chapter examines the nature of transfers and its role in achieving fiscal
equalization. Apart from this section, the chapter is divided (p.250) in four
sections. The first section discusses the theoretical issues related to the
Page 2 of 44
principles of fiscal equalization and compares the Indian system with that of
established federations like Australia and Canada. The second section measures
the extent of vertical fiscal imbalance and provides estimates of horizontal
inequalities in provisioning of expenditures. In the third section, the fiscal
capacities across states and inequalities there in are examined and the
effectiveness of horizontal transfer mechanism in equalizing fiscal capacity is
estimated econometrically in a panel data framework. The study summarizes its
findings in the fourth section and draws conclusions.
Fiscal Equalization Transfers: Issues and Country Experiences

There are two rationales for intergovernmental transfers: (a) to offset fiscal
disadvantage and cost disabilities across various constituent units within a
federation, and (b) to ensure certain minimum levels of public services with
substantial benefit spillovers (Breton 1965; Oates 1972). In order to address the
former, a general-purpose transfer in the form of unconditional grants is
recommended, while to ensure the latter, specific purpose matching transfers
from the higher levels of government is recommended. In the present context,
fiscal equalization is defined as a systemic process of intergovernmental
financial transfers directed towards equalization of the budget capacity or
economic performance of a number of associated governments (Mathews 1980).
Fiscal equalization could be both vertical and horizontal. However, in the context
of the present chapter, we concentrate mostly on horizontal fiscal equalization.
Defining standards and norms for equalization is not an easy task and it differs
across countries. The equalization transfers, however, can broadly be classified
into four categories (Mathews 1980):
1. A fixed and arbitrarily determined amount, which is distributed in

accordance with the designate allocation criteria.9
2. Equalization to the standards of revenue raising and service provision
which are available to a government or governments with the highest
fiscal capacity.
3. Equalization to the average standard of revenue raising and service
provision for all governments in the equalization system.
(p.251) 4. Equalization to minimum standards of public services; for
example, a minimum standard of service provision as under Australian
grants for schools.
The fiscal capacities differ across various constituent units of federation because
of the differences in their revenue bases and the differences in the unit costs of
providing public services. However, in a federal setup, these constraints are not
a justification of differential expenditure assignments. In other words, the
expenditure functions of any federal unit are not one-to-one functional
relationships of revenue base or the unit costs of proving public services. The
expenditure functions are constitutionally defined responsibilities. Thus,
irrespective of the revenue capacity, each unit has to perform these functions. In
Page 3 of 44
other words, the size of the government, measured in terms of expenditure

assignment, may go far beyond the own revenue capacity of a particular unit of
federation. One of the ways to overcome these differences in fiscal capacities is
to make provision of equalization grants by the higher level of government. It
should be noted that fiscal equalization grant may only constitute a part of the
total transfers, not the entire entitlements that goes in the form of transfers of
revenues and grants. Within total grants, the relative importance given to fiscal
equalization grants also differ across federations.
The fiscal equalization is a guiding principle of federal transfers in various

established federations like Canada and Australia.10 Although, unconditional
transfers from the federal government to the provinces have been in Canada
since confederation, equalization payments are post–Second World War
phenomenon (Boadway and Flatters 1982). The fiscal equalization grants in
Canada are determined by estimating the below-average taxable capacity which
is defined as the difference between the per capita revenue raised for each
specific revenue source on a national basis and the per capita revenue raised by
the provinces for each specific revenue source, using a national average tax
rate.
The equalization formula in Canada represents a gross equalization in the sense

that below-average taxable capacity provinces are moved up in terms of their
fiscal capacity, not the above-average taxable capacity provinces are moved
down, which occurs in the case of net equalization (Krelove et al. 1997). It has
been noted in several studies that equalization grants in Canada have powerful
influence on spending. These grants lead to a significant equalization of fiscal
capacities (p.252) across provinces, although they do not eliminate them.
Through the principle of revenue equalization, a redistribution of resources also
occurs as relatively more federal funds come from the provinces having higher
revenue capacity (Boadway and Hobson 1993). The major problem of
equalization formula of Canada is that it does not take into account the cost and
expenditure needs differences. To the extent the services are more costly, or
there is a greater need for services in some provinces, the formula does not
make any explicit provision for these differences. However, equalization
payment to the provinces is independent of the federal budget deliberations, but
is determined quite independently, as it is tied to provincial government decision
regarding tax rate on tax bases. Unlike Canada, in India, the quantum of
statutory transfers is subject to fluctuations in the revenue outcome of the
central government since only a fixed share of the tax revenues of the central
government is transferred to the states. The Twelfth Finance Commission
increased the share of tax devolution from 29.5 per cent to 30.5 per cent of the
shareable central tax revenues.11 The Thirteenth Finance Commission has
further increased the tax devolution to 32 per cent. As it is a fixed share of all
central taxes, if the central revenue mobilization falls, automatically the volumes
of transfers to the states decline. However, the present system of sharing of all
Page 4 of 44
taxes is an improvement from the earlier system of tax-specific sharing of

income tax and union excise duties. Sharing all taxes ensures that the pain and
the gain of cyclical variations in central revenue is shared (Bird and Smart 2002:
901). However, given the fact that in India, the fiscal inequality is much larger
than other federations like Canada and Australia, the pain of cyclical variation in
central revenue is felt more in low fiscal capacity states as compared to high
fiscal capacity states.
In Australia, the Commonwealth Grants Commission decides on the fiscal

equalization grants by investigating the relative fiscal capacities (Craig 1997).
The estimation of relative fiscal capacities of state and territories are done by
estimating both revenue-raising capacity and expenditure needs. In India also,
apart from tax devolution, a portion of total grants is provided as non-plan
revenue deficit grants, which is, by nature, a fiscal capacity equalization grants
provided by the Finance Commission. The assessed non-plan revenue deficit by
the Finance Commission in a sense reflects the additional resource need of a
particular state to provide the essential public services after the devolution of
taxes. Ideally the volume of non-plan revenue deficit (p.253) grants should be
such that even if it is not designed to offset shortfall in fiscal capacity and cost
disabilities, it should enable the states at least to equalize expenditures in a
limited way. However, in the Indian context, it has been noted that ‘although the
transfer system on the whole has an equalizing effect, it is not designed to offset
shortfall in fiscal capacity and cost disabilities fully’ (Rao and Singh 2002).
Expenditure Provisioning: An Interstate Comparison

Although, the primary objective of the system of federal transfers in any
federation is to equalize the shortfall in fiscal capacities and cost disabilities
across provinces to provide comparable levels of public services at reasonably
comparable levels of taxation, in the Indian federation we find large variations in
different components of government expenditures across states in per capita
terms, including the discretionary non-plan expenditure meant for maintenance
of public services. These expenditures exclude interest payment and pension
obligations to government employees12 as they are committed and sticky upward
due to perpetuating fiscal imbalance and consequent debt overhang and
increase in life expectancy, respectively. Even after excluding these, primary
expenditure excluding pension and non-plan revenue expenditure remains only
partially discretionary as a large proportion of these expenditures goes as salary
obligation to government employees which by nature is committed. It is to be
noted that the coefficient of variations (CV) in per capita plan revenue
expenditures and capital expenditures are higher than that of the other
components of expenditures. Wide variations in per capita expenditures reflect
differences in the capacity in expenditure provisioning across states in essential
public services including education and health and the outcome thereon (see
Table 6.1).
Page 5 of 44
Figures 6.1a and 6.1b reveal the movement of per capita income and the per
capita expenditures of the state governments. As evident from the figures, states
with lower level of per capita income are also the states with lower level of per
capita discretionary expenditures, whether plan or non-plan and revenue and
capital expenditure. In other words, states with lower levels of fiscal capacities
(reflected in per capita income) are spending less in per capita terms for
essential public services. Bagchi (2003) observed that ‘although transfers from
(p.254)
Page 6 of 44
Table 6.1 Disparities in Per Capita Sub-national Expenditure: Summary Statistics
1987–8 1993–4 1999–2000 2002–3 2007–8 (Acc.) 2008–9 (RE)
Max/Min CV Max/Min CV Max/Min CV Max/Min CV Max/Min CV Max/Min CV
Total 2.73 0.30 2.66 0.25 2.72 0.27 3.48 0.30 2.95 0.27 2.51 0.25
Expendit
ure
Revenue 2.29 0.26 2.32 0.24 2.66 0.26 3.67 0.32 3.42 0.31 2.85 0.27
Expendit
ure
Non-plan 2.55 0.30 2.47 0.28 2.53 0.28 4.04 0.36 4.38 0.38 3.51 0.34
Revenue
Expendit
ure
Plan 3.06 0.30 2.78 0.29 4.12 0.34 5.96 0.46 3.87 0.36 3.61 0.41
Revenue
Expendit
ure
Capital 5.54 0.54 6.59 0.43 5.19 0.52 3.30 0.37 5.02 0.36 17.02 0.48
Expendit
ure
Source: Finance Accounts and Twelfth Finance Commission. Available at http://fincomindia.nic.in/
Note: RE indicates revised budgetary estimates not the actual expenditure. CV = Coefficient of Variations.
Page 7 of 44
(p.255) the centre have seemed

to moderate the disparities in the
revenue capacity of different
states. However, the gap between
the rich and the poor states in per
capita revenue expenditure
remains high’. In Table 6.2, the
states are arranged in ascending
order of their total per capita
Figure 6.1a Aggregate Government
discretionary expenditure
Expenditure and Sub-national Income: A
(excluding interest payment and
Comparison
pension) growth for the period
between 1987–8 and 2008–9. The Source: Finance Accounts of Various
growth of plan, non-plan, and States and Central Statistical
aggregate expenditure showed Organisation.13
wide fluctuations across states. It
is to be noted that, excluding the
(p.256)
Figure 6.1b Revenue Expenditure and

Sub-national Income: A Comparison
Source: Finance Accounts of Various
States and Central Statistical
Organisation.
Page 8 of 44
Table 6.2 Real Growth of Discretionary Government Expenditure: Key Components (in per cent per annum)
State Expenditure
Plan Revenue Non-plan Revenue Revenue Capital Total
Bihar 2.53 8.68 7.43 5.37 6.96
Assam 8.26 9.60 9.21 2.67 8.13
Punjab 5.55 10.56 9.80 1.65 8.17
Uttar Pradesh 5.58 10.66 9.53 6.13 8.86
Rajasthan 6.75 11.64 10.38 7.50 9.81
Odisha 9.06 11.98 11.00 6.80 10.05
Madhya Pradesh 8.73 11.58 10.83 6.89 10.23
Haryana 7.99 11.25 10.55 10.26 10.57
Tamil Nadu 7.12 12.25 11.14 8.83 10.83
Maharashtra 8.09 11.85 11.36 8.32 10.94
Gujarat 7.87 13.35 12.24 7.90 11.42
West Bengal 11.63 10.99 11.10 13.26 11.43
Karnataka 11.97 11.98 11.97 9.58 11.53
Andhra Pradesh 12.65 11.04 11.46 13.45 11.87
Kerala 17.00 11.51 12.79 8.40 12.23

Source: Finance Accounts and Twelfth Finance Commission. Available at http://fincomindia.nic.in/.
Page 9 of 44
interest payment and pension, the non-plan expenditure growth is an indicator of the
priority of government expenditure in allocating funds for maintaining the provision of
public services. It is evident that especially in low-income states, the discretionary non-
plan expenditure growth and total expenditure growth is much lower than that of high-
and middle-income states (see inequality section on the distribution of states according
to their income), except for Punjab and Andhra Pradesh.14 This wide difference in the
level of non-plan revenue expenditure again indicates wide differences in the provision
and quality of basic public services across state governments in India. The horizontal
fiscal transfer mechanism at least should enhance the fiscal capacity of those state
governments having below all state average capacity in the provision of public services
even if one assumes the most unrealistic assumption that cost disability factor is
constant across states. In reality, the estimated cost indices show substantial interstate
variations in the cost of providing selected services by the (p.257) states and also the
cost differences across the states differ substantially from one service to another (Rao
and Agarwal 1994).
As mentioned earlier, states are provided non-plan revenue deficit grants to
meet the deficit in the non-plan revenue accounts essentially arising due to the
expenditure needs to maintain public services and the resources available in the
hands of the states. The non-plan revenue deficit grants is provided by the
Finance Commission after assessing the revenue expenditure needs of individual
state governments. In such a design of estimation of non-plan revenue deficit, it
may so happen that as the low-income states operate already at a low level of
expenditure compared to high- and middle-income states, their non-plan account
may go into surplus either with tax devolution or a meagre provision of non-plan
revenue deficit grants. On the other hand, the states with better provision of
public services with higher non-plan revenue expenditure may emerge as high
non-plan revenue deficit states and thus may enjoy the higher provision of the
grants. Thus, the inequality in the provision of public services may perpetuate
across states and, in fact, relative inequality in the provision of public services
may rise across states. The system of federal transfers as practiced in India,
prima facie, has the potential to make the system of federal transfers regressive.
These gap-filling grants have been criticized many times as being a form of fiscal
dentistry without correcting the real problem of fiscal inequalities across states.
The Extent of Vertical Fiscal Imbalance

Before we examine the vertical and horizontal imbalance and the corresponding
fiscal transfers, we examine the relative size of the central and state
governments and disparity thereon. Table 6.3 makes it evident that the combined
size of the central and state governments have increased more than threefold in
relation to GDP between 1950–1 and 2009–10 budget estimate (BE) and within
that the increase in the size of the state government is from 4.75 per cent of
GDP in 1950–1 to 15 per cent of GDP in 2009–10. However, the combined
government expenditure as a percentage of GDP declined by 3.5 percentage
point between 1990–1 and 1996–7. In the subsequent years, there was an
Page 10 of 44
improvement in the ratio and reached to 28.47 per cent of GDP in 2009–10 BE.
The decline in the combined government expenditure (p.258)
Page 11 of 44
Table 6.3 Trends in Expenditure to GDP Ratio (in per cent)
Year Combined Centre States Share in Combined Expenditure
Centre’s States’
1950–1 9.89 5.13 4.75 51.90 48.00
1960–1 17.88 9.40 8.49 52.60 47.50
1970–1 17.17 10.34 9.51 60.20 55.40
1980–1 24.44 14.87 13.49 60.80 55.20
1990–1 26.83 17.74 14.30 66.10 53.30
1991–2 26.30 16.52 14.84 62.80 56.40
1992–3 26.11 16.37 14.43 62.70 55.30
1993–4 25.89 16.49 14.21 63.70 54.90
1994–5 25.03 15.27 14.37 61.00 57.40
1995–6 24.20 14.66 13.78 60.60 57.00
1996–7 23.38 14.13 13.46 60.40 57.60
1997–8 24.15 13.64 13.76 56.50 57.00
1998–9 25.44 14.41 14.20 56.60 55.80
1999–2000 26.54 14.94 15.11 56.30 56.90
2000–1 26.30 14.90 14.40 56.70 54.70
2001–2 26.90 15.20 14.70 56.50 54.70
Page 12 of 44
Year Combined Centre States Share in Combined Expenditure
Centre’s States’
2002–3 27.00 15.00 14.50 55.50 53.70
2003–4 27.70 13.10 15.30 47.20 55.30
2004–5 25.50 12.40 14.10 48.80 55.20
2005–6 25.20 13.40 13.90 53.20 55.10
2006–7 25.40 13.20 14.30 52.00 56.20
2007–8 25.10 14.20 13.30 56.40 53.00
2008–9 (RE) 28.70 16.00 15.00 55.60 52.40
2009–10 (BE) 28.70 16.20 15.00 56.60 52.30

Source: Indian Public Finance Statistics, Department of Economic Affairs, Ministry of Finance, Government of India
(Various Issues) and Economic Survey, Ministry of Finance, Government of India (Various Issues).
Note: RE indicates revised budgetary estimates not the actual expenditure and BE indicates budget estimates.
Page 13 of 44
during the 1990s was due to the steady decline in the central government expenditure.
The central government expenditure declined sharply by around 3 percentage points
during this period. However, the state government expenditure as a percentage of GDP
was around 14 per cent during the same period. The increase in the combined
government expenditure to GDP ratio in recent years is to be attributed to the increase
in the central government expenditure. The share of centre (p.259) in the combined
expenditure increased from 51.9 per cent to 66 per cent between 1950–1 and 1990–1,
and thereafter it started declining and reached to 47.2 per cent in the year 2003–4,
with a corresponding increase in the share of states. From 2004–5, there has been a
sharp increase in central expenditure with a decline in the states’ share.
It is to be noted that with the compression of the central government
expenditure, by the end of the 1990s the expenditure commitments of both the
tiers of governments have become almost equal except for the year when the
state government expenditure to GDP ratio exceeded that of the central
government. If we look at the command over revenue resources by both the tiers
of government, the sharp vertical imbalance becomes quite evident. The revenue
mobilization by the central government declined from 12.17 per cent to 10.74
per cent of GDP during 1990–1 to 1998–9 (see Table 6.4). However, states’ own
revenue mobilization did not decline during this period, which hovered around 7
per cent of GDP. Despite the decline in the central government revenue to GDP
ratio, the relative command over revenue resources to finance its own
expenditure did not decline during the 1990s due to the decline central
government expenditure. As the relative size of government expenditure of both
centre and states have converged due to the decline in central government
expenditure and marginal increase in the state government expenditure, the
vertical imbalance has increased sharply during this period. However, in recent
years, the trend seems to have reversed due to the increase in centre’s
expenditure.
The quantum of vertical transfer in the form of tax sharing and grants, that is,
non-debt-creating resources, is shown in Table 6.5. During the period 1990–1 to
1999–2000, transfers as a percentage of GDP declined from 4.73 per cent to
3.79 per cent, mainly due to the decline in grants transfers to the states. The tax
transfers to GDP ratio also declined. The aggregate transfers to the states also
declined steadily from more than 5 per cent of GDP in 1991–2 to little less than 4
per cent of GDP in 1999–2000 (see Figure 6.2). The decline in the resource
transfers has accentuated the vertical imbalance inherent in the system of
federal fiscal structure of India. This decline in transfers adversely affected the
finances of the state government by increasing their dependence on borrowing,
which, in turn, adversely affected the provision of discretionary government
expenditure by increasing the committed liabilities like interest payment
obligations. Also, the (p.260)
Page 14 of 44
Table 6.4 Trends in Revenue to GDP Ratio (in per cent)
Year Revenues as Share of GDP Pre-tax Devolution Post-tax Devolution
Combined Centre’s Gross States’ Own Centre’s Share States’ Share Centre’s Share States’ Share
1950–1 7.91 4.90 3.30 61.95 41.72 55.88 47.79
1960–1 10.25 6.80 5.10 66.34 49.76 56.98 59.12
1970–1 12.84 8.91 5.84 69.39 45.48 56.54 58.33
1980–1 16.58 11.32 7.82 68.28 47.17 52.35 63.09
1990–1 17.46 12.17 6.96 69.70 39.86 55.04 54.52
1991–2 18.62 12.69 7.42 68.15 39.85 54.03 53.97
1992–3 18.10 12.66 7.05 69.94 38.95 54.81 54.09
1993–4 17.14 11.39 7.22 66.45 42.12 51.34 57.23
1994–5 17.58 11.45 7.64 65.13 43.46 51.19 57.39
1995–6 17.44 11.72 7.30 67.20 41.86 53.04 56.02
1996–7 17.11 11.79 6.92 68.91 40.44 53.95 55.41
1997–8 16.95 11.45 6.94 67.55 40.94 50.68 57.82
1998–9 15.63 10.74 6.44 68.71 41.20 54.32 55.60
1999-2000 16.89 11.60 8.14 68.68 48.22 55.42 61.48
2000–1 16.50 10.40 6.70 63.20 40.70 48.30 55.70
2001–2 16.50 10.10 7.10 61.20 42.90 46.90 57.20
Page 15 of 44
Year Revenues as Share of GDP Pre-tax Devolution Post-tax Devolution
Combined Centre’s Gross States’ Own Centre’s Share States’ Share Centre’s Share States’ Share
2002–3 17.00 9.50 7.20 55.60 42.20 42.00 55.80
2003–4 17.80 9.60 7.50 54.00 42.00 40.30 55.80
2004–5 17.90 9.40 7.40 52.50 41.60 38.70 55.40
2005–6 18.50 9.40 7.60 50.70 41.00 36.70 55.00
2006–7 20.10 10.10 8.30 50.40 41.00 36.20 55.20
2007–8 20.20 10.90 7.00 54.10 34.70 38.70 50.10
2008–9 20.00 10.00 7.60 50.20 38.30 35.70 52.80
2009–10 19.30 9.80 7.50 50.70 38.80 36.90 52.70

Note: RE indicates revised budgetary estimates not the actual expenditure and BE indicates budget estimates.
Page 16 of 44
decline in the volume of transfers has adversely affected the poorer states more as
their dependence on central transfers is much larger than the high-income states.15
However, the central transfer started increasing gradually in recent years primarily
due to the increase in the buoyancy of central taxes in the phase of high economic
growth.
Another noteworthy feature of Indian federal fiscal arrangement is such that
until recently, the centre used to act as a lender to the states. (p.261)
Table 6.5 Vertical Transfer of Revenues (in per cent)
Year Share in Central Taxes Share in Grants Total Transfers
1950–1 0.48 0.16 0.64
1960–1 0.96 1.39 2.35
1970–1 1.65 1.19 2.84
1980–1 2.64 1.84 4.48
1990–1 2.50 2.22 4.73
1991–2 2.58 2.33 4.91
1992–3 2.75 2.37 5.12
1993–4 2.61 2.46 5.07
1994–5 2.46 1.98 4.43
1995–6 2.45 1.77 4.21
1996–7 2.56 1.69 4.25
1997–8 2.65 1.59 4.25
1998–9 2.25 1.48 3.73
1999–2000 2.24 1.54 3.79
2000–1 2.47 1.79 5.24
2001–2 2.35 1.86 5.29
2002–3 2.32 1.76 5.22
2003–4 2.45 1.76 5.13
2004–5 2.47 1.66 4.90
2005–6 2.59 1.99 4.73
2006–7 2.86 2.11 5.08
2007–8 3.10 2.19 5.43
2008–9 2.91 2.23 5.28
Page 17 of 44
Year Share in Central Taxes Share in Grants Total Transfers
2009–10 RE 2.68 2.31 5.10

Source: Indian Public Finance Statistics, Department of
Economic Affairs, Ministry of Finance, Government of India
(Various Issues) and Economic Survey, Ministry of Finance,
Government of India (Various Issues).
According to the Article 293(1) of the Constitution, states indebted to the centre
cannot borrow without the prior permission from the centre. The central loans to the
states were given to finance state plan, small-savings loans prior to 1 April 1999, loans
for CSS/central plan schemes, miscellaneous loans provided by various central
ministries, medium-term loans, and ways-and-means loans given by the Ministry of
Finance. It is to be noted that the share of loans in total resources transferred to the
states declined significantly from more than 42 per cent in the year 1970–1 to 18.22
per cent. Still central loans constituted the bulk of the outstanding stock of state debt
and the average cost of state debt was much higher than that of the centre
(Chakraborty 2005). The Twelfth Finance Commission has observed that one of the (p.
262) principal reasons for high
cost of state debt is increasing
interest rates on central loans,
which contributed to the growing
burden of debt servicing of states.
In this context, the Twelfth
Finance Commission has also
recommended that ‘the central
government should not act as an
intermediary for future lending
and allow states to approach Figure 6.2 Tax Shares, Grants, and Total
market directly’ (Twelfth Finance Transfers
Commission Report 2004: 266). Source: Indian Public Finance Statistics,
Hopefully this would achieve the
Department of Economic Affairs, Ministry
parity in interest rate in both
of Finance, Government of India (Various
central and state borrowing and in
Issues).
the low interest rate regime would
create greater fiscal space for the
states. But its success would
critically depend on the improvement in the overall fiscal health of individual states to
make them successful in an auction-based market-borrowing regime which is still in its
infancy in India. The discontinuation of central loan is reflected in its negligible share
in recent years (see Table 6.6).
Apart from this, the Twelfth Finance Commission has also started an incentive-
based fiscal consolidation plan for the states by introducing rule-based fiscal
control. The incentive structure as designed mandated that the states will be
eligible for Debt Consolidation and Relief Facility (DCRF) upon enactment of
Fiscal Responsibility Legislation (FRL). Except Sikkim and West Bengal, all other
states enacted FRL to avail DCRF. The nature of fiscal consolidation during the
Page 18 of 44
era of rule-based fiscal control in states and its implications for federal transfers,
(p.263)
Page 19 of 44
Table 6.6 Composition of Resource Flows to States (in per cent)
Year Share in Central Taxes Grants from the Centre Loans from the Centre Gross Resource Flow to
States
1970–1 31.52 25.55 42.92 100
1971–2 31.03 29.26 39.70 100
1972–3 29.92 26.68 43.41 100
1973–4 31.64 25.74 42.62 100
1974–5 36.26 31.38 32.36 100
1975–6 38.22 30.81 30.98 100
1976–7 35.26 33.84 30.90 100
1977–8 31.46 34.31 34.23 100
1978–9 26.59 35.80 37.62 100
1979–80 39.70 28.10 32.19 100
1980–1 38.95 28.73 32.32 100
1981–2 40.36 26.96 32.68 100
1982–3 36.90 28.91 34.18 100
1983–4 35.67 29.93 34.40 100
1984–5 33.64 30.39 35.97 100
1985–6 32.52 30.69 36.79 100
Page 20 of 44
States
1986–7 35.15 32.11 32.74 100
1987–8 34.01 32.64 33.36 100
1988–9 34.65 32.72 32.63 100
1989–90 39.79 26.20 34.01 100
1990–1 34.32 31.39 34.29 100
1991–2 37.22 34.21 28.57 100
1992–3 39.62 34.64 25.74 100
1993–4 38.04 35.85 26.11 100
1994–5 38.85 31.74 29.41 100
1995–6 41.55 30.61 27.84 100
1996–7 42.43 28.49 29.08 100
1997–8 44.31 37.53 18.15 10016
1998–9 48.37 31.94 19.69 100
1999–2000 45.88 31.48 22.64 100
2000–1 47.17 34.22 18.61 100
2001–2 44.40 35.25 20.35 100
2002–3 44.32 33.66 22.01 100
2003–4 47.69 34.29 18.02 100
Page 21 of 44
States
2004–5 50.47 33.92 15.62 100
2005–6 54.72 42.05 3.23 100
2006–7 56.25 41.47 2.29 100
2007–8 57.17 40.34 2.50 100
2008–9 55.01 42.23 2.76 100
2009–10 RE 52.55 45.34 2.11 100

Page 22 of 44
(p.264) especially on fiscal equalization remains an open issue. Chakraborty (2008)

examined that improvement in fiscal balance has been associated with increasing
disparities in developmental spending across states.
Inequality in Fiscal Capacity and Horizontal Transfers
As mentioned earlier, one of the major factors in determining the fiscal capacity
of a unit within the federation is the revenue base. Income being the base of
taxes, it would be worthwhile examining the real per capita income of states. It
can be seen from Table 6.7, the real per capita income of major states in India
varied within a range of Rs 10,206 to Rs 41,896 in the year 2008–9, when states
are arranged in ascending order of their real per capita income. As evident from
the table, Bihar is the lowest income state and Goa is the highest income state
and Bihar’s real per capita income is only 18.06 per cent of that of Goa. The
distance of per capita income continues to remain significantly high between the
low-, middle-, and high-income states.17 State-wise growth of real per capita
income shown in Table 6.7 reveals wide difference in growth performances
across states and it also shows that poorer regions is lagging behind the leading
regions of the country in terms of growth.
The relative income divergence, estimated as a ratio of group average income of

low- and middle-income states18 to high-income states revealed that group
average income of low-income states was little above 50 per cent of that of high-
income states in the beginning of the 1980s and the same has declined gradually
over the years to around 40 per cent by the end of the 1990s (see Figure 6.3).
Similarly, the middle-income category states though did not show a gradual
divergence from the high-income states, but definitely there was a decline in the
ratio of middle-income states’ group average income to high-income states. The
ratio showed an upward trend during the late 1990s. As evident from Figure 6.4,
there has been a divergence of real mean income of high-income states with that
of the middle- and low-income states. This divergence is particularly sharp
during the 1990s. The lack of convergence becomes particularly evident if we
plot the initial real per capita net state domestic product (NSDP) (1980–1)
against the growth rate of states income from 1980–1 to 2008–9 (Figure 6.5).
The preceding analysis revealed an increase in the divergence of mean income

of middle- and low-income states from the high-income (p.265)
Page 23 of 44
Table 6.7 Real Per Capita Income: An Interstate Comparison (in Rs)
States 1980–1 1985–6 1990–1 1999–2000 2003–4 2005–6 2006–7 2007–8 2008–9 Growth
rates
Bihar 3,427 4,014 4,474 5,786 6,117 6,745 8,233 8,818 10,206 1.77
Uttar 4,133 4,446 5,342 9,749 10,120 10,766 11,311 11,981 12,637 2.02
Pradesh
Madhya 5,084 5,275 6,350 12,384 11,870 12,712 13,307 13,943 14,918 1.19
Pradesh
Odisha 4,085 4,483 4,300 10,622 11,900 13,877 15,760 17,352 18,212 2.79
Rajasthan 4,254 4,657 6,760 13,619 15,579 15,736 17,480 18,769 19,708 3.60
West 4,952 5,387 5,991 15,888 18,374 20,187 21,773 23,456 24,720 4.28
Bengal
Andhra 4,604 5,248 6,873 15,427 18,819 21,728 23,898 26,229 27,362 5.00
Pradesh
Karnataka 4,943 5,347 6,631 17,502 18,236 22,295 23,621 26,536 27,526 4.82
Tamil 5,266 6,321 7,864 19,432 20,707 25,558 28,320 29,445 30,652 4.80
Nadu
Gujarat 6,455 7,274 8,788 18,864 22,378 26,268 25,335 31,594 33,608 4.54
Punjab 8,442 10,257 11,776 25,631 27,075 28,487 30,154 31,662 33,198 2.99
Kerala 5,692 5,688 6,851 19,461 23,159 27,714 30,476 33,372 35,457 4.45
Page 24 of 44
States 1980–1 1985–6 1990–1 1999–2000 2003–4 2005–6 2006–7 2007–8 2008–9 Growth
rates
Maharasht 7,102 7,890 10,159 23,011 24,859 28,684 31,702 34,406 35,033 4.59
ra
Haryana 7,514 9,172 11,125 23,222 28,805 32,980 36,669 39,462 41,896 4.03
Goa 9,473 9,311 14,709 42,296 42,206 52,201 56,021 60,232 NA 5.69
Source: Central Statistical Organisation, Ministry of Statistics and Programme Implementation, Government of India.
The table is sorted according to the per capita income at 2007–8.
Note: Per capita income is based on NSDP at 1993–4 prices up to 1990–1. Since 1999–2000, the per capita income is based on 1999–
2000 prices.
Page 25 of 44
(p.266) categories of states. The

real per capita income of states
also revealed negligible growth in
the case of low-income category
states compared to high- and
middle-income category of states
except for a few exceptions. As the
distance of income has increased
over the years, (p.267) and
corresponding erosion of relative Figure 6.3 Relative Income Divergence
fiscal capacities across low-income from High-income States
states in relative terms, in a
Source: Central Statistical Organisation.
system of equitable fiscal transfer
mechanism; one would expect a
distribution pattern of transfers
more towards these states to
correct for accentuating fiscal
disadvantages, if not cost
disabilities.
Figure 6.4 Real Per Capita Income:

1980–1 to 2007–8
Note: HighIncPCInc – High-income
per capita income; MiddleIncPCInc –
Middle-income per capita income;
LowIncPCInc – Low-income per
capita income.
Page 26 of 44
The distribution of federal Figure 6.5 Growth Rate versus Initial Per
resources across various Capita State Income
income categories of states
shown in Table 6.8 reveals that
between 1987–8 and 2002–3
there has been a sharp increase in the share of tax transfers to the low-income
category of states. The share of middle-income states in the total tax transfers
remained stagnant during the same period and the share of high-income states
declined. While the share of grants devolved to low-income states also declined
during this period, the share of middle-income states in total grants increased
sharply. Thus, if we look at the total transfers, it is the low-income states, whose
share in the total kitty of transfers from the centre has declined with a
corresponding increase in the share of middle-income states up to 2002–3.
However, 2003–4 onwards, the share of transfers seems to have increased
towards low-income states. This has particularly happened due to the increase in
the weight of the distance of income by the Eleventh Finance Commission to
62.5 per cent for horizontal sharing of resources. However, the share (p.268)
Page 27 of 44
Table 6.8 Distribution of Resources across Various Income Categories of States (in per cent)
1987–8 1990–1 1995–6 1999– 2000–1 2001–2 2002–3 2003–4 2004–5 2005–6 2006–7 2007–8 2008–9 2009–
2000 10
Tax transfers to states
Low 51.32 50.59 51.62 51.83 55.35 57.73 58.15 55.10 55.20 55.37 55.60 55.67 56.02 57.80
income
Middle 33.18 34.02 33.99 33.44 32.08 31.74 31.86 33.10 33.77 31.11 31.24 31.28 31.08 29.98
income
High 15.49 15.39 14.39 14.73 12.56 10.53 9.99 11.79 11.03 13.53 13.16 13.05 12.90 12.23
income
Transfers of grants to states
Low 49.16 55.32 49.61 45.62 43.05 40.87 42.34 38.95 46.36 37.76 41.37 42.24 43.29 44.29
income
Middle 29.61 28.86 32.97 35.96 38.88 41.84 35.02 41.29 34.95 40.27 33.02 36.51 33.54 32.33
income
High 21.23 15.82 17.42 18.42 18.08 17.29 22.64 19.75 18.69 21.97 25.61 21.24 23.17 23.37
income
Total transfers to states
Low 50.44 52.61 50.96 49.75 51.30 52.05 52.91 49.93 52.40 49.05 50.42 50.97 50.88 52.31
income
Middle 31.73 31.81 33.66 34.28 34.32 35.14 32.91 35.73 34.15 34.39 31.89 33.11 32.07 30.94
income
Page 28 of 44
1987–8 1990–1 1995–6 1999– 2000–1 2001–2 2002–3 2003–4 2004–5 2005–6 2006–7 2007–8 2008–9 2009–
2000 10
High 17.83 15.57 15.38 15.97 14.38 12.81 14.18 14.34 13.46 16.55 17.69 15.92 17.05 16.76
income
Source: Finance Accounts and Twelfth Finance Commission, Comptroller and Auditor General of India, New Delhi.
Available at http://fincomindia.nic.in/.
Page 29 of 44
(p.269) of grants to low-income states also increased in recent years. It is to be noted

that the distribution of grants presented in Table 6.8 includes all the grants, namely,
Finance Commission grants, Planning Commission grants, and discretionary grants.
The per capita tax transfers and grants in selected years are shown in Tables 6.9
and 6.10. If we compare the per capita tax transfers across high-, middle-, and
low-income states, it becomes evident that low-income states are receiving
higher per capita tax transfers vis-à-vis high- and middle-income states. In case
of transfer of grants, no clear progressive pattern is evident. The per capita
grant transfers to Bihar and Uttar Pradesh was below the all-state average.
Regressivity in the pattern of grants transfer become further evident when we
look at the coefficient of variations in per capita grants transfer to states which
declined from 0.85 in the year 1987–8 to 0.33 in the year 2003–4. However, this
seems to have changed in recent years with some increase in the coefficient of
variations.
We assume that in a system of progressive fiscal transfers, a negative functional

relationship will exist between the per capita transfers, per capita income, and
fiscal autonomy. The fiscal autonomy is defined as the ratio of own revenues of
the state government and total expenditure. We also have introduced a time
dummy to control from the various policy changes during the rule-based fiscal
control and related tax and expenditure reform measures introduced 2005–6
onwards.
Thus, we specify a functional form:
(1)
(2)
(3)
where:
(p.270)
Page 30 of 44
Table 6.9 Per Capita Tax Transfers: Select Years (in Rs)
1987–8 1990–1 1995–6 1999– 2000–1 2001–2 2002–3 2003–4 2004–5 2005–6 2006–7 2007–8 2008–9 2009–
2000 10
Mahara 93.00 131.00 204.00 292.00 327.00 253.00 230.00 339.00 354.00 483.00 575.00 714.00 742.00 782.00
shtra
Gujarat 95.00 113.00 262.00 353.00 313.00 290.00 261.00 375.00 416.00 623.00 805.00 972.00 1,128.0 1,066.0
0 0
Punjab 84.00 126.00 208.00 278.00 298.00 249.00 261.00 301.00 355.00 477.00 601.00 748.00 890.00 934.00
Haryan 72.00 116.00 207.00 270.00 165.00 210.00 348.00 273.00 276.00 525.00 556.00 688.00 795.00 781.00
a
Tamil 124.00 183.00 305.00 437.00 448.00 460.00 483.00 558.00 661.00 776.00 982.00 1,229.0 1,287.0 1,366.0
Nadu 0 0 0
Karnata 107.00 149.00 299.00 412.00 487.00 493.00 517.00 598.00 706.00 758.00 955.00 1,191.0 1,243.0 1,314.0
ka 0 0 0
Rajasth 102.00 176.00 315.00 414.00 502.00 503.00 524.00 612.00 718.00 867.00 1,085.0 1,345.0 1,394.0 1,465.0
an 0 0 0 0
Kerala 105.00 170.00 336.00 482.00 501.00 505.00 530.00 621.00 735.00 763.00 966.00 1,208.0 1,394.0 1,590.0
0 0 0
Andhra 119.00 176.00 362.00 449.00 524.00 534.00 559.00 649.00 767.00 870.00 1,098.0 1,371.0 1,599.0 1,456.0
Prades 0 0 0 0
h
Page 31 of 44
1987–8 1990–1 1995–6 1999– 2000–1 2001–2 2002–3 2003–4 2004–5 2005–6 2006–7 2007–8 2008–9 2009–
2000 10
West 116.00 156.00 279.00 384.00 525.00 531.00 559.00 649.00 766.00 791.00 998.00 1,246.0 1,452.0 1,582.0
Bengal 0 0 0
Madhya 123.00 168.00 310.00 415.00 658.00 563.00 598.00 676.00 793.00 973.00 1,218.0 1,510.0 1,566.0 1,580.0
Prades 0 0 0 0
h
Uttar 140.00 169.00 338.00 447.00 546.00 605.00 631.00 767.00 854.00 1,012.0 1,267.0 1,568.0 1,813.0 2,047.0
Prades 0 0 0 0 0
h
Odisha 135.00 222.00 379.00 491.00 708.00 716.00 749.00 883.00 1,045.0 1,267.0 1,600.0 1,998.0 2,330.0 2,211.0
0 0 0 0 0 0
Bihar 135.00 190.00 378.00 504.00 795.00 733.00 765.00 874.00 1,040.0 1,167.0 1,465.0 1,818.0 2,108.0 2,493.0
0 0 0 0 0 0
Goa 252.00 459.00 568.00 614.00 781.00 795.00 821.00 988.00 1,150.0 1,690.0 2,091.0 2,558.0 2,907.0 3,057.0
0 0 0 0 0 0
Maxim 3.50 4.10 2.80 2.30 4.82 3.79 3.57 728.00 856.00 1,127.0 1,416.0 1,759.0 2,042.0 2,315.0
um/ 0 0 0 0 0
Minimu
m
Mean 120.13 180.27 316.67 416.13 513.10 504.76 531.23 770.00 871.00 774.00 1,303.0 1,612.0 1996.0 1,883.0
0 0 0 0
CV 0.34 0.46 0.29 0.22 0.346 0.353 0.341 0.356 0.373 0.373 0.380 0.377 0.391 0.405
Page 32 of 44
Available at http://fincomindia.nic.in/.
Page 33 of 44
(p.271)
Page 34 of 44
Table 6.10 Per Capita Transfer of Grants to the States (in Rs)
1987–8 1990–1 1995–6 1999– 2000–1 2001–2 2002–3 2003–4 2004–5 2005–6 2006–7 2007–8 2008–9 2009–
2000 10
Andhra 67.00 116.00 217.00 264.00 287.00 436.00 329.00 562.16 339.48 501.18 615.15 870.71 1,502.7 1,592.2
Prades 6 5
h
Bihar 67.00 115.00 105.00 142.00 128.00 125.00 163.00 253.50 322.75 373.39 578.17 632.48 1,044.4 1,080.7
0 6
Goa 425.00 640.00 574.00 250.00 497.00 437.00 552.00 385.17 511.00 462.07 589.81 961.04 2,130.3 2,531.7
3 2
Gujarat 118.00 89.00 102.00 235.00 346.00 291.00 576.00 350.38 374.74 488.18 575.31 675.35 840.60 935.68
Haryan 100.00 89.00 164.00 233.00 224.00 240.00 250.00 305.25 242.76 487.26 488.12 590.07 716.15 922.47
a
Karnata 60.00 85.00 121.00 274.00 293.00 327.00 309.00 366.29 390.89 653.27 855.52 883.34 868.11 1,012.8
ka 7
Kerala 65.00 125.00 146.00 208.00 191.00 305.00 290.00 280.07 401.44 624.75 629.79 649.17 923.61 895.11
Madhya 77.00 130.00 159.00 209.00 250.00 244.00 298.00 282.33 379.96 449.83 673.90 847.87 1,023.6 1,273.5
Prades 1 9
h
Mahara 67.00 97.00 131.00 156.00 111.00 171.00 152.00 226.93 265.09 385.69 816.29 705.92 1,324.9 1,425.0
shtra 7 6
Page 35 of 44
1987–8 1990–1 1995–6 1999– 2000–1 2001–2 2002–3 2003–4 2004–5 2005–6 2006–7 2007–8 2008–9 2009–
2000 10
Odisha 130.00 192.00 248.00 479.00 388.00 336.00 481.00 455.53 617.04 694.73 812.35 1,174.0 1,836.3 1,813.3
0 4 7
Punjab 61.00 88.00 138.00 217.00 337.00 219.00 272.00 228.82 237.16 860.29 859.59 799.14 831.90 757.91
Rajasth 155.00 194.00 240.00 279.00 456.00 365.00 376.00 425.67 482.96 477.79 609.06 776.56 993.58 1,009.1
an 4
Tamil 70.00 103.00 127.00 221.00 245.00 221.00 251.00 334.06 413.44 467.33 510.63 995.29 1,018.8 1,080.5
Nadu 2 8
Uttar 71.00 148.00 150.00 151.00 165.00 196.00 134.00 143.51 235.24 297.96 428.36 460.98 690.87 810.22
Prades
h
West 86.00 104.00 118.00 192.00 393.00 364.00 273.00 229.96 271.62 670.41 513.87 561.86 756.60 706.98
Bengal
Maxim 7.13 7.56 5.63 3.37 4.47 3.49 4.28 3.92 2.62 2.89 2.01 2.55 3.08 3.58
um/
Minimu
m
Mean 107.84 154.31 182.50 233.89 287.34 285.15 313.77 321.98 365.70 526.28 637.06 772.25 1,100.1 1,189.8
8 5
CV 0.85 0.90 0.64 0.34 0.40 0.33 0.43 0.33 0.30 0.28 0.22 0.24 0.38 0.41
Available at http://fincomindia.nic.in
Page 36 of 44
Note: In this table we have excluded Assam as with regard to grants Assam gets a preferential treatment as it is a special category state.
Page 37 of 44
(p.272) These functional forms specified in equations 1 to 3 are estimated

econometrically in a panel data framework by pooling data for 15 major non-
special category states for a period of 10 years, starting with fiscal year 1990–1
and ending with the fiscal year 2009–10. The coefficients are given in Table 6.11.
The result indicates a regressive fiscal transfer mechanism in operation in India
when controlled for fiscal autonomy. The random effect model of tax transfer
also shows a positive functional relationship between per capita income when
controlled for fiscal autonomy.
The regression Table 6.11 explains that fiscal autonomy has a negative
relationship on central tax transfers to states on a per capita basis. This can be
attributed to the fact that more a state is able to meet its expenditures from its
own revenue, the less it requires central tax assistance. The time dummy (from
2005) also has positive impact on central tax transfers. The time dummy
captures most of the policy changes that has occurred since 2005. A positive
sign for time dummy coefficients indicates that policy changes have impacted
positively the transfers from the centre to states be it growth or reform in direct
and indirect taxes at the central and state level, including the introduction of
value added tax.
It is also to be noted that there could be multicolinearity between per capita

income and fiscal autonomy and that, in turn, might produce inconsistent
results. In order to avoid the problem of multicolinearity, we have estimated
these four functional forms in bivariate framework by separately estimating the
relationship between fiscal transfers and per capita income and fiscal transfer
and fiscal autonomy. This also helps checking the robustness of the result. It was
found that even in this case the relationship between fiscal transfers and per
capita income is positive in case of aggregate transfers, tax transfers, grants,
and negative with respect to fiscal autonomy. This brings us to the point that
even though the transfer system has shown progressivity when looked at with
respect to fiscal autonomy, it is only at the margin because of the problem of
endoginity income and fiscal capacity. This has been further accentuated by the
fragmented transfer system through multiple channels and growing regional
inequalities. This chapter also observes that though at levels the transfer system
appears progressive, it shows regressive sign when one relates with the state
level per capita income over time.
(p.273)
Page 38 of 44
Table 6.11 Dependent Variable: Log of Per Capita Tax and Grants Transfers to States
Multivariate Bivariate Bivariate
Tax Grants Aggregate Tax Grants Aggregate Tax Grants Aggregate

Devolution Devolution Transfer Devolution Devolution Transfer Devolution Devolution Transfer
ln (fiscauto) –0.188 –0.234 –0.310 −0.188 0.073 −0.176
(–3.36) (–2.59) (–4.75) (−1.28) (0.38) (−1.21)
ln Pcit .224 0.299 0.229 0.717 0.584 0.579
(1.65) (2.32) (2.00) (3.10) (4.80) (3.97)
Timedum 0.684 0.76 0.720
(13.12) (13.39) (15.07)
Model 404.33 280.49 455.76 1.63 9.63 0.14 22.99 1.45 15.76
Significance
(0.000)* (0.000)* (0.000) (0.201) (0.002) (0.707) (0.000) (0.228) (0.000)
(Wald
Chi^2)
Number of 151 151 151 169 151 169 151 169 151
observation
s
Source: Author’s computation based on finance and accounting data, Comptroller and Auditor General of India, New
Delhi and Central Statistical Organisation, New Delhi.
Notes: Figures in parenthesis are t values.
*: Figures in parenthesis are p values for the chi^2
Page 39 of 44
(p.274) To conclude, it should be emphasized that during the 1990s, in India, there
has been an accentuation of both vertical and horizontal imbalances. The detailed
analysis of transfers revealed that aggregate transfer to the states declined during the
1990s resulting in accentuation of vertical imbalance. However, during this period,
though central government expenditure as a percentage of GDP declined, the state
governments were unable to compress their expenditure. The study also observed
accentuating regional inequality in India and lack of convergence in per capita income
across states in the last 27 years. However, buoyant growth and higher revenue
mobilization in recent years seems to have helped the states in terms of higher
transfers. The study also noted that improvement in fiscal balance in the era of rule-
based fiscal control was associated with increasing inequality in development
spending.
In order to examine whether principle of federal transfers followed the
principles of fiscal equalization, the econometric investigation in a panel data
framework revealed that aggregate tax transfers per capita was positively
related to the per capita income of the state implying the regressive nature of
transfers. Though, the fiscal autonomy was found to be negatively related to the
transfers implying progressivity, it failed to eliminate horizontal inequality. The
system of federal transfers needs to move more towards fiscal equalization to
achieve horizontal equity that states with lower fiscal capacity can bring up the
level of public services to a normative level through higher provision of
expenditure at comparable levels of taxation.
References
Bagchi, A. 2003. ‘Rethinking Federalism: Changing Power Relations between the

Centre and the States’, Publius: The Journal of Federalism, 33(4): 21–42.
Bird, Richard and Michael Smart. 2002. ‘Intergovernmental Fiscal Transfers:

International Lessons for Developing Countries’, World Development, 30(5):
899–912.
Breton, Albert. 1965. ‘A Theory of Government Grants’, Canadian Journal of

Economics and Political Science, 31(2): 175–87.
Boadway, Robin W. and Frank Flatters. 1982. Equalization in a Federal State: An

Economic Analysis. Ottawa: Canada Government Publishing Centre.
Boadway, Robin W. and Paul A.R. Hobson. 1993. Intergovernmental Fiscal

Relations in Canada. Toronto: Canadian Tax Foundation.
Chakraborty, Pinaki. 2005. ‘Debt Swap in Low Interest Rate Regime: Unequal
Gains and Future Worries’, Economic and Political Weekly, 40(40): 4357–62.
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———. 2008. ‘Budget Rules, Fiscal Consolidation and Government Spending:

Implications for Federal Transfers’, presented in a seminar ‘Issues Before the
Thirteenth Finance Commission’ organized by National Institute of Public
Finance and Policy, 23–4 May.
(p.277) ———. 2010. ‘Deficit Fundamentalism vs. Fiscal Federalism:

Implications of 13th Finance Commission’s Recommendations’, Economic and
Chakraborty, Pinaki, Anit N. Mukherjee, and H.K. Amarnath. 2010. ‘Interstate

Distribution of Central Expenditure and Subsidies’, Working Paper No. 66,
National Institute of Public Finance and Policy.
Craig, J. 1997. ‘Australia’, in Teresa, Ter-Minassian (eds), Fiscal Federalism in

Theory and Practice, 175–200. Washington, DC: International Monetary Fund.
Government of India. 2004. Twelfth Finance Commission Report. New Delhi.
———. 2000. Eleventh Finance Commission Report. New Delhi.
Gulati, I.S. 1987. Centre State Budgetary Transfers (First Edition). New Delhi:
Krelove, R., Janet G. Stotsky, and Charles L. Vehorn. 1997. ‘Canada’, in Teresa
Ter-Minassian (eds), Fiscal Federalism in Theory and Practice, pp. 201–25.
Washington, DC: International Monetary Fund.
Mathews, R.L. 1980. ‘Mechanisms for Fiscal Equalization’ in Bhajan S. Grewal,

Geoffrey Brennan, and R.L. Mathews (eds), The Economics of Federalism, pp.
255–84. Canberra: Australian National University Press. Originally published in
1977 as part of Report of the Study Group on the Role of Public Finance in
European Integration, Vol. II, Commission of the European Communities,
Brussels.
Oates, W.E. 1972. Fiscal Federalism. New York: Harcourt Brace Jovanovich.
Reserve Bank of India (RBI). 2004. State Finances: A Study of Budget of 2004–
05. Mumbai.
Rao, M. Govinda and Vandana Agarwal. 1994. ‘Inter-governmental Fiscal

Transfers in India: Some Issues of Design and Measurement’, in Amaresh Bagchi
and Nicholas Stern (eds), Tax Policy and Planning in Developing Countries, pp.
195–221. New Delhi: Oxford University Press.
Rao, M. Govinda and Nirvikar Singh. 2002. ‘Fiscal Transfers in a Developing

Country: The Case of India’, paper presented at University of Birmingham
conference on Comparative Federalism, January.
Page 41 of 44
Rao, M. Govinda. 2007. ‘Fiscal Adjustment: Rhetoric and Reality’, Economic and
———. 2010. ‘The 13th Finance Commission’s Report: Conundrum in

Conditionalities’, Economic and Political Weekly, 45(48): 46–56. (p.278)
Notes:
(*) I am grateful to ICSSR and Prabhat Patnaik for giving me this opportunity to
write this chapter. The errors and omissions that may still remain in the chapter
are my own.
(1.) Under the Constitution, the Finance Commission is appointed by the

President of India every five years mainly to decide on the distribution of
resources, namely, tax sharing and grants from the centre to the states.
(2.) These statutory transfers are unconditional transfers and the state
governments according to their own expenditure priorities based on local needs
use resources thus transferred through these channels.
(3.) It is important in this context to remember that Planning Commission is an

executive authority of the central government rather than a constitutional body
like Finance Commission.
(4.) The share of plan grants in total grants constitutes 47 per cent of the total
grants transferred to the states.
(5.) The Eleventh Finance Commission (2000), noted that during the course of
the last three decades, the central sector plan schemes/CSS have become an
important vehicle for transfer of resources to the states, outside the state plans,
and over and above, the transfers following through the mechanism of Finance
Commission. These were started primarily to provide funding for projects in
areas/subjects considered to be of national importance and priority by the
central government. The details of the schemes are drawn up by the centre and
their implementation and funds for implementation are allocated to the state
governments directly through District Rural Development Agencies or similar
created organizations. There is little freedom left to the state governments to
modify the schemes to local governments or to divert funds to areas, which are
considered of local priority. On the other hand, the state budgets are burdened
with additional revenue expenditure when the schemes are completed and their
maintenance expenditure is pushed under the non-plan category. The Eleventh
Finance Commission recommended that CSS need to be transferred to the states
along with funds. Plans for transfer of CSS was contemplated and recommended
by earlier Finance Commissions also to improve the flexibility of the state
governments in deciding its own expenditure priorities and improve its financial
Page 42 of 44
position. But so far no decision in this regard considered necessary by the

central government.
(6.) Data pertains to the Fiscal Year 2002–3 taken from RBI (2004).
(7.) As mentioned by Rao (2007: 1253), these kinds of transfers have been:
‘undermining the role of systems and institutions in the transfer system. In fact,
even under the transfers for state plans, normal assistance, which is given
according to the Gadgil formula, constituted less than 48 per cent. Thus, we
have a situation where the grants system has become predominantly purpose
specific with a cobweb of conditionalities specified by various central ministries.
Furthermore, quite a considerable proportion of grants which used to be given
to the states now directly goes to autonomous agencies. This raises questions
about the capacity to deliver public services by these autonomous agencies,
mechanisms to augment the capacity and as the funds do not pass through
states’ consolidated funds, of accountability’.
(8.) The share of grants recommended by Twelfth Finance Commission for the
period between 2005–6 and 2009–10 is 18.87 per cent of the total Finance
Commission transfers which is substantially larger than the share of grants
recommended by the earlier Finance Commissions (Twelfth Finance Commission
Report 2004: 5).
(9.) The example of this scheme is the general revenue sharing, which was
introduced in the USA in 1972.
(10.) In Canada, equalization payment is an unconditional payment of grants to

only those provinces with below average taxable capacity (Krelove et al. 1997).
(11.) The total recommended transfers through the Twelfth Finance Commission
(including tax devolution and grants) works out to be 29.98 per cent of the
shareable central revenues for the period between 2005 and 2010.
(12.) Interest payment and pension liabilities are one of the fast-growing current
expenditure of both central and state governments in India.
(13.) For all Central Statistical Organisation references, the GDSP data has
been accessed from http://mospi.nic.in/Mospi_New/site/inner.aspx?
status=2&menu_id=92, last accessed on 13 July 2015.
(14.) Punjab is a high-income state and Andhra Pradesh is a middle-income state.
(15.) The share of central transfers in total revenues of a poor income state like
Bihar is as high as 73 per cent when the all state average of the same is only
36.50 per cent.
Page 43 of 44
(16.) The econometric estimates in panel data also showed Fiscal Responsibility
Act (FRA) not having any positive and significant impact on development
spending when controlled for revenue effect of VAT and increased central
devolution. The result seems robust, as this has been corroborated by the
exploratory data analysis even when off budget CSS spending is added with the
per capita development spending of the states (see Chakraborty 2008).
(17.) In order to introduce the high degree of progressivity in the system of

transfers, Tenth, Eleventh, and Twelfth Finance Commissions have used distance
of income as one of the principal indicators for the horizontal sharing of
resources from the centre to the states.
(18.) The low-income group is defined as the first five low-income states, namely,
Bihar, Odisha, Uttar Pradesh, Madhya Pradesh, and Rajasthan. The middle-
income states is the group of next five states, namely, West Bengal, Andhra
Pradesh, Kerala, Karnataka, and Tamil Nadu. The remaining five states are
classified as high-income states.
Page 44 of 44
Intersectoral Linkages in the Indian Economy during the Post-reform Period

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
Intersectoral Linkages in the Indian Economy

during the Post-reform Period
Mausumi Das
DOI:10.1093/acprof:oso/9780199458950.003.0007

The Indian economy has experienced a very high, albeit uneven, growth process.
This has resulted in a sharp rise in the share of services in total GDP relative to
both manufacturing and agriculture. This change in the intersectoral
composition of GDP has not been accompanied by a concomitant change in the
employment shares of various sectors. The ‘disproportionality’ of the growth
process and the consequent intersectoral imbalances depend crucially on the
nature and direction of intersectoral linkages that are active within the economy.
The chapter examines these linkages in light of the existing theoretical
literature. It analyses how growth in one sector can get transmitted to other
sectors though various demand and supply channels. It traces these linkages for
the Indian economy and analyses how they are impacted upon by the current
growth process in order evaluate the issue of long run ‘sustainability’ and
‘desirability’.
Keywords: growth, structural transformation, intersectoral linkages, sectoral imbalance, sustainability
The Indian economy has been growing steadily over the past two decades at an
average annual growth rate of 6–7 per cent, which makes it one of the fastest
growing economies in the world. One striking feature of this late-twentieth
century Indian growth story is that the high growth trajectory has mostly been
driven by the service sector. The service sector has maintained a steady growth
rate of over 10 per cent per annum over the last five years (2005–6 to 2009–10)
and the share of services (construction included) in India’s GDP at factor cost
Page 1 of 21
has been rising significantly over all these years and reached 63.4 per cent in
2009–10. In comparison, the other two sectors (in particular agriculture) have
lagged behind not only in terms of growth rates but also in terms of their
respective shares in GDP. The contrast is particularly stark for the agricultural
sector, which has exhibited an average annual growth rate of only about 2–3 per
cent over the last two decades (falling into the negative zone during 2008–9) and
its share to India’s GDP has been declining steadily and has fallen to 14.6 per
cent in 2009–10 (see Figure 7.1).
India’s recent growth experience differs significantly from the conventional

notion of structural transformation as well as from the observed historical
pattern in various developed nations (and also in the growth-miracle countries of
the twentieth century). First, unlike other countries, it was not the
manufacturing sector that led the economy to a regime of high growth and
associated structural change. In fact, the share of industry in India’s GDP has
increased only marginally over this period of 20 years and accounts for less than
one-third (p.282)
of the country’s GDP. Instead, the

services sector has replaced
agriculture as the major
contributor to the GDP. Thus,
there is a clear departure from the
traditional route of structural
transformation, which involves
transition from agriculture to
industry and then to services.
Secondly, this structural change in
sectoral composition of GDP has
not been accompanied by a
concomitant change in the
respective employment shares
(see Figure 7.2). For example,
while the share of services in GDP Figure 7.1 Average Annual Growth Rates
was 51 per cent in 2002, its across Sectors
corresponding share in Source: Economic Survey, 2010–11,
employment was only 22 per cent. Ministry of Finance.
This disparity between GDP share
and employment share has, in
fact, widened over the decade as the share of services in GDP has risen to about 64 per
cent while its employment share has increased only marginally (see Figure 7.3). In
contrast, agriculture still employs more than 50 per cent of the total labour force of the
economy, even though its output share has fallen (p.283)
Page 2 of 21
(p.284) to less than 15 per cent.

This divergence between service
sector output and service sector
employment is a feature that is
peculiar to India. In all other fast
growing economies of the late
twentieth century (including
China), the rise in GDP share of
services went hand in hand with
an increase in the employment
share (Papola 2006).
The ‘disproportionality’ of the
Figure 7.2 Sectoral Shares in GDP
growth process and the
consequent intersectoral
Economy, RBI.
imbalances have raised several
questions regarding its
‘desirability’ and ‘sustainability’
in the long run. Both these
issues depend crucially on the
nature and direction of
intersectoral linkages that are
active within the economy. The
purpose of the present chapter
is to examine these linkages in
light of the existing theoretical
literature and analyse how the
current growth process impacts
them, in order to evaluate the Figure 7.3 Sectoral Shares in
issues of ‘sustainability’ and Employment
‘desirability’ in this context. Source: Handbook of Statistics on Indian
Economy, RBI.
The chapter is organized as
follows. In the next section we
consider possible demand-side and supply-side linkages across various sectors
and their implications for growth. Here we draw upon various theories from
economic development and developing-economy-macroeconomics to highlight
how existence or absence of these linkages may foster or hinder growth. Later in
the chapter, we try to decipher which of these linkages are currently active
within the economy in light of the empirical literature that explicitly measures
these linkages. This is followed by an attempt to explain why the intersectoral
linkages associated with the recent growth process have evolved in a particular
pattern and an analysis of the implications of this pattern for long-run growth
and welfare. The last section concludes the discussion.
Page 3 of 21
Intersectoral Linakages: Theory

Traditional development literature proposes various supply-side (production)
linkages across sectors which have implications for the process of development.
One of the earliest models of this kind was adapted from Lewis (1954),
subsequently extended by Ranis and Fei (1961), which looks at the growth–
employment linkages from industry to agriculture in a dual economy set-up. The
process of development entails transfer of surplus labour from the agricultural
sector to a growing industrial sector. The workers continue to earn a constant
wage because of existence of surplus labour in the agricultural sector (with zero
marginal product). The profits in the manufacturing (p.285) sector are
channelized to capital formation in that sector which fuels further growth. This
process continues until the surplus labour in the traditional sector is exhausted,
whereupon the workers get paid in accordance with their marginal product.
Labour-augmenting technological progress in the manufacturing sector further
enhances the growth process due to more profits and therefore more investment
(at constant wages).
The Lewis–Ranis–Fei growth–employment linkage works through a simultaneous

transfer of surplus labour and of agricultural surplus (foodgrains) from
agriculture to manufacturing, sustaining the labour force in manufacturing.
Thus, growth is driven by the accumulation of capital but is limited by the ability
of the economy to produce a surplus of food. Unless labour productivity in the
agricultural sector rises as well, the process of growth eventually comes to a
halt due to wage-goods (food) constraint. The possibility of a wage-goods
constraint limiting the process of development shows up in other theories as
well—notably in Kalecki, which we discuss in detail later.
Another kind of production linkage was emphasized in the doctrine of

‘unbalanced growth’ put forward by Hirschman (1958). Hirschman argues that
growth first happens in a leading industry (primarily due to some
entrepreneurial innovations), which eventually spreads to other industries
though various backward and forward ‘linkages’. These linkages include higher
demand for intermediate inputs in complementary industries, social learning of
more efficient business practices across industries, etc. Notice, however, that
these linkages are mostly intra-industry in nature and will work between
agriculture and manufacturing as a whole only to the extent that: (i) agricultural
production consists primarily of goods which are used as intermediate inputs in
manufacturing; and (ii) agricultural production process becomes more
mechanized and is guided by capitalist business practices. In a predominantly
agrarian economy where the bulk of agricultural production consists of
foodgrains produced by family farms using primitive techniques, the production
linkages highlighted by Hirschman are unlikely to play an important role in
explaining intersectoral relationship between the farm and the non-farm sectors
and its evolution over time.
Page 4 of 21
A very different type of linkage operating through the demand-side has been
highlighted in the writings of Rosenstein-Rodan (1943) and Nurkse (1953). The
basic idea expounded by these authors is (p.286) that expansion of different
sectors is complementary. An increase in the output of one sector increases the
size of the market for others. Thus, if a sector expands on its own, it may make a
loss due to insufficiency of demand; however, if many sectors expand at once,
then each can make a profit due to complementary expansion in demand for
each sector. This argument is best captured by Rosenstein-Rodan’s example of a
shoe factory. Consider the producer of a shoe factory, who is contemplating an
expansion of output. Any such expansion would involve more employment, which
would generate additional income. However, given that only a small fraction of
the additional income generated will be spent on shoes, the resulting extra
demand for shoes will be insufficient to exhaust the initial increase in supply.
Thus, either the price of shoes will fall or the producer will be left with unsold
new shoes. Either way, the producer might find it unprofitable to carry out the
expansion in the first place. By the same token, if a number of producers of
various commodities undertake expansion of production simultaneously, the
multiplier effect may ensure sufficient demand for each of these products. This
necessitates a coordinated expansion of all sectors (balanced growth) and a ‘big
push’.
This idea of demand complementarity across sectors has been modelled

explicitly in the recent development literature (by Murphy et al. [1989]; later
extended by Ciccone and Matsuyama [1996]; Murata [2002]) as a source of
‘coordination failure’ and associated multiple equilibria. The Murphy, Shleifer,
and Vishny model (MSV) adds a new dimension to the demand-complementarity
argument of Rosenstein-Rodan by postulating simultaneous existence of two
alternative technologies for each sector: a traditional constant returns to scale
(CRS) technology and a modern increasing returns to scale (IRS) technology,
which is more productive but requires an initial fixed cost to become
operational. Thus, adoption of modern technology in a sector requires sufficient
demand to cover at least the fixed cost. The authors then go on to show the
coexistence of two possible equilibria. If all sectors simultaneously adopt the IRS
technology, demand complementarity across sectors ensures that the fixed cost
is covered for each producer and the economy is transformed into an
industrialized high-productivity economy. On the other hand, if every producer
expects in isolation that no one else would adopt the IRS technology, then s/he
also has no incentive to do so (due to lack of demand); as a result the economy
remains underdeveloped and (p.287) traditional, characterized by low
productivity in every sector. What is interesting about this construction is that
the low productivity underdevelopment trap appears as realization of rational,
self-fulfilling expectations of producers. Any change in mutual expectation
(triggered by changes in policy or changes in environment) may propel the
economy from an underdeveloped to a developed one by setting in motion a
Page 5 of 21
series of positive consumption linkages. Moreover, demand complementarities

across sectors not only have an impact on current demand and current output,
but also influence the choice of technology, which has implications for the future
growth path of the economy.
One weakness of the Nurkse and Rosenstein-Rodan (and later, MSV) balanced
growth and big push framework is that it does not recognize the possibility of
structural bottlenecks arising in any of the sectors that may hinder the
realization of such demand linkages. And this is where the Kaleckian
macroeconomics (Kalecki 1972) becomes relevant. There is a basic similarity
between the Kaleckian framework and the balanced growth proposition of the
development economics in the following sense: both focus on the intersectoral
linkages that operate through demand externalities and both argue for a
proportional expansion of all sectors. But Kalecki explicitly recognizes the
structural constraints in agriculture which may make expansion of output in the
agricultural sector infeasible, which in turn limits the expansion of the other
sectors as well.
To see how structural bottlenecks working through intersectoral consumption

linkages can affect the rate of growth of the aggregate economy in the Kaleckian
fashion, once again consider a dual economy setup characterized by a
manufacturing sector producing investment goods (capital) and an agricultural
sector producing consumption goods (wage goods).1 Real wage rate is fixed in
terms of the agricultural commodity. The economy is characterized by surplus
labour, which implies: (i) output in the manufacturing sector can be increased
without reducing the output in the agricultural sector; and (ii) increased
employment does not involve an increase in the wage rate (that is, labour supply
is perfectly elastic at the constant real wage). Output in the agricultural sector is
produced by competitive produces with a standard concave production function
with labour as the only input. Thus, employment in agricultural sector is
determined by the equality of marginal product of labour with the given real
wage. This, in turn, fixes the output in agriculture—independent of the (p.288)
relative price ratio across sectors. Industry output, on the other hand, responds
to demand with the industry prices being determined as a constant mark-up over
nominal wages (underlying an oligopolistic market structure). Everybody spends
a constant proportion of his/her income in buying consumption goods
(consumption expenditure) and spends the rest in buying capital goods
(investment expenditure). It is easy to see that the price ratio of industry vis-à-
vis agriculture (that is, intersectoral terms of trade) will be constant in this
economy. This is so since the real wage rate is fixed in terms of the agricultural
goods, making nominal wage rate proportional to the agricultural price level;
and the manufacturing price level is a mark-up over the nominal wage rate.
Thus, from the market clearing condition for the manufacturing sector, one can
immediately observe that the demand for (and, therefore, the supply of) industry
output depends critically on the supply of agricultural output. An exogenous
Page 6 of 21
increase in agricultural output leads to a proportional increase in the industry

output, generating balanced growth. However, the converse is not true. An
exogenous increase in industrial output with a given supply of wage goods can
only lead to excess supply of industrial goods and concomitant excess demand
for agricultural goods. This would lead to a rise in the agricultural prices which,
in turn, would result in higher nominal wages and, therefore, higher industry
prices. In other words, in the presence the wage–goods constraint, any lopsided
or ‘disproportional’ stimulus for growth in the non-agricultural sector may not
only be self-limiting (in the sense that non-agricultural output actually fails to
grow) but also trigger off inflation within the economy.2
Variants of this Kaleckian framework (with intersectoral demand linkages along

with some structural constraints) have been explored extensively in the context
of developing economies, in general, and India, in particular (see, for example,
Bose [1989]; Dasgupta and Sinha [1989]; Dutt [1989]; Patnaik [1972]; Rakshit
[1982]; Taylor [1979]; and others).3 Many of these models bring in a more
nuanced class structure which relates the aggregate demand problem to the
problem of income distribution. Some are based on nominal wage rigidity rather
than real wage rigidity.
Another variant of the wage–goods constraint works through the terms of trade
effect. It is argued that supply bottleneck in agriculture with an expanding
industrial sector may result in a rising terms of trade of agriculture vis-à-vis
industry which would eventually stifle (p.289) growth in the industrial sector.
This term of trade effect was emphasized in various studies explaining the
industrial stagnation in India during the mid-1960s (see, for example, Ahluwalia
[1979]; Bharadwaj [1987]; Bhattacharya and Rao [1993]; Chakravarty [1979];
[1985]; Nayyar [1978]; Raj [1976]; Rangarajan [1982]; Thamarajakshi [1990];
Vaidyanathan [1977]).
Notwithstanding the differences in mechanism, all these models highlight the

importance of simultaneous expansion of farm and non-farm sectors. Any
disproportional intersectoral growth of the non-farm sector would lead to
inflationary pressure in the economy, working through intersectoral demand
linkages.
A subset of these models (for example, Dasgupta and Sinha [1989]; Patnaik
[1972]) adds dynamic equations of price and/or output adjustments and show
that the wage–goods constraint may lead to increased volatility and cyclical or
even chaotic growth paths.
Notice that the wage–goods constraint, implicit in the Lewisian framework and
considered explicitly in the neo-Keynesian/Kaleckian framework, may not be
binding in an open economy which can import food. Import of food relaxes the
domestic supply bottleneck in food production. However, for this strategy to be
Page 7 of 21
sustainable, the country needs to have a steady supply of foreign exchange.

Otherwise, the structural constraint will show up again in the form of a foreign
exchange constraint and corresponding balance of payments (BoP) crisis. In fact,
domestic supply constraint in agriculture can be successfully overcome if only
the expansion of industry output is accompanied by a parallel increase in the
export of industrial goods. In this latter case, the increasing requirement for
wage goods coming from industry can be met by importing foodgrains, which, in
turn, is financed by export of the industrial product.
Intersectoral Linkages: Evidence from India

As we have noted earlier, the Indian economy has undergone a structural
transformation over the past two decades—with the services sector emerging as
the driving force of the economy boosting growth, and the share of agriculture
as a proportion of GDP falling steadily over time. Economic theory, discussed in
the previous section, suggests various linkages through which such structural
transformation may happen. The question that follows is: which of these linkages
(p.290) played a crucial role during the process of structural transformation of
the Indian economy?
The intersectoral linkages across sectors are usually measured using three
distinct methods: (i) by constructing a Social Accounting Matrix (SAM), which
compiles information about inflows and outflows from various sectors (as
captured in the corresponding Input–Output Matrix) as well as information on
receipts and expenditures on various macroeconomic accounts (as captured in
the corresponding National Income Accounting Statistics); (ii) by running
causality tests across growth rates of various sectors; and (iii) by constructing
detailed econometric models with various sectors and running regressions to
estimate the corresponding coefficients. All the three methods have been used
extensively in the case of India to examine the relationship across sectors and
how it has evolved over time. A number of recent empirical studies have
examined these linkages for the post-reform period (that is, since the 1990s).
These include Banga (2005), Banga and Goldar (2004), Chandrasekhar (2007),
Dasgupta and Singh (2005), Eswaran et al. (2009), Gordon and Gupta (2004),
Hansda (2001), Kaur et al. (2011), Pieters (2010), Rath and Rajesh (2006),
Rodrik and Subramanian (2004), Saikia (2011), Sastry et al. (2003), Singh
(2006), Ten Raa and Sahoo (2007), and others. In this section, we draw upon the
basic findings of these studies to comment on the salient features that underlie
the Indian growth experience.
The first striking feature of India’s service-led growth story is that the Lewisian
employment–growth linkage that entails large-scale movement of labour from
the agriculture to the non-agricultural sectors (manufacturing and service) is
conspicuous by its absence. Instead of the non-agricultural sectors absorbing the
surplus labour from agriculture, agriculture has remained the primary source of
employment for more than half of the total labour force.4 To be sure, there has
Page 8 of 21
been some reduction of labour force in agriculture (for example, from 63.4 per
cent in 1983 to 53.9 per cent in 2004), but it is nowhere comparable to what has
been observed in most of mature industrialized countries (for example, UK, USA,
France, Japan, and Germany, where the share of agriculture has fallen to less
that 5 per cent of the GDP with a concomitant fall in its employment share to
less than 5 per cent) or East Asia (for example, China, where the share of
agriculture is GDP is about 30 per cent and so is its employment share).
Moreover, there has been a decline in the labour absorptive (p.291) capacity in
almost all sectors (including agriculture), as reflected in their respective
employment elasticity.5 Employment elasticity in some sectors has even turned
negative over the years (see Table 7.1).
Secondly, detailed input–output analysis and other econometric methods have

been used by various authors to examine the existence and quantification of
intersectoral production linkages during the post-reform period (see, for
example, Hansda [2001]; Kaur et al. [2011]; Saikia [2011]; Sastry et al. [2003]).
All these studies emphasize the existence of strong and significant production
linkages between manufacturing and services, thus corroborating a Hirschman-
type backward and forward linkage story. In fact, some studies suggest that the
growing use of services as inputs in manufacturing has led to enhancement of
productivity in the manufacturing sector (Banga and Goldar 2004). As for
agriculture, there has been some evidence of positive production linkages with
manufacturing, suggesting greater degree of mechanization in agriculture (Kaur
et al. 2011). However, linkages between agriculture and services have remained
rather weak (see Table 7.2).
What about the aggregate demand linkages across sectors? Recall that if the
aggregate demand linkages across sectors are strong, any kind of sectoral
imbalances would show up in the form of a wage-goods constraint, as
highlighted by Kalecki and others. Since the disproportionality between
agricultural and non-agricultural growth rates in the Indian economy has been
rather stark, one would have expected that this would lead to accelerating
inflation and/or depleting
Table 7.1 Employment Elasticity in Various Sectors
Sectors 1983 to 1993–4 1993–4 to 1999–2000
Agriculture 0.70 0.01
Mining and quarrying 0.59 −0.41
Manufacturing 0.38 0.33
Electricity, gas, and water supply 0.63 −0.52
Construction 0.86 0.82
Page 9 of 21
Sectors 1983 to 1993–4 1993–4 to 1999–2000
Trade, hotels, and restaurants 0.68 0.62
Transport, storage, and 0.55 0.63

communications
Financing, insurance, real estate, and 0.45 0.64

business services
Community, social, and personal 0.68 −0.25

services
Source: Singh (2006).
(p.292)
Table 7.2 Production Linkages across Sectors
Agriculture Industry Services
1979–80
Agriculture 0.160 0.130 0.039
Industry 0.068 0.345 0.105
Services 0.020 0.149 0.096
1989–90
Agriculture 0.166 0.042 0.035
Industry 0.144 0.373 0.172
Services 0.047 0.188 0.185
1993–4
Agriculture 0.145 0.035 0.034
Industry 0.140 0.365 0.150
Services 0.048 0.213 0.195
1998–9
Agriculture 0.117 0.081 0.019
Industry 0.075 0.397 0.145
Services 0.050 0.173 0.144

Source: Kaur et al. (2011).
foreign exchange reserves with an eventual decline (or increased volatility) in the
growth rate. Surprisingly, none of these have happened in the Indian case. The price
level has remained more or less stable over the past two decades of high growth with a
reasonably low level of inflation.6 The foreign exchange reserves have been rising (for
Page 10 of 21
example, from US$ 151.6 billion in 2005 to US$ 2.79.1 billion in 2010). Moreover,
volatility of the GDP growth rate has declined over this period (as measured by the
standard deviation of growth rate—which has fallen steadily from a figure of 5.8 during
1990–1 to 1995–6 to 1.9 during 2001–2 to 2005–6) (Rath and Rajesh 2006). Thus, it
appears that the limited supply of wage goods has not acted as a binding constraint on
expansion of production in the non-agricultural sectors. This suggests that the Kalecki-
type aggregate demand linkage between agriculture and non-agriculture has remained
weak and insignificant in the post-reform Indian economy.
Finally, general equilibrium computations based on extended SAMs for the post-
reform Indian economy predict a rise in income inequality and increasing
poverty among the rural households. (See, for example, Ten Raa and Sahoo
[2007]; Pieters [2010]). Thus, the trickle-down effect postulated in the traditional
development (p.293) literature seems to have failed in the context of the post-
reform Indian economy.
Explanation
From the above discussion, it is evident that India’s recent growth experience
has been rather unique in that it has not been supported by a strong
intersectoral linkage between agriculture and manufacturing—either from the
demand side or from the supply side. On the other hand, traditional development
theory tells us that such production and demand linkages are precisely the
propagation mechanisms through which sudden growth spurts in specific
sectors result in sustained growth and development of the aggregate economy.
Absence of these linkages would create bottlenecks on the demand side or the
supply side, such that eventually growth would peter out. What then explains the
high growth trajectory of the Indian economy which seems to continue
undeterred for more than two decades now?
One possible answer to this apparent puzzle lies in the recent inventions and
innovations that occurred at the world technological frontier. The growth
impetus for the Indian economy came primarily from the services sectors, and it
is the production of services that experienced major technological breakthrough
in the late twentieth century which drastically enhanced its productivity and
reduced costs. Since most of these innovations were labour-saving in nature, the
supply side linkage via employment (à la Lewis) did not accompany the growth
in production.
But then the lopsided growth of the services sector should have resulted in
demand bottlenecks in Kaleckian fashion, leading to either hyperinflation or a
BoP crisis, thereby thwarting of the growth process itself. None of these
happened in India. Why?
The answer to this question is threefold. Notice that a stagnant agricultural

sector cannot act as a binding constraint for the other two sectors if any of the
following holds: (i) there exists an external market where manufacturing and
services products could be exported to and foodgrains can be imported from; (ii)
Page 11 of 21
the agricultural income can be sufficiently squeezed to provide for the

consumption of workers engaged in manufacturing and services; and (iii) the
pattern of demand shifts away from agricultural products so that expansion of
the other two sectors become, to some extent, self-perpetuating. It seems that
(p.294) all these three factors are indeed present in the Indian economy, which
makes the Kaleckian wage-goods constraint ineffective.
First, the export-content of services output in India is very high. For example,
India’s share in world export of commercial services doubled from 0.6 per cent
in 1990 to 1.2 per cent in 2000, while its share in global merchandise exports
went up only marginally, from 0.5 per cent to 0.7 per cent (Hansda 2001). In
fact, India is currently among the top 12 service exporters of the world
(Economic Survey 2010–11). At the same time, imports of agricultural products
have gone up. Table 7.3 shows the imports–production ratios for select
agricultural crops since 1990. It is evident that for certain crops such as pulses,
wheat, and sugar, the imports to production ratio has increased significantly
during this period of high growth. This indicates that export earnings from
services were indeed channelized towards financing import of foodgrains, which
allowed the economy to circumvent the Kaleckian wage-goods constraint.
Secondly, the high GDP growth rate has indeed been accompanied by a squeeze
in the agricultural income. The domestic terms of trade has remained against
agriculture throughout the growth process. This unfavourable movement in the
terms of trade has been accompanied
Page 12 of 21
Table 7.3 Imports to Production Ratio for Select Food Items (in per cent)
Year Pulses Wheat Sugar Tea
1990–1 5.6 0.1 0.1 –
1991–2 2.6 – 0.0 –
1992–3 3.0 2.4 0.0 –
1993–4 4.7 0.4 0.0 5.0
1994–5 3.9 0.0 − –
1995–6 4.0 0.0 1.0 –
1996–7 4.6 0.9 0.0 –
1997–8 7.8 2.2 2.7 –
1998–9 3.8 2.5 5.8 0.0
1999–2000 1.9 1.8 6.5 0.6
2000–1 3.2 0.0 0.2 1.3
2001–2 16.6 0.0 0.1 1.2
2002–3 17.6 – 0.2 2.8
2003–4 11.6 0.0 0.5 1.2
2004–5 10.2 – 7.2 3.6
2005–6 12.0 – 2.9 2.0

Source: Balakrishnan (2010).
Page 13 of 21
(p.295) by a decline in the rate of growth of agricultural income (in real terms)
during this period. As Eswaran et al. (2009) have shown, while the average daily real
earnings in agriculture grew at the rate of 3.33 per cent per annum during the period
1983–93, this rate fell substantially to 1.8 per cent per year in the next decade (1993–
2003). Moreover, only 22 per cent of this growth can be attributed to the linkages with
the non-farm sector; the rest comes from an exogenous increase (albeit meagre) in
agricultural productivity.
Finally, shift in pattern of demand away from agriculture has also played its role.
The services sector in India, especially the IT and the information and
communications technology (ICT) sectors, is extremely skill-intensive. As a
result, employment opportunities in services have mostly been limited to a small
group of people who possess the requisite skills (for example, proficiency in
English, a degree in engineering or management). Since acquiring these skills
requires a lump sum investment (in terms of education years as well as
resources) in some specialized branches of education, only a handful of elite
could afford to acquire these skills. The relative shortage of such skills has
pushed up the remuneration of those who are employed in this sector compared
to those who are employed elsewhere. The implication of this skewed earning
pattern is that demand generated by these earnings is skewed towards higher-
end manufacturing goods and services rather than agricultural commodities. As
a result, the demand linkages from non-agricultural sector to agricultural sector
that typically generate the wage–goods constraint are simply not there. In other
words, rising inequality and accompanying skewed demand pattern implies that
the non-agricultural sectors can keep expanding in a self-sustaining circular
pattern of high incomehigh demandhigh income, without having to necessarily
engage with the agricultural sector.7
Implications: Sustainability and Desirability

The fact that the services-led output growth has been associated with limited
increase in employment (the so-called ‘jobless’ growth) implies that a majority of
the population has been excluded from the benefits of high GDP growth. Indeed
there is a rising inequality between the rural and the urban sector, and those
who are engaged in agriculture have little to rejoice about the asymmetric
distribution (p.296) of the income gains resulting from growth. The high GDP
growth rate has not trickled down to the lowermost level either in the form of
greater absorption of labour from the agricultural sector or in the form of higher
demand for agricultural goods (both of which would have meant a rise in
agricultural income). Since agricultural wage rate could be taken as a proxy for
poverty (because it is the fall-back income of the landless agricultural workers,
who fall in the category of poorest of the poor)8, this slow pace of growth of
agricultural wages in an era of high GDP growth suggests that the impact of
growth on poverty reduction has been rather limited.
There has been a general concern about the sustainability of this disproportional
growth process. Part of this concern arises due to perceived supply constraint in
Page 14 of 21
agriculture resulting in inflation.9 We have just discussed why limited supply of

agricultural goods did not become a binding constraint for the service-led
growth in Indian economy. However, the strategy of exporting services and
importing foodgrains to keep inflation under control also makes the economy
extremely vulnerable to external shocks. The strategy works fine as long as India
has enough foreign exchange reserve. However, any world crisis that either hits
the export market or results in capital flight from the domestic economy would
have a negative spillover effect, thereby curbing the growth process.10
Another part of the concern about sustainability grows out of the rising income
inequality and the widening rural–urban income gap. While this in itself is a
highly undesirable outcome of the uneven growth process, another key question
is its political viability. The rising trend of political violence and increased
naxalite influence suggest that widening disparity across social and economic
classes has resulted in low tolerance that may eventually germinate into a
political crisis disrupting growth.
Quite apart from its political ramification, rising inequality can hamper the long-
run growth process by failing to generate sufficient human capital over time.
Some recent studies in the development economics literature (notably Banerjee
and Newman [1993]; Galor and Zeira [1993]) have highlighted a negative
relationship between inequality and growth (thereby challenging the
conventional notion of equity–efficiency trade-off).
These authors argue that in the presence of credit market imperfections and
indivisibilities in human capital investment, greater (p.297) inequality implies
that poorer people are unable to invest in human capital. This reduces overall
average productivity and lowers growth. Thus, even in the absence of wage-
goods constraint, the increasing income inequality in the Indian economy may
render the growth process unsustainable in the long run working through this
latter channel.
Another major issue about sustainability (as well as desirability) is the

environmental consequences of high non-agricultural growth. While production
of services itself is more environment-friendly, the growing production linkages
of services with manufacturing can result in an escalation of environmental
degradation. Also, developing the infrastructure required for rapid services
growth (for example, roads and power) could have negative environmental
consequences. These are, however, issues which are relevant for any fast
growing economy—irrespective of whether growth process is balanced or
unbalanced.
A close examination of the intersectoral linkages in the Indian economy reveals

that the production and demand linkages to and from agriculture is largely
missing, which has resulted in greater inequality between the rural and the
Page 15 of 21
urban sector. Moreover, within the urban sector itself, the earning differential
between the high-skilled jobs and low-skilled jobs has increased. Consequently,
the benefits of high and sustained GDP growth over the past two decades have
been unevenly distributed, which is neither desirable nor politically viable. As
several authors have pointed out, a somewhat balanced growth of all the three
sectors is desirable and productivity-improving investment in agriculture could
mitigate some of the anomalies arising out of the uneven growth.
There is, however, another policy issue that needs to be mentioned here. As we
have discussed earlier, the services sector jobs require specific skills that are
currently possessed by a minority of the population. An emphasis on education
and training, as a medium- and long-term policy, can improve the skill profile of
majority of the population, enabling them to move to the skill-intensive non-
agricultural sectors, thereby reducing the dependence on agriculture. The
lumpiness of investment (in terms of enrolment years as well as resources) in
(p.298) acquisition of such skills acts as an entry barrier here. Therefore, a
well thought-out integrated policy of primary, secondary, and tertiary education
is required to provide equal job opportunities across population, which may also
be growth-enhancing in the long run.
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Notes:
(1.) The model discussed here is an adaptation of Chapter 2 from Rakshit (1982).
(2.) The algebra of the model is straightforward. With the real wage being fixed
at
employment and output, respectively, in the agricultural sector are determined as

follows:
and
Price level in manufacturing is given by
Finally, since a constant proportion (c) of total income is spent on agricultural goods
and the rest on manufacturing goods, the market clearing condition, given by
can be simplified to the following relationship:
This last relationship highlights crucial dependence of manufacturing demand on the

agricultural sector’s output.
(3.) An excellent survey of many of these closed-economy structuralist models
can be found in Bagchi (1997).
(4.) Chandrashekhar (2007) and Eswaran et al. (2009) have analysed the sectoral
labour flows and their implications for poverty and inequality.
(5.) Transport and communications and Financing and other business services
are two exceptions.
Page 20 of 21
(6.) The average annual rate of inflation (of WPI) throughout the 1990s and for
most part of the current decade has been about 6 per cent (see Rath and Rajesh
2006). While the inflation rate went up between 2006 and 2009, it has been
fluctuating rather than exhibiting any steady upward trend, since then.
Moreover, it has shown a significant downward movement since 2014. It is yet
too early to say whether this phenomenon is transitory or permanent. However,
the point remains that inflation remained substantially low during 1991–2007,
despite more than a decade long episode of disproportional growth of services
vis-à-vis agriculture.
(7.) This line of reasoning has been put forward by both Singh (2006) and
Chadrasekhar (2007).
(8.) According to Deaton and Drèze (2002), agricultural wages could be taken as
a measure of poverty in its own right.
(9.) See, for example, Bhattacharya and Mitra (1990).
(10.) This increased vulnerability aspect has been discussed in detail in

Chandrasekhar and Ghosh (2006).
Page 21 of 21
Labour Conditions in Contemporary India

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001

Praveen Jha
DOI:10.1093/acprof:oso/9780199458950.003.0008

Decent employment and livelihood options ought to be among the most
important policy objectives on any meaningful agenda of economic development.
India’s experience, on this count, has been quite unsatisfactory since
Independence. Like many other developing countries, India has made
inadequate progress in terms of addressing the problems of poverty,
unemployment, and occupational structural transformation. As is well-known,
even today vast masses of the country’s population continue to eke out an
existence primarily through their dependence on agriculture and a variety of
non-rural informal activities under extremely fragile conditions. Furthermore,
since the early 1990s, during the era of neo-liberal reforms, the standard
correlates of the well-being of the masses in general have come under further
relative pressure. This chapter in an attempt to provide an overview of labour
conditions in contemporary India while locating it in the trajectory of economic
transformation since Independence.
Keywords: macroeconomic regimes and labour outcomes, political economy of labour in

contemporary India, structural transformation, labour conditions, informality, labour institutions,
bargaining power
Generation of opportunities for decent work and livelihood ought to be among

the most important policy objectives on any meaningful agenda of economic
development. On this front, the Indian experience, spanning over decades, has
been complex, with a few bright patches, but on the whole not very satisfactory.
Like many other developing countries, India has made inadequate progress in
terms of addressing the problems of poverty, unemployment, and occupational
Page 1 of 78
structural transformation. Even during the first four decades after

Independence, achievements on these counts were unimpressive, despite the
strategy of relatively autonomous development and public sector–led
industrialization that resulted in unprecedented and quite respectable growth
outcomes with reference to any appropriate benchmark; since the early 1990s,
that is, in the era of neo-liberal reforms, the above noted correlates of the well-
being of the masses in general have come under further relative pressure. As is
well known, even today, vast masses of the country’s population continue to eke
out an existence primarily through their dependence on agriculture, under
extremely fragile conditions.
One may also suggest that the prospect of any substantial shift in occupational
structure away from agriculture seems remote in India, as in most developing
countries, in the near future. The dual economy models and other modernization
paradigms, that had hypothesized a relatively smooth transition in occupational
structure, seemed to have got it wrong in retrospect. In fact, as discussed in
some detail in Jha (2003), in most of the developing world, even when the
increases (p.303) in output of the non-agricultural sectors have been rapid,
growth of employment in such sectors have been far from impressive.1 For India,
the share of agriculture in total employment has reduced from 73 per cent in
1950 to about 55 per cent in 2012 but this decline over the same period has
been much slower than that in the share of GDP (59 per cent to 17 per cent).
Also, some of the transfer of workers to non-agricultural sectors may not be due
to any positive development but on account of distress diversification
(particularly in a variety of self-employed services), and may also hide the fact
that sections of them happen to be part-time agricultural workers as well.
Hence, it would be reasonable to argue that in terms of labour absorption in
modern manufacturing or services sector, the country is not favourably placed
and a major decline in dependence on agriculture, and the transfer of labour
into decent livelihood options elsewhere, does not seem to be on cards at least in
near foreseeable future.
Given the backdrop sketched here, it is of utmost importance to assess the

implications of the globally ascendant neo-liberal policy regimes for employment
scenario and overall well-being of labour. Persistence of high levels of
unemployment in different regions of the global economy in the recent decades
of neo-liberal reforms lend strong support for the view that the macroeconomic
policies based on such doctrines are hardly consistent with a progressive
employment agenda, even in the structurally more favourably placed economies,
let alone in the more adverse circumstances prevailing in most developing
countries. As is well known, among the major premises of neo-liberalism was the
argument that in the case of developing countries, the inward-looking capital-
intensive import substitution policy had resulted in a bias against agriculture
and other employment-intensive activities, with respect to both the domestic and
external markets, and thus labour utilization had been well below potential; it
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was hoped by the advocates of neo-liberalism that the marketist reforms would
rectify the aforementioned bias and facilitate a surge of investment, both from
domestic and foreign sources, in labour-intensive projects with significant export
orientation. All the available evidence since the ascendancy of the neo-liberal
economic policy package confirm that the expectations regarding greater labour
utilization in the global economy, through changes in structure as well as
intensity of employment, have not been realized. (p.304) (p.305)
Box 8.1 Measures of Employment and Unemployment
Usual Principal Status (UPS): A person is counted as being in the labour

force on UPS basis if he or she was engaged in economic activity (work) or
was seeking or was available for work for the major part of the preceding
365 days. Those classified as being in the labour force on this basis are
further classified as employed or unemployed depending on whether the
majority of the days in the labour force were spent in economic activity or in
seeking/being available for work. The UPS unemployment rate is the
proportion of those classified as unemployed on this basis, expressed as a
percentage of those classified as being in the labour force. On this criterion,
persons can be counted as being employed even if they were unemployed (or
were outside the labour force) for a significant part of the year. Equally, a
person can be counted as unemployed even though he or she may have been
employed for part of the year.
Usual Principal and Subsidiary Status (UPSS): This provides a more

inclusive measure covering, in addition, the participation in economic
activity on a more or less regular basis of those classified as unemployed on
the UPS basis as well as those classified as being outside the labour force on
the same criterion. This would result in a larger proportion of the population
in the labour force, with a higher proportion of workers and lower
unemployment rates relative to the UPS criterion.
Current Weekly Status (CWS): The reference period here is the week, that
is, the 7 days before the interview. A person is counted as employed if he or
she was engaged in economic activity for at least 1 hour on any day during
the reference week. A person not engaged in economic activity even for 1
hour on any day but seeking or available for work during the reference week
is classified as unemployed. To the extent that employment varies seasonally
over the year, the labour force participation rates on the CWS basis would
tend to be lower. However, reflecting the unemployment during the current
week of those classified as being employed on the UPS (and the UPSS)
criterion, the CWS unemployment rates would tend to be higher. The
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difference between the unemployment rates on the CWS and the UPS basis
provide one measure of seasonal unemployment.
Current Daily Status (CDS): On the basis of the reported time disposition
of the person on each day of the reference week (in half-day units for the
various activities in a day), man-days in employment or unemployment are
aggregated to generate estimates of man-days in employment or
unemployment. The man-day unemployment rate is the ratio of man-days in
the labour force (that is, man-days in employment plus man-days in
unemployment). This measure captures the within-week unemployment of
those classified as employed on the CWS basis. It is widely agreed that the
CDS measure of unemployment most fully captures open unemployment in
the country.
Source: Planning Commission (2001).
Box 8.2 Different Types of Employment
Self-employed in household enterprises: Persons who operate their own

farm or nonfarm enterprises or are engaged independently in a profession or
trade on own-account or with one or a few partners. The essential feature of
self-employment is that the remuneration is determined wholly or mainly by
sales or profits of the goods or services produced. In the ‘putting out’
system, where part of a job is done in different household enterprises,
persons are considered self-employed if they have some tangible or
intangible means of production, they work in an enterprise, and the fee or
remuneration consists of two parts, namely, the share of their labour and the
profit of the enterprises. Self-employed persons may be further categorized
as follows.
Own-account workers: Self-employed persons who operate enterprises on

their own account or with one or a few partners and who during the
reference period by and large run the enterprise without hiring any labour.
They may, however, have unpaid helpers to assist them in the activity of the
enterprise.
Employers: Self-employed persons who work on their own account or with

one or a few partners and by and large run their enterprise by hiring labour.
Helpers in household enterprises: Self-employed persons, mostly family

members, who keep themselves engaged in household enterprises, working
full- or part-time, and do not receive a regular salary or wages in return for
the work performed. They do not run the household enterprise on their own
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but assist the related person living in the same household in running the
enterprise.
Regular salaried/wage employee: Persons working in others’ farm or non-

farm enterprises (both household and non-household) and getting in return
salary or wages on a regular basis (and not on the basis of daily or periodic
renewal of work contract). This category includes not only persons getting
time-based wage but also persons receiving piece wage or salary, and paid
apprentices, both full time and part time.
Casual wage labour: A person casually engaged in others’ farm or non-farm

enterprises (both household and non-household) and getting in return wages
according to the terms of the daily or periodic work contract.
Source: Jha (2009).
In much of the developing world, there is overwhelming evidence to support the

view that the employment elasticity of whatever growth that has occurred in
recent years has been extremely low. Based on a careful survey of the relevant
literature, Chandrasekhar (2002) (p.306) concludes: ‘what is striking is how
low most of the employment elasticities appear to be. Even more striking is the
negative elasticities that emerge in some cases, also in a range of manufacturing
sectors that are typically thought of as being labour-intensive’. The previously
noted study also reports that employment scenario for aggregate industry,
rather than just manufacturing, has been as grim during the period under
consideration. The inescapable conclusion that emerges is: the period of
globalization and liberalization has been far off the mark as regards creating a
conducive scenario from the point of view of employment expansion. Clearly the
hopes of the advocates of neo-liberal marketist reforms have not materialized.
In fact, such a development is hardly surprising. As Patnaik has argued in

several of his writings (for example, 2006), employment elasticity of growth
tends to fall sharply with a shift from a dirigiste to an open economic regime due
to several factors. These include, inter alia, (a) growing dominance of finance
capital which militates against the growth of the real sectors, (b) changes in the
nature of production processes which tend to be more capital intensive, and (c)
imitation of developed country’s lifestyle by elite of the developing countries; the
net effect of all these is a growing divergence between growth of output and that
of employment.
Coming back to the Indian experience, by all accounts, the problem of

widespread unemployment across all sectors of the economy has tended to
become progressively more serious after the introduction of economic reforms.
The rate of employment generation in the recent years has fallen considerably
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and the unemployment rate, on current daily basis, as per the National Sample
Survey (NSS) rounds, went up to over 8 per cent in 2004–5 from around 6 per
cent in 1993–4. However, some relief on this front was experienced in 2009–10
and 2011–12 when this rate came down to less than 7 and 6 per cent,
respectively. Moreover, and not unexpectedly, increase in the incidence of
unemployment has been sharper for relatively more vulnerable social and
economic groups, a point often acknowledged by major data sources such as
economic census, population census, employment exchange statistics for
different years, and various rounds of NSS. In fact, approximately within a
decade of the launching of neo-liberal reforms, two of the initiatives of the
Planning Commission—(a) Task Force on Employment Opportunity, headed by
M.S. Ahluwalia, and (b) Special Group on Targeting Ten Million Employment
Opportunities per year, (p.307) headed by S.P. Gupta—had examined the
relevant trends in some detail and had indicated that the adverse employment
experience of 1990s may worsen further in the subsequent years. Similar
conclusions have been reached by almost every official report and other studies
since then. It has been suggested by some that even with a high GDP growth
rate of 8 per cent per annum, the unemployment rate may touch more than
double of the current one by the end of the Twelfth Five Year Plan (FYP).
The obvious important message emerging from these numbers is that during the
period of neo-liberal reforms, challenges of labour absorption for the Indian
economy have been further aggravated. Moreover, even the traditional parking
lot, namely agriculture, is unable to perform the function of the residual sector
and the rural areas have borne the brunt of sharp deceleration in employment
generation. In fact, the much talked about process of diversification of
employment from the mid-1970s to the late 1980s, away from agriculture and
primary activities towards a variety of nonagricultural avenues, has tended to
come under pressure and the growth of the latter has also slowed down
considerably. As is well known, it was primarily on account of very significant
acceleration in public expenditure in the rural areas in 1970s and 1980s that the
above-noted diversification had gathered momentum. However, the 1990s
witnessed a policy shift for the worse in this regard.
Apart from the quantity of employment, the issue of quality is also important as
the overwhelming proportion of workers employed in the informal sector
(accounting for about 93 per cent of the country’s labour force) work under
extremely vulnerable conditions and low wages; thus, the country has a large
count of working poor who remain entrapped in low-productive activities and
persistent poverty. Furthermore, increasing casualization and marginalization
are growing features of the labouring landscape in the formal sector itself.
Not unexpectedly, along with the employment trends, most indicators relating to
the well-being of workers have come under substantial pressure in the era of
neo-liberal reforms2; this is examined in some detail in the third section of this
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chapter. But before that, for a better conceptualization of the recent

developments, the country’s development strategy since Independence
(particularly with reference to its employment implications) is sketched briefly.
The fourth section is (p.308) in the nature of concluding remarks highlighting
the concerns and challenges at the current juncture.
A Brief Overview of India’s Development Trajectory and Implications for

the Labour Market Outcomes
The importance of radical land reforms and state-facilitated infrastructure in
shaping impressive agricultural transformation and its linkage to overall rapid
economic growth, poverty reduction, and well-being of the rural masses as a
whole is widely acknowledged. It has become increasingly clear that for a
country like India where across states large sections of the population are
dependent on agriculture for their livelihood, feasibility of successful
agricultural transformation through any route that ignores the issue of land
reform is highly suspect. A fundamental failure of India’s development
throughout the dirigiste era was its inadequacy with respect to addressing the
agrarian questions and the associated structural transformation. This has had
profound implications for prospects of decent livelihoods for the masses in
general.
Inability to address the agrarian question effectively was linked to the basic
contradictions inherent in the postcolonial State. Furthermore, it also implied
constraints on the prospects of mobilization of resources by the State for
accelerating the growth of productive forces to enhance the pace of
accumulation and creation of opportunities that would have increased the
participation of the poor in the growth process. Hence, it would be reasonable to
argue that the failure of the dirigiste paradigm in India lay essentially not in
what it attempted but in its relative neglect of confronting the agrarian question
headlong.
As is well known, on the eve of Independence from British rule, India was largely
an agrarian economy where agriculture and allied activities provided
employment to around three-fourth of the total workforce and contributed more
than half of the GDP. Industry and service sectors constituted close to 15 and 28
per cent of GDP, while accounting for around 10 and 15 per cent in terms of
employment, respectively.
One of the major objectives of the First FYP (1951–6) was to raise the level of
savings and investment in the economy to accelerate the rate of growth. The
projects in infrastructure and in agriculture, (p.309) particularly in public
irrigation, received much emphasis in this plan. Though employment generation
was set as one of the core objective of this plan, no significant steps were taken
for it. The Second FYP (1956–61), also often designated as the ‘Nehru-
Mahalanobis strategy of development’, was largely concerned with expanding
Page 7 of 78
the productive ability through forging strong industrial linkages as rapidly as

possible. The emphasis in investment shifted to heavy industrialization aimed at
a diversified industrial structure and rapid import substitution; as regards the
overall economic management, the public sector acquired the role of strategic
entrepreneur in what came to be known as a prominent model of mixed
economy. The Third FYP was essentially a continuation of the second plan, in
terms of the broad thrust and emphasis on industries such as machinery and
steel. With respect to the core objective of speeding up the rate of growth of
industrial production, the strategy started showing quick and impressive results.
However, with respect to generation of employment opportunities, there was
little to celebrate.
The growth prospects of employment creation hit a jolt further due to the major
exogenous shocks that the country was subjected to in 1960s. Two military
engagements in quick succession (in 1962 and 1965) led to severe cut-backs in
public investment; furthermore, two successive monsoon failures in 1965 and
1966 led to drastic reductions in food production and availability, which also had
obvious negative consequences for the overall growth prospects. In fact, largely
owing to these exogenous shocks, the government temporarily abandoned five-
year planning for the next three years (1966–9). The point worth emphasizing
here, with respect to the first couple of decades of development trajectory after
Independence, is that the promises and expectations regarding employment
generation remained largely unfulfilled. The fundamental assumption underlying
official thinking, that increases in investment and national income would be
accompanied by commensurate increase in employment opportunities, was
clearly off the mark.
By the early 1970s, there was a reluctant acknowledgement in official discourses

that the development strategy pursued hitherto was not delivering towards the
objective of creating adequate employment opportunities and the ‘directly
targeted programmes’ of employment generation and poverty alleviation started
coming in to being. As it happens, both the Fifth and the Sixth FYPs admitted the
possibilities (p.310) of real conflict between employment and growth, and
made a strong case for prioritizing the former. However, even in these plans, the
main focus of developmental process reverted to the traditional growth
approach, with the usual assumption that employment would increase with rise
in investment, irrespective of the choice of techniques. As an implicit
acknowledgement of the limitations of ‘trickle down’ approach, during these
plans there were substantial increases in government spending in target areas
and for the well being of the targeted population. Also, consequent upon the
nationalization of banks and under the ‘directed’ lending programmes, a
significant proportion of the bank credits were directed to ‘priority’ sectors with
positive spin-off for a substantial section of the population at the lower rung of
the economic ladder. Furthermore, particularly since the early 1980s, availability
of cheap credit for the middle and upper classes tended to increase noticeably. It
Page 8 of 78
was a combination of all these factors, inter alia, leading to a revival of GDP
growth rate since mid-1970s.
Thus, during the period from the mid-1970s to the late 1980s (especially
between 1977 and 1991), the Indian economy underwent a phase of recovery,
which was significantly consumption-led and in turn, gave a push to the
generation of employment opportunities. However, even during this period, the
organized sectors of the economy grew much faster in terms of income and
output without commensurate increase in employment. In fact, the 1980s’
growth of such employment was 1.5 per cent per annum, much less than the
rate of population growth. Within this, the employment in the private organized
sector grew at a much slower rate, averaging a growth rate of only 0.2 per cent
per annum. There was a drop in labour absorption by the agricultural sector also
and agricultural employment grew at a rate substantially below the rate of
population growth. Thus the respectable rates of growth of output in agriculture
and the organized private sector failed to translate into any significant
acceleration of employment in these important sectors (Sen 1996).
Although there was not much improvement in the employment scenario in the
1980s, the decade was characterized by rising real wages, including the real
wages for unskilled workers both in rural and urban areas and this was, in large
measure, on account of the important changes that occurred in the nature of
intersectoral and other linkages in the economy (Sen 1996). Also, as mentioned
earlier, (p.311) during this period the central government stepped up its
revenue expenditure in rural areas, by expanding employment programmes,
either through its own rural development schemes or by instructing banks to
extend more credit for such initiatives. In fact, a major hallmark of the 1980s
was a large number of rural development schemes along with a plethora of
special schemes for a variety of identifiable target groups. Consequently, there
was a noticeable growth of non-agricultural employment in rural areas; in fact,
after a long period of stagnation in the share of agricultural sector in total
workforce, a sign of decline became visible, resulting mainly from the expansion
of rural non-agricultural sector. The NSS data show that the share of
agricultural workers among all male rural workers declined steadily from 80.6
per cent in 1977–8 to 71.7 per cent in 1989–90 and for rural females, this share
dropped from 88.1 per cent in 1977–8 to 81.4 per cent in 1989–90. As was
highlighted by several researchers, the true significance of this shift is probably
better understood in incremental terms: these figures imply that non-
agricultural sector absorbed about 70 per cent of the total increase in the rural
workforce between 1977–8 and 1989–90. Moreover, 22.3 per cent of all casual
labour days spent on non-agricultural activity in 1987–8 were on public works
programmes of the government, showing a significant rise from 17.7 per cent in
1977–8 and 14.9 per cent in 1983. Nearly 60 per cent of all new government
Page 9 of 78
jobs created during this period went to rural areas. Thus the agency of the State
played a key role in diversifying opportunities for the rural poor.
There were some other factors which facilitated shift of workers from
agricultural sector to non-agricultural sectors. In certain regions, the industrial
development and the growth of services linked to this created employment
opportunities not only in the tertiary sector but also in small-scale industry in
rural areas. In fact, the growth of rural non-agricultural employment was the
main factor behind the rise in rural wages between 1977–8 and 1989–90.
Possibly, a spillover of the positive developments in rural areas also led to an
increase in employment in urban areas, although mostly of casual nature in
industrially or commercially developed regions. According to the NSS data, the
share of casual workers among male in urban employment increased from 13
per cent in 1977–8 to 16 per cent in 1989–90. The share of casual workers
among females in urban employment increased from little above 25 per cent in
1977–8 to around 28 per cent in 1983 and (p.312) then declined to around 22
per cent in 1989–90. One of the probable causes of decline in the women’s share
in urban casual employment during the second half of the 1980s may be an
increase in the real wages and incomes of a section of such households above a
threshold level; there is some evidence to suggest that such increase at times
results in withdrawal of women from paid word. In any case, the point worth
emphasizing here, given the limited geographical spread of such direct links to
modern industry and commerce, is that in most areas the pivotal role in the
expansion of rural and non-agricultural employment was played by the
expansion of government expenditure.
However, it is important not to overstate the gains of the 1980s. Although

increases in employment and wages improved the condition of rural workers
even at the lower rungs in economic hierarchy, their employment diversification
into non-agriculture continued to have many characteristics of a distress
phenomenon, given the overall tendency of labour use in agriculture. The main
sectors providing this type of non-agricultural employment were secondary
sectors like construction, mining, and small-scale manufacturing, and there is
evidence that over time the incidence of poverty among those employed in some
of these sectors became larger than in agriculture.
The increases in government spending undoubtedly increased the industrial and

overall growth rates; the latter being at well above 5 per cent per annum for the
decade of the 1980s was a significant improvement over the long-run trend
growth rate of around 3 per cent for the preceding three decades. Moreover, as
emphasized earlier, increased government spending resulted in some positive
employment as well as income effect for the masses also. But, as it became
evident by late 1980s, the specific strategy of pump-priming had a clear
downside to it. Much of the increased expenditure was through a borrowing
spree by the government, both internally and externally; furthermore, a very
Page 10 of 78
substantial part of the external borrowing was from commercial sources. Not
unexpectedly, combination of these elements led to a sharp increase in the gross
fiscal deficit of the government as well as in the external debt and debt-service
payments.
The enormous increase in external debt, a growing portion of which consisted of

short-term borrowings, exposed the economy to the caprices of international
lenders and investors, and particularly to the danger of sudden capital flight due
to confidence crises. The foreign reserves of the country during this time were
depleted to abysmally (p.313) low levels and in this backdrop, the then
government launched a major stabilization and structural adjustment
programmes by accepting the conditionalities imposed by Bretton Woods
Institutions (IMF and World Bank) in the name of economic reforms. As is well
documented now, launched in July 1991, these reforms represented a sharp
break from the dirigiste regime of the past four decades and put the country on
quite a different policy route in its economic journey (for detailed accounts of
these, see Ghosh and Chandrasekhar [2002]; Patnaik and Chandrasekhar
[1995]).
The performance of the Indian economy in the neo-liberal regime continues to

be a subject of intense debate, especially in the context of provisions of adequate
and sustainable livelihood options for a large section of the population. The
essential picture that emerges is one of overall worsening in employment and
conditions of work even though there have been a significant acceleration in
output growth particularly in services sectors. As regards the agricultural sector,
its performance has tended to worsen considerably not only with respect to
employment but also output growth. Fundamentally, there has been a change in
the pattern of growth where the non-agricultural sector has shown substantial
acceleration in output per worker compared to the agricultural sector, and thus
the gap between the two has tended to increase very substantially. Furthermore,
employment content of growth process has gone down significantly during the
reform era. In particular, rural India which houses more than two-thirds of the
working population of our country has been among the worst hit during the
period of reforms.
Factors like substantial compression of rural development expenditures,

increasing input prices, vulnerability to world market price fluctuations due to
greater openness, inadequate/non-existent crop insurance and substantial
weakening of the provisioning for credit, along with the governments’ apathy to
the demand for remunerative prices for farm produce are among the obvious
causal correlates of the contemporary agrarian crisis in the country. It is to be
expected that in a period of agrarian distress, agricultural labourers are likely to
be the worst hit, through adverse impacts on wages and employment
opportunities directly in agriculture, and indirectly through multiplier effects in
non-agriculture as well. Changes relating to several aspects of the world of work
Page 11 of 78
and workers during this period show several disturbing trends, and the relevant
issues are discussed in the next section.
(p.314) A Snapshot of Labour Market and the Major Challenges

The present section attempts a sketch of the major features of the conditions of
labour in the context of India’s recent growth and economic policy experience.
Much of the discussion in this section is for the period from the early 1980s, so
as to also focus on differences between the immediate pre-reform decade and
the period of reforms. Unless indicated otherwise, data used in this chapter is
drawn from different rounds of NSS.3
As already emphasized in the earlier sections, the robust GDP growth rate of
Indian economy for almost three decades is certainly impressive but the
incongruity and mismatch between the growth rate and the well-being indicators
of labour, including the pace of employment generation, is quite stark and
among the most important challenges confronting the country.
Labour Force Participation Rate, Worker–Population Ratio, Employment and

Unemployment Trends
Labour Force Participation Rate
During the last three decades, in spite of the long-term stability, some
fluctuations in the labour force participation rate (LFPR) was observed in
various rounds of the NSS surveys and such fluctuations (especially LFPR of
women at the margin) are often related to transitory features such as a good or
bad agricultural year, particularly in rural areas. For instance, the increase in
female participation experienced between 1999–2000 and 2004–5 may have
occurred because of the need to substitute for male workers who were looking
for better opportunities outside agriculture in a distressed agricultural year. Or
else, it could be a reflection of the need to supplement household earnings in a
bad year.4 In other words, higher LFPR (as in 2004–5), neither necessarily
reflects improved performance with respect to employment availability, nor does
it indicate durable change in structure of labour market; as it happens, these
rates slid downwards in 2009–10 and further in 2011–12 (Table 8.1). In urban
areas both for urban male and female, no significant changes have been
observed during the entire period of the study, that is, from 1983 to 2011–12.
However, as in the case of (p.315)
Page 12 of 78
Table 8.1 Labour Force Participation Rate in Rural Areas (in per cent)
NSS Round Rural Male Rural Female
PS PS + SS CWS CDS PS PS + SS CWS CDS
38th (1983) 54.0 55.5 53.1 52.1 25.2 34.2 23.7 21.8
43rd (1987–8) 53.2 54.9 52.6 52.5 25.4 33.1 23.0 22.2
50th (1993–4) 54.9 56.1 54.8 53.4 23.7 33.1 27.5 23.3
55th (1999– 53.3 54.0 53.1 51.5 23.5 30.2 26.3 21.9
2000)
61st (2004–5) 54.6 55.5 54.5 53.0 25.0 33.3 28.7 23.7
64th (2007–8) 55.1 55.9 54.7 53.6 22.0 29.2 24.5 20.4
66th (2009– 54.8 55.6 54.8 53.6 20.8 26.5 23.1 19.7
10)
68th (2011– 54.7 55.3 54.5 53.4 18.1 25.3 21.5 18.0
12)
Source: Various rounds of NSS reports.
Page 13 of 78
rural females, LFPR for urban females also fluctuated over this period (Table 8.2).
Worker–Population Ratio
Worker–population ratio (WPR) is a broad indicator of the availability of job
opportunities,5 and on the whole, there has not been much change in this rate
for almost last three decades (Tables 8.3 and 8.4). However, the WPR in different
rounds of NSS show some fluctuations, mainly on account of macroeconomic
policy shifts. For instance, the
Page 14 of 78
Table 8.2 Labour Force Participation Rate in Urban Areas (in per cent)
NSS Round Urban Male Urban Female
38th (1983) 53.1 54 52.7 52.1 12.9 15.9 12.8 11.9
43rd (1987–8) 52.8 53.4 52.7 52.3 12.9 16.2 13.1 12.5
50th (1993–4) 54.2 54.3 53.9 53.4 13.2 16.5 15.1 13.4
55th (1999– 53.9 54.2 53.9 52.9 12.6 14.7 13.8 12.3
2000)
61st (2004–5) 56.6 57.1 56.6 56.1 14.9 17.8 16.7 15
64th (2007–8) 57.3 57.6 57.2 56.8 12.6 14.6 13.8 12.5
66th (2009– 55.6 55.9 55.6 55 12.8 14.6 14.1 12.9

10)
68th (2011– 56 56.3 56.1 55.5 13.4 15.5 14.8 13.6

12)
Page 15 of 78
(p.316)
Page 16 of 78
Table 8.3 Worker–Population Ratio in Rural Areas (in per cent)
PS PS+SS CWS CDS PS PS+SS CWS CDS
38th (1983) 52.8 54.7 51.1 48.2 24.8 34 22.7 19.8
43rd (1987–8) 51.7 53.9 50.4 50.1 24.5 32.3 22 20.7
50th (1993–4) 53.8 55.3 53.1 50.4 23.4 32.8 26.7 22
55th (1999– 52.2 53.1 51 47.8 23.1 29.9 25.3 20.4

2000)
61st (2004–5) 53.5 54.6 52.4 48.8 24.2 32.7 27.5 21.6
64th (2007–8) 53.8 54.8 52.5 49 21.6 28.9 23.7 18.7
66th (2009– 53.7 54.7 53.1 50.1 20.2 26.1 22.3 18.2
10)
68th (2011– 53.5 54.3 52.6 50.4 17.6 24.8 20.7 16.9
12)
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Table 8.4 Worker–Population Ratio in Urban Areas (in per cent)
38th (1983) 50 51.2 49.2 47.3 12 15.1 11.8 10.6
43rd (1987–8) 49.6 50.6 49.2 47.7 11.8 15.2 11.9 11
50th (1993–4) 51.3 52.1 51.1 49.8 12.1 15.5 13.9 12
55th (1999– 51.3 51.8 50.9 49 11.7 13.9 12.8 11.1

2000)
61st (2004–5) 54.1 54.9 53.7 51.9 13.5 16.6 15.2 13.3
64th (2007–8) 55 55.4 54.5 52.9 11.8 13.8 12.9 11.3
66th (2009– 53.9 54.3 53.6 52.2 11.9 13.8 13 11.7

10)
68th (2011– 54.2 54.6 53.9 52.8 12.5 14.7 13.8 12.5
12)
Page 18 of 78
increased government expenditure and consequently, expansion of employment

opportunities in rural areas during the decade of the 1980s is clearly visible in the
overall WPR in rural areas between 1983 and 1993–4; over this period, the WPR in
rural areas increased by 1 percentage point on the usual basis, 2 percentage points on
the weekly basis, and more than 2 percentage points on the daily basis. This rise in the
WPR, particularly on current daily status (CDS) basis, indicates the expansion of work
opportunities created by various self-employment as well as casual wage employment
programmes. However, the neo-liberal regime has been marked by a tendency to
compress the overall public expenditure in rural areas. Therefore, the (p.317) 1990s
experienced a decline in the absorption capacity in the rural economy as a whole, and
consequently, a fall in the WPR was observed for both male and female during the
same period. After a noticeable dip in this rate during 1999–2000, there was a
marginal recovery in 2004–56 for both males and females (particularly for females in
both urban and rural areas). But, for the next three rounds in 2007–8, 2009–10, and
2011–12, while the WPR for rural males increased marginally, it declined for rural
females and this indicated an overall worsening of the employment generation
scenario in the rural areas. Looking at the entire neo-liberal era, that is, from 1993–4
to 2011–12, WPR remained stagnant. Now, if we exclude the employment opportunities
created by Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA)
during the later period, one can infer that the ability of the rural economy to generate
adequate work has remained very limited.
For the entire period from 1983 to 2011–12, the above rate marginally improved
for both urban males and females. In spite of high and sustained GDP growth for
last three decades, the overall worker population ratio for person as a whole
does not show rise in any significant manner during the recent period (that is,
between 2004–5 and 2011–12), which clearly indicates a situation far from being
satisfactory on the employment-generation front. For urban female, WPR has
shown a marginal rise taking the entire period from 1983 to 2011–12.
Age-specific participation rates provide further insights in the dynamics of

employment opportunities. In the younger age groups, any decline in the
participation rate may reflect a positive change as it might have resulted from a
rise in the school enrollment ratio (Table 8.5). In the rural areas, this effect is of
course not absent and during the entire period from 1983 to 2009–10 there has
been continuous decline in the worker population ration between the age group
of 6 to 14 years for both male and female. However, even within 4 to 9 years age
group, the female WPR has been increasing for subsidiary basis since 1999–2000
and this indicates that increased enrolment ratio for female during the recent
decade has some limitations in explaining the overall decline in the WPR.
Nevertheless, on the whole, increase in enrolment seems to have played a
significant role in work participation between the ages of 6 and 14. (p.318)
Page 19 of 78
Table 8.5 Worker–Population Ratio in Various Age Groups (in per cent)
Age Group Year* Rural Urban

(in years)
Male Male Female Female Male Male Female Female
PS SS PS SS PS SS PS SS
4–9 4 0.20 0.20 0.10 0.30 0.20 0.00 0.00 0.10
3 0.20 0.10 0.10 0.20 0.20 0.00 0.10 0.20
2 0.50 0.10 0.60 0.10 0.30 0.00 0.10 0.10
1 0.90 1.10 1.10 0.30 0.40 1.10 0.30 0.20
0 1.97 0.60 1.78 0.67 0.54 0.21 0.50 0.16
9–14 4 2.70 1.70 2.10 1.40 2.40 0.40 0.80 0.40
3 5.40 1.40 4.90 1.50 4.40 0.40 2.40 0.90
2 8.20 0.90 7.40 2.20 4.60 0.30 2.80 1.80
1 11.20 2.60 10.40 3.70 5.90 0.70 3.50 1.00
0 21.28 2.80 16.19 7.04 9.31 1.97 5.41 1.55
15–29 4 62.60 2.20 21.80 7.00 55.60 0.80 12.40 2.00
3 71.20 3.00 28.80 12.20 60.50 1.80 14.30 4.10
2 72.10 2.00 30.70 9.30 58.30 1.00 12.40 2.50
1 74.00 3.50 31.10 13.60 60.10 1.70 13.30 4.00
0 78.92 2.80 36.12 13.54 64.00 2.63 14.51 4.16
Page 20 of 78

(in years)
30–44 4 99.00 0.10 36.10 11.20 97.90 0.10 21.50 3.70
3 98.10 0.30 45.80 15.40 97.20 0.30 25.40 5.60
2 97.80 0.40 44.30 12.90 96.80 0.10 22.30 4.30
1 98.40 0.20 42.50 17.30 97.40 0.10 23.00 6.50
0 98.12 0.37 45.73 15.64 97.22 0.25 23.41 5.74
44–59 4 96.20 0.30 38.20 8.60 93.60 0.10 19.90 2.00
3 95.80 0.40 44.40 12.50 91.70 0.60 21.70 3.50
2 95.30 0.50 40.70 11.10 91.80 0.30 21.80 3.20
1 96.30 0.50 40.10 14.30 93.10 0.40 23.10 5.20
0 94.98 0.55 40.68 14.52 92.11 0.44 22.81 4.97
60 and 4 63.60 1.00 19.00 3.60 33.50 0.60 6.10 0.90

above
3 63.00 1.40 19.70 5.60 35.50 1.10 8.60 1.40
2 62.20 1.70 17.40 4.40 38.60 1.60 8.20 1.20
1 68.30 1.60 17.20 6.90 42.90 1.30 9.10 1.20
0 64.08 2.69 15.52 7.09 48.50 1.72 11.60 2.20
All ages 4 53.70 1.00 20.20 5.90 53.90 0.40 11.90 1.90
Page 21 of 78

(in years)
3 53.50 1.10 24.20 8.50 54.10 0.80 13.50 3.10
2 52.20 0.90 23.10 6.80 51.30 0.50 11.70 2.20
1 53.80 1.50 23.40 9.40 51.30 0.80 12.10 3.40
0 61.28 2.17 28.73 10.57 58.22 1.47 13.76 3.49

Source: Various rounds of NSS survey reports.
Note: * Years are as follows: 0 represents 1983, 1 represents 1993–4, 2 represents 1999–2000, 3 represents 2004–5, and 4 represents
2009–10.
Page 22 of 78
(p.319) Further, in the age group of 15 to 29, there was a sharp fall in the WPR
during the later half of the recent decade for both male and female in rural
areas. Further, fall in WPR for female is also evident in the age groups of 30 to
44, as well as 45 to 59. Given the marginal increase in the enrolment ratio in
higher education for female, it should be obvious that this fall is on account
economic reasons such as shrinkage in the employment availability in rural
areas. As discussed earlier, the scope for skilled or semi-skilled jobs has
remained limited for both male and female in rural areas for the entire period of
study and more so under the neo-liberal era; therefore, a substantial section
among the educated are finding it difficult to get decent employment.
In urban areas also, there has been continuous decline in the WPR for the age
group of 6 and 14 years for both male and female during the last three decades
(partly on account of increasing school enrolment/attendance). Decline at this
rate for males in the age group of 15 to 29 in recent years (that is, between
2004–5 and 2009–10) reflects most likely worsening employment prospects for a
section of workers in their prime age. For female, the trend of falling WPR is
evident in almost all the age groups in recent years, which clearly indicates that
full-time work opportunities shrunk in the urban labour market during the most
recent period.
As regards the rate of growth of rural employment since the early 1980s, it
increased at an annual rate of 1.72 per cent between 1983 and 1993–4 before it
nose-dived to 0.66 per cent between 1993–4 and 1999–2000; subsequently, it
picked up to 1.97 per cent between 1999–2000 and 2004–5 (a year of indifferent
agricultural performance)7 and then fell again significantly. In urban areas, the
growth rate of employment between 1983 and 1993–4 was 3.10 per cent per
annum. And it was approximately the same for the next decade also (that is,
between 1993–4 and 2004–5, although there was decline during the first half but
recovery during the second). The point worth emphasizing here is that between
2004–5 and 2009–10, though the economy witnessed a high growth rate, total
number of usual with subsidiary status workers increased only by 2.3 million.8
This was in sharp contrast to the relatively significant expansion of around 60
million during the previous period between 1999–2000 and 2004–5. During the
period from 1999–2000 to 2004–5, male employment increased by 20.2 million in
rural areas, while in the next period from 2004–5 to 2009–10, it rose by only
13.4 million. The corresponding figures for the urban areas (p.320) were 15
million and 9.8 million, respectively. Rural female employment, which rose by
18.3 million during 1999–2000 and 2004–5, registered a decline of 19.2 million
between 2004–5 and 2009–10. In the urban areas, the female employment rose
by 6.4 million in the first and declined by 1.7 million during the next period
(Chandrasekhar and Ghosh 2011).
Page 23 of 78
Thus, a clear mismatch between the high rate of growth of GDP and pace of
employment generation indicates a significant fall in the elasticity of
employment with respect to output. In other words, the key message that gets
reinforced by the latest round of the NSS is that the transition to a high-growth
trajectory has not delivered much on the employment front. The data since the
early 1990s indicate that the increase in employment seems to occur when
workers, especially female workers, are pushed into the workforce by increased
adversity in their economic circumstances (for example, a bad agriculture year),
and there have been few positive impulses for employment. Moreover, organized
manufacturing and services appear to contribute very little additional
employment creation, and the expectation that these would add significantly to
the generation of employment opportunities once neo-liberal policies succeeded
in delivering growth has hardly materialized. On the contrary, there has been a
significant dip in the absolute count of the workers in organized segments of the
economy. These facts cumulatively suggest that, in the years of high growth,
much of the increase in employment was in the categories of casual and self-
employment which had extremely adverse distributional and social welfare
implications (Chandrasekhar 2010; Chandrasekhar and Ghosh 2007; Himanshu
2011; Jha 2009).
The Unemployment Scenario

The unemployment rate on CDS basis is a better indicator of the level of
unemployment as well as underemployment of the working population.
Moreover, since in India a majority of the workers, both in rural as well as in
urban areas, are categorized by casual labour and in most of the cases, they are
hired on a daily basis, therefore current daily basis of measuring the
unemployment rate can only reflect the closer trends and the pattern of
unemployment for such a huge mass of workforce, both in rural and urban
areas, as compared to both usual and current weekly status (CWS) status (Tables
8.6 and 8.7). The relevant data, (p.321)
Page 24 of 78
Table 8.6 Unemployment Rate in Rural Areas (in per cent)
38th (1983) 2.1 1.4 3.7 7.5 1.4 0.7 4.3 9.0
43rd (1987–8) 2.8 1.8 4.2 4.6 3.5 2.4 4.4 6.7
50th (1993–4) 2.0 1.4 3.1 5.6 1.3 0.9 2.9 5.6
55th (1999– 2.1 1.7 3.9 7.2 1.5 1.0 3.7 7.0
2000)
61st (2004–5) 2.1 1.6 3.8 8.0 3.1 1.8 4.2 8.7
64th (2007–8) 2.3 1.9 4.1 8.5 1.9 1.1 3.5 8.1
66th (2009– 1.9 1.6 3.2 6.4 2.4 1.6 3.7 8.0
10)
68th (2011– 2.1 1.7 3.3 5.5 2.9 1.7 3.5 6.2
12)
Page 25 of 78
Table 8.7 Unemployment Rate in Urban Areas (in per cent)
38th (1983) 5.9 5.1 6.7 9.2 6.9 4.9 7.5 11.0
43rd (1987–8) 6.1 5.2 6.6 8.8 8.5 6.2 9.2 12.0
50th (1993–4) 5.4 4.1 5.2 6.7 8.3 6.1 7.9 10.4
55th (1999– 4.8 4.5 5.6 7.3 7.1 5.7 7.3 9.4
2000)
61st (2004–5) 4.4 3.8 5.2 7.5 9.1 6.9 9.0 11.6
64th (2007–8) 4.0 3.8 4.7 6.9 6.6 5.2 6.5 9.5
66th (2009– 3.0 2.8 3.6 5.1 7.0 5.7 7.2 9.1
10)
68th (2011– 3.2 3.0 3.8 4.9 6.6 5.2 6.7 8.0
12)
Page 26 of 78
since the early 1980s, show a clear worsening in this respect during the reform period.
In rural areas, between 1983 and 1993–4, there was a significant decline in the
unemployment rate on CDS basis, both for male and female. During the next decade,
between 1993–4 and 2004–5, the corresponding rates rose sharply.9 In urban areas,
there was a small decline in unemployment over the longer period, that is, 1983 to
2004–5, for both male and female workers, but it was hardly adequate to compensate
the considerable worsening in rural areas. As emphasized repeatedly in the foregoing,
such trends are indicative of setbacks in generation of productive employment
opportunities and deterioration in the quality of employment in the recent growth
process.
(p.322) However, some positive trends in the reduction in unemployment rate
are discernible in the period between 2004–5 and 2011–12. In rural areas the
unemployment rate for male declined from 8 per cent in 2004–5 to 6.4 per cent
in 2009–10 and 5.5 in 2011–12. For rural females, the corresponding figures
were 8.7, 8.1, and 6.2, respectively, on current daily basis. Similarly, in the urban
areas the unemployment rate for male declined from 7.5 per cent in 2004–05 to
5.1 per cent in 2009–10 and further to 4.9 per cent in 2011–12. For urban
females these figures were 11.6, 9.1, and 8, respectively. Given the trend of
stagnant regular wage and increasing casualization and persisting informality in
the labour market, these quantitative improvements in the unemployment rates
in the recent period do not, however, indicate better quality jobs. Moreover,
decline in unemployment rate can be attributed more to the decline in labour
force participation rate than to the creation of sufficiently more jobs. Besides, in
rural areas, MGNREGA played a significant role and looking at the overall
capacity of the rural economy to generate additional employment, it can be
inferred that whatever improvement on the employment front is visible in rural
areas can be attributed to MGNREGA rather than to the rise in the systemic
capacity to absorb additional labour force during the entire period under
consideration.
Status of Employment
Regular employment as a whole has been under tremendous pressure during the
last three decades, and it is instructive to look at the relevant numbers (Tables
8.8 and 8.9). For rural male, the proportion of regular employed was about 10
per cent in 1987, declined to 8.5 per cent in 2009–10. However, in 2011–12, it
showed an increase and again reached at 10 per cent. Also, in urban areas, the
share of regular employed in male category, remained more or less stagnant
between 1999–2000 and 2009–10 and clearly showed a significant decline
between 1983 and 2009–10. The marginal increase in regular employment
during the period from 1983 to 2011–12, for both rural and urban females, was
too small to raise the share of regular employed in total employment. We may
also note that the annual increment in regular employment was about 2 million
during 1993 to 2005, and it declined to approx 1 million during 2005 to 2010.
Nevertheless, some (p.323)
Page 27 of 78
Table 8.8 Age-group-wise Unemployment Rate (Usual Status Adjusted) (in per cent)
Age Groups (in years) Rural Males Rural Females Urban Males Urban Females
15–19 (1)* 3.3 (1) 1.9 (1) 11.9 (1) 12.8
(2) 5.5 (2) 3.2 (2) 14.2 (2) 13.2
(3) 5.9 (3) 3.6 (3) 12.1 (3) 11.1
(4) 8.2 (4) 5.1 (4) 12.2 (4) 10.6
20–4 (1) 4.9 (1) 2.8 (1) 12.6 (1) 21.7
(2) 5.2 (2) 3.5 (2) 12.8 (2) 19.4
(3) 4.7 (3) 5.7 (3) 11.1 (3) 19.6
(4) 5.5 (4) 6.1 (4) 9.7 (4) 18.8
25–9 (1) 2.3 (1) 0.9 (1) 5.7 (1) 9.7
(2) 2.6 (2) 1.6 (2) 7.2 (2) 9.3
(3) 1.6 (3) 3.2 (3) 4.9 (3) 12.6
(4) 1.8 (4) 3.2 (4) 4.3 (4) 11.7
15–29 (1) 3.5 (1) 1.9 (1) 9.6 (1) 15.0
(2) 4.3 (2) 2.7 (2) 10.8 (2) 13.9
(3) 3.9 (3) 4.2 (3) 8.8 (3) 14.9
(4) 4.7 (4) 4.6 (4) 7.5 (4) 14.3

Note: * (1): 1993–4; (2): 1999–2000; (3): 2004–5; (4): 2009–10.
Page 28 of 78
Table 8.9 All India Employment Status: Composition of Workers (UPSS) by Sex and Rural–Urban Residence (NSS Data
1983 to 2009–10) (in per cent)
Residence Male/Female Year Self-employed Regular Employed Casual Labour
Rural Males 1983 60.5 10.3 29.2
1987–8 58.6 10.0 31.4
1993–4 57.9 8.3 33.8
1999–2000 55.0 8.8 36.2
2004–5 58.1 9.0 32.9
2007–8 55.4 9.1 35.5
2009–10 53.5 8.5 38.0
Rural Females 1983 61.9 2.8 35.3
1987–8 60.8 3.7 35.5
1993–4 58.5 2.8 38.7
1999–2000 57.3 3.1 39.6
2004–5 63.7 3.7 32.6
2007–8 58.3 4.1 37.6
2009–10 55.7 4.4 39.9
(p.324) Urban Males 1983 40.9 43.7 15.4
1987–8 41.7 43.7 14.6
Page 29 of 78
1993–4 41.7 42.1 16.2
1999–2000 41.5 41.7 16.8
2004–5 44.8 40.6 14.6
2007–8 42.7 42.0 15.4
2009–10 41.1 41.9 17.0
Urban Females 1983 45.8 25.8 28.4
1987–8 47.1 27.5 25.4
1993–4 45.4 28.6 26
1999–2000 45.3 33.3 21.4
2004–5 47.7 35.6 16.7
2007–8 42.3 37.9 19.9
2009–10 41.1 39.3 19.6
Rural persons 1993–4 58.0 6.4 35.6
1999–2000 55.8 6.8 37.4
2004–5 60.2 7.1 32.8
2007–8 56.3 7.5 36.2
2009–10 54.2 7.3 38.6
Urban persons 1993–4 42.3 39.4 18.3
Page 30 of 78
1999–2000 42.2 40.0 17.7
2004–5 45.4 39.5 15.0
2007–8 42.6 41.2 16.2
2009–10 41.1 41.4 17.5
All India Males 1993–4 53.7 16.7 29.6
1999–2000 51.5 17.2 31.3
2004–5 54.7 17.2 28.1
2007–8 56.0 9.0 35.1
2009–10 50.0 17.7 32.2
All India Females 1993–4 56.8 6.2 37.0
1999–2000 55.8 7.1 37.1
2004–5 61.4 8.3 30.3
2007–8 56.0 9.0 35.1
2009–10 27.3 10.1 36.6

Page 31 of 78
sign of improvement in this regard is clearly visible during the most recent period from
2009–10 to 2011–12.
Although, the data for the 61st and 66th NSS Rounds shows that the rate of
regular employment generation in the private organized sector (p.325) has
picked up recently, it is also clear that this was more than offset by decline in the
share of regular employment in rest of the economy. In fact, it is quite striking
that over 80 per cent of all new jobs created in the recent years have been of
casual nature, with construction alone accounting for a substantial share.
In other words, in spite of the high growth rate in the Indian economy the
process of informalization and casualization in the world of work has been on the
rise during the last two decades. A substantial segment of workers who are
unable to find even casual employment often remain self-employed, which, to a
large extent, is same as being underemployed or disguisedly unemployed.10
Further, it is quite clear that the process of casualization and contractual
employment has gained momentum in the organized sectors (Bhalla 2008; Dutta
2005; Mathur and Mishra 2007; Neethi 2008).
Persistent Informality
Overwhelming informality with low earnings remains one of the most important
characteristics of the labour market in India. According to the National
Commission for Enterprises in the Unorganized Sector (NCEUS), out of the 62.6
million workers employed in the organized sector in 2004–5, 29.1 million were
unorganized workers as per the criterion of social security provisions. Similarly,
out of 395 million workers employed in the unorganized sector, only 1.4 million
workers are provided social security benefits and hence, classified as organized
workers. This implies that in the total employed workforce of 457.5 million
workers in 2004–5, only 34.9 million workers were entitled for social security
benefits, that is, 7.6 per cent of the total workers in 2004–5 are treated as
organized workers and the remaining 422.6 million (92.4 per cent) as
unorganized workers in the economy. Between 1999–2000 and 2004–5, though
the total employment in the economy increased from 397 million to about 458
million (an increase of 61 million during the five-year period), the entire increase
of employment opportunities was in the category of unorganized workers (Datt
2007) (Tables 8.10–8.17).
Further, in 2004–5, out of the total workforce of about 458 million, around 56.5
per cent (258 million) of workers were self-employed and 28.3 per cent (130
million) were casual workers. The remaining 15 per cent (69 million) were
working as regular workers. However, the proportion of self-employed in the
unorganized sector was around (p.326)
Page 32 of 78
Table 8.10 Percentage Share and Annual Rate of Growth of Sectors in Value Added (1999–2000 prices)
Year Agriculture and Manufacturing, Trade, Transport, Financing, Public

Allied Activities, and Utilities, and Storage, and Insurance, and Real Administration,
Mining Construction Communication Estate Defence, and Other
Services
Percentage Share
1980–1 39.93 22.03 17.44 7.48 13.10
1985–6 37.17 22.18 18.28 9.04 13.31
1990–1 34.04 23.24 18.34 10.58 13.78
1995–6 29.88 24.32 20.48 11.97 13.34
2000–1 26.17 23.51 22.29 13.03 14.97
2004–5 21.74 25.10 24.52 14.68 13.93
2006–7 19.77 26.06 25.55 15.79 12.81
Rate of Growth per Annum
1980–1 to 1985–6 3.35 5.79 5.57 9.05 5.41
1985–6 to 1990–1 3.98 7.66 5.71 9.76 6.40
1990–1 to 1995–6 2.57 6.00 7.43 8.57 4.24
1995–6 to 2000–1 2.83 5.29 6.98 7.55 8.76
2000–01 to 2004–5 2.55 6.37 9.73 7.00 5.41
2004–5 to 2005–6 5.92 10.63 11.51 10.24 6.72
Page 33 of 78
Year Agriculture and Manufacturing, Trade, Transport, Financing, Public

Allied Activities, and Utilities, and Storage, and Insurance, and Real Administration,
Mining Construction Communication Estate Defence, and Other
Services
2005–6 to 2006–7 3.76 11.45 11.81 13.91 6.88

Source: Growth rates are computed from figures based on National Accounts Statistics, Central Statistical
Organisation, cited in the Economic Survey, 2009–10, Government of India.
Page 34 of 78
(p.327)
Table 8.11 Rate of Growth of Workers (UPSS) (in per cent per
annum)
Activity 1983 to 1993–4 to 1999– 1999–2000 to

1993–4 2000 2004–5
Agriculture and allied 1.38 –0.15 1.892

activities
Mining and quarrying 4.16 –2.85 2.857
Manufacturing 2.14 2.05 3.157
Electricity, gas 4.50 –0.88 –0.544
Construction 5.32 7.89 7.836
Trade, hotel 3.57 5.04 5.734
Transport 3.24 6.04 4.629
Financial services 7.18 6.20 8.594
Community, social, and 2.90 0.55 2.426

personal services
Total workers 2.04 0.98 2.964

Source: Mitra (2008).
Page 35 of 78
Table 8.12 Structure of Employment in Urban Areas (in per cent)
Primary Secondary Tertiary Primary Secondary Tertiary
38th (1983) 10.3 34.2 55.0 31.0 30.6 37.6
43rd (1987–8) 9.1 34.0 56.9 29.4 31.7 38.9
50th (1993–4) 9.0 32.9 58.1 24.7 29.1 46.2
55th (1999–2000) 6.6 32.8 60.6 17.7 29.3 52.9
61st (2004–5) 6.1 34.4 59.5 18.1 32.4 49.5
64th (2007–8) 5.8 34.3 59.7 15.3 32.3 52.4
66th (2009–10) 6.0 34.6 59.3 13.9 33.3 52.8

Page 36 of 78
64 per cent (253 million) out of a total of 395 million workers and that of casual
workers was around 29 per cent (116 million). These two most vulnerable groups
constitute around 93 per cent among the unorganized sector and the regular workers
account for only 7 per cent. In other words, 93 per cent of the country’s workforce
suffers from absence of any kind of social security. The situation is relatively better in
organized sector where 69 per cent of workers are working as regular workers and
only 31 per cent are self-employed or casual workers (Table 8.18). (p.328)
Page 37 of 78
Table 8.13 Industry of Employment for Rural Males (in per cent)
Activities 1983 1987–8 1993–4 1999–2000 2004–5 2007–8 2009–10
Agriculture and 77.5 74.5 74.1 71.4 66.5 66.5 62.5

allied activities
Mining and 0.6 0.7 0.7 0.6 0.6 0.6 0.8

quarrying
Manufacturing 7.0 7.4 7.0 7.3 7.9 7.7 7.1
Electricity 0.2 0.3 0.3 0.2 0.2 0.2 0.2
Construction 2.2 3.7 3.2 4.5 6.8 7.7 11.4
Trade, hotels 4.4 5.1 5.5 6.8 8.3 7.6 8.2
Transport 1.7 2.0 2.2 3.2 3.8 4.0 4.2
Other services 6.1 6.2 7.0 6.2 5.9 2.8 5.6

Page 38 of 78
Table 8.14 Industry of Employment for Rural Females (in per cent)
Activities 1983 1987–8 1993–4 1999–2000 2004–5 2007–8 2009–10
Agriculture and 84.7 86.2 85.3 83.3 83.3 83.5 78.9

allied activities
Mining and 0.4 0.4 0.3 0.3 0.3 0.3 0.3

quarrying
Manufacturing 6.9 7.0 7.6 8.4 8.4 7.4 7.6
Utilities 0.0 0.1 0.0 0.0 0.0 0.0 0.0
Construction 2.7 0.9 1.1 1.5 1.5 2.0 4.2
Trade, hotels 2.1 2.1 2.0 2.5 2.5 2.3 3.1
Transport 0.1 0.1 0.1 0.2 0.2 0.2 0.3
Other services 3.0 3.4 3.6 4.6 4.6 4.6 5.7

Page 39 of 78
A look at poverty figures reveals that there are stark differences in poverty
ratios among casual workers, self-employed, and regular workers in the non-
agricultural sector (Table 8.19). As expected, poverty ratios were highest for the
causal workers, followed by the self-employed workers, and lowest among
regular workers (Table 8.20). The NCEUS report further reveals that overall
poverty ratio among all workers was of the order of 19.3 per cent (according to
the data provided by NSS 61st Round in 2004–5), but there was a sharp
difference in the poverty ratio among the unorganized (p.329)
Page 40 of 78
Table 8.15 Industry of Employment for Urban Males (in per cent)
Activities 1983 1987–8 1993–4 1999–2000 2004–5 2007–8 2009–10
Agriculture and 10.6 9.1 9.0 6.5 6.1 5.8 5.9

allied activities
Mining and 1.2 1.3 1.3 0.9 0.9 0.6 0.7

Quarrying
Manufacturing 26.8 25.7 23.5 22.4 23.5 23.5 21.9
Utilities 1.1 1.2 1.2 0.8 0.8 0.7 0.7
Construction 5.1 5.8 6.9 8.7 9.2 9.5 11.5
Trade, hotels 20.4 21.5 21.9 29.4 28.0 27.8 27.0
Transport 10.4 9.7 9.7 10.4 10.7 10.9 10.5
Other services 24.7 25.2 26.4 19.0 20.8 21.0 21.8

Page 41 of 78
Table 8.16 Industry of Employment for Urban Females (in per cent)
Activities 1983 1987–8 1993–4 1999–2000 2004–5 2007–8 2009–10
Agriculture and 31.5 29.4 24.7 17.6 18.1 15.3 11.8

allied activities
Mining and 0.7 0.8 0.6 0.4 0.2 0.3 0.3

quarrying
Manufacturing 26.7 27.1 24.1 24.0 28.2 27.5 25.8
Utilities 0.2 0.2 0.3 0.2 0.2 0.2 0.4
Construction 3.2 3.7 4.1 4.8 3.8 4.3 5.1
Trade, hotels 9.5 9.8 10.0 16.9 12.2 12.8 12.4
Transport 0.6 1.2 1.3 1.8 1.4 1.8 1.5
Other services 26.7 27.8 35.0 34.2 35.9 37.8 42.7

Page 42 of 78
workers, standing at 20.4 per cent as against the organized workers at a low level of
4.9 per cent.
As regards sectoral distribution, the proportion of informal workers to total
workers has been highest in trade, followed by manufacturing, transport and
real estate, and business services.11 In terms of composition of employment,
manufacturing and trade constitute around 70–5 per cent of total informal sector
employment. In urban areas, the share of trade (41 per cent) exceeds the share
of manufacturing (30 per cent). Hence, the dominance of the tertiary activities in
(p.330)
Page 43 of 78
Table 8.17 Sector-wise Employment (in million)
Year Sector Informal/Unorganized Formal/Organized Total

Workers Workers
1999–2000 Informal/Unorganized 341.3 (99.6) 1.4 (0.40) 342.7 (100)

Sector
Formal/Organized Sector 20.5 (37.5) 33.6 (62.2) 54.1 (100)
Total 361.8 (91.2) 35.0 (8.80) 296.8 (100)
2004–5 Informal/Unorganized 393.5 (99.6) 1.4 (0.40) 394.9 (100)

Sector
Formal/Organized Sector 29.1 (46.6) 33.5 (53.4) 62.6 (100)
Total 422.6 (92.4) 34.9 (7.6) 457.5 (100)

Source: NSS 61st Round (2004–5) and NSS 55th Round (1999–2000), Employment–Unemployment Surveys, computed
by NCEUS.
Note: Figures in brackets are percentages.
Page 44 of 78
the informal sector, which was observed three decades ago, does not appear to have
undergone any major change (Mitra 2008).
Employment Elasticity and Labour Productivity
As discussed by several scholars, the ongoing growth pattern in India is
characterized by low employment elasticity and rising labour productivity over
the last three decades. The growth in labour productivity in the face of slow
employment growth can be attributed to a rise in capital intensity with or
without any improvement in the level of technology or a rise in organizational/
managerial efficiency. As is generally acknowledged, productivity growth
without a commensurate rise in real wages is indicative of the fact that the
productive gains are not being shared with labour.
The employment elasticity defined as the annual rate of growth of employment

(UPSS) relative to the annual rate of growth of gross value added (at factor cost)
is extremely low at the aggregate level (Table 8.21). It declined from 0.40 during
the period from 1983 to 1993–4 to 0.15 during the period from 1993–4 to 1999–
2000. Agriculture and allied activities recorded negative employment elasticity
in the 1990s because employment fell in absolute terms in these (p.331)
Page 45 of 78
Table 8.18 Size and Distribution of the Organized and Unorganized Sector Workers by Industry and Status: 2004–5
Status Agriculture Non-agriculture All
Organized Unorganize Total Organized Unorganize Total Organized Unorganize Total

d d d
Number of Workers (Million)
Self- 2.3 163.9 166.2 2.9 89.2 92.1 5.2 253.1 258.2
employed
Regular 1.3 1.5 2.8 41.9 24.8 66.7 43.2 26.4 69.5
workers
Casual 2.5 87.4 89.9 11.7 28.1 39.8 14.2 115.5 129.7
workers
Total 6.1 252.8 258.9 56.5 142.1 198.5 62.6 394.9 457.5
Percentage Distribution of Workers
Self- 38.1 64.8 64.2 5.1 62.8 46.4 8.3 64.1 56.5
employed
Regular 20.1 0.6 1.1 74.3 17.4 3.6 69.0 6.7 15.2
workers
Casual 41.8 34.6 34.7 20.7 19.8 20.0 22.7 29.2 28.3
workers
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Percentage 2.4 97.6 100.0 28.4 71.6 100.0 13.7 86.3 100.0
of total
Page 46 of 78
Source: NSS 61st Round (2004–5) and NSS 55th Round, Employment–Unemployment Survey, computed by NCEUS.
Page 47 of 78
(p.332)
Page 48 of 78
Table 8.19 Poverty Ratios among Unorganized and Organized Workers: 2004–5 (in per cent)
Sector Rural/Urban/Total Unorganized Workers Organized Workers All Workers
Agricultural Total 20.5 13.8 20.4
Non-agricultural Rural 17.2 3.5 15.7
Urban 23.7 4.3 19.6
Total 20.4 4.1 17.8
All Rural 19.2 5.4 18.7
Urban 25.1 4.5 21.0
Total 20.4 4.9 19.3

Source: NCEUS (2007: 24).
Page 49 of 78
Table 8.20 Poverty Ratios among Non-agricultural Workers by Nature of Employment: 2004–5 (in per cent)
Nature of Employment Rural Urban
Organized Unorganized Organized Unorganized
Casual workers 21.9 23.1 35.0 41.5
All workers 11.2 17.2 10.4 24.1
Self-employed 11.2 15.9 11.4 21.4
Regular workers 5.2 11.5 6.8 20.2

Source: NCEUS (2007: 25).
Page 50 of 78
activities. Similarly, in mining and utilities too, the negative figure was evident.
Manufacturing registered an elasticity of barely 0.29 in the period from 1993–4 to
1999–2000, declining from 0.37 during 1983–93. Construction, trade, transport, and
financial services experienced relatively higher employment elasticity and, among
them, all activities except trade registered either constant or increasing employment
elasticity in the second period relative to the first.
In the period 1999–2000 to 2004–5, considerable improvement in employment
elasticity is evident across several activities. Despite a decline in the growth of
value added in agriculture as compared to the earlier periods, employment
growth picked up to unity in this sector. Trade, hotels, and financing and
business services also registered an increase in employment elasticity. However,
transport, storage, and communication experienced a marked decline in (p.
333)
Page 51 of 78
Table 8.21 Rate of Growth of GDP (per cent per annum) and Employment Elasticity
Activity Rate of Growth of GDP (per cent p.a.) Employment Elasticity
1983 to 1993–4 1993–4 to 1999– 1999–2000 to 1983 to 1993–4 1993–4 to 1999– 1999–2000 to
2000 2004–5 2000 2004–5
Agriculture and 2.82 2.84 1.82 0.49 −0.05 1.04

allied activities
Mining and 6.02 5.09 4.69 0.69 −0.56 0.61

quarrying
Manufacturing 5.79 7.08 6.24 0.37 0.29 0.51
Electricity, gas 8.07 6.71 3.43 0.56 −0.13 −0.16
Construction 4.76 6.16 7.88 1.12 1.15 0.99
Trade, hotels 5.43 8.77 7.59 0.66 0.57 0.76
Transport 5.91 8.97 11.89 0.55 0.67 0.39
Financial services 9.63 8.03 6.4 0.75 0.77 1.34
Community, 5.17 8.22 5.25 0.56 0.07 0.46

social, and
personal services
Total 5.05 6.42 5.79 0.4 0.15 0.51

Page 52 of 78
employment elasticity, implying that the perceptible increase in the value added
growth rate in this activity did not generate employment proportionately.
Since employment growth decelerated in agriculture, mining, and utilities in the
1990s as compared with the 1980s, the rapid productivity growth in these
activities in the second period is obvious (Table 8.22). Similar is the case with
community, social, and personal services. What is interesting to note is that
activities such as trade, transport, and financial services, which experienced a
rise in the employment growth rate, also reported a rise in productivity growth
in the 1990s relative to the 1980s. Even in manufacturing, where the
employment growth rate declined marginally in the second period compared to
the first, productivity growth accelerated from 3.40 per cent to 5.05 per cent per
annum. It is only in construction activity that productivity growth was negative
in both the periods, despite positive growth rates both in terms of value added
and employment. Labour productivity in the period 1999–2000 to 2004–5
decelerated considerably across (p.334)
Page 53 of 78
Table 8.22 Labour productivity (Rs) and Growth Rate (per cent per annum)
Activity Product 1983 Product 1993–4 Product 1999– Product 2004–5 Growth rate Growth rate Growth rate
(in 1993–4 (in 1993–4 2000 (in 1993– (in 1999–2000 1983 to 1993–4 1993–4 1999– 1999–2000 to
prices) prices) 4 prices) prices) 2000 2004–5
Agr. and allied 8,806.15 10,104.70 12,080.40 19,113.50 1.31 2.98 −0.07
activities
Mining and 62,699.00 74,414.80 120,128.00 183,233.00 1.63 7.98 1.84

quarrying
Manufacturing 20,659.90 2,927.76 39,976.30 55,012.08 3.40 5.05 3.08
Elect., gas 99,914.10 140,622.00 221,883.00 349,469.00 3.25 7.60 3.97
Construction 37,181.70 34,754.30 33,337.10 59,675.90 −0.64 −0.69 0.04
Trade, hotels 30,015.70 35,770.00 45,069.40 68,098.30 1.67 3.85 1.85
Transport 3,818.24 49,497.60 59,637.90 89,689.60 2.44 3.11 7.26
Financial 202,842.00 255,921.00 288,838.00 460,895.00 2.21 2.02 −2.19

services
Communication 22,623.90 26,653.00 46,198.50 79,516.30 1.56 9.17 2.82

services
Total 155,881.00 20,866.50 28,926.20 45,145.90 2.78 5.44 2.82

Page 54 of 78
(p.335) several activities. At the aggregate level, it was almost halved. Only
transport, storage, and communication registered an increase.
Sectoral Shifts in Employment
The sectoral composition of the employment and value added has witnessed a
major change in the last two decades. Since the employment intensity in the
non-agricultural sectors is lower than that of agriculture, employment
diversification of the economy has not kept pace with the diversification of the
economy in terms of value added. Consequently, although the share of
agriculture in GDP went down significantly from 42 per cent to 23 per cent over
the period, 1981–2005, the structure of the workforce was still dominated by
agriculture (68 per cent in 1983 to 56 per cent in 2004–5) (Bhalla 2008; Mitra
2008). While the GDP share of manufacturing has marginally declined to around
24 per cent in 2004–5 from being one-fourth of the GDP in the 1990s, its share
of employment has increased marginally from 11.24 per cent in 1983 to 12.09
per cent in 1999–2000 and 12.20 per cent in 2004–5. In other words, the shift
away from agriculture has not led to a significant increase in the share of
employment in the manufacturing sector. On the other hand, the GDP share of
trade, hotels and transport, storage, and communication increased by almost 7
percentage points between 1981 and 2005. In terms of growth rate also, these
activities, along with financing, real estate, and business services, increased
their share very rapidly. As regards the disaggregated trends (by rural–urban
and by genders), these are provided in Table 8.23.
The registered manufacturing sector which is, in general, characterized by

relatively high earnings and better working environment, played very
insignificant role in overall occupational transformation of the labour force in
India for over last three or more decades. In India, Annual Survey of Industries
(ASI) and Director General of Employment and Training (DGET) provide figures
on registered manufacturing sector employment. As it happens, both of these
sources present a different picture about the current scenario regarding
employment in registered manufacturing sector. The figures given by ASI tells us
that registered manufacturing employment rose between the mid-1980s and
mid-1990s and declined subsequently touching a low in 2002–3.12 While this
does not point to a long-run increase in (p.336)
Page 55 of 78
Table 8.23 Annual Trend Rates of Growth of IIP (in per cent)
Period Total Manufacturing Mining and Quarrying Electronics
1950–1 to 1964–5 (a) 7.2 7.1 5.9 13.6
1965–6 to 1979–80 (b) 4.7 3.8 6.9 6.2
1965–6 to 1974–5 (b) 4.3 2.7 9.4 3.8
1975–6 to 1984–5 (c) 4.9 4.3 6.6 7.3
1985–6 to 1994–5 (d) 6.2 6.2 4.2 8.3
1995–6 to 2004–5 (e) 5.5 5.8 2.7 5.0
2000–1 to 2006–7 (e) 7.3 7.9 4.0 4.8

Source: Chandrasekhar (2010).
Notes:
((a)) Based on series with base 1950–1 = 100

((b)) Based on series with base 1970 = 100
((c)) Based on series with base 1970 = 100
((d)) Based on series with base 1980–1 =100
((e)) Based on series with base 1993–4 = 100
Page 56 of 78
registered manufacturing employment, it suggests that there has been no absolute

decline in employment between the mid-1990s and mid-2000s (Figure 8.1).13
While differences in coverage and definitions can possibly explain the
discrepancy in the level of employment and its direction between
(p.337) these two sources, in all,

it does not appear that there has
been any improvement in
organized manufacturing
employment during the period of
high growth, which was also a
period of high manufacturing
growth (Chandrasekhar 2010;
Chandrasekhar and Ghosh 2007)
(Table 8.23 and Figure 8.2). So to
understand the occurrence of
Figure 8.1 ASI Estimates of Registered
these outcomes, we need to look
Manufacturing Employment
at the pattern of organized
manufacturing growth in the Source: Annual Survey of Industries,
period since liberalization, and Central Statistical Organization, 2007–8.
especially in recent times.
Looking at the data (Table 8.24)
which provides rates of growth of sub-groups based on the used-based
classification of the Index of Industrial Production (IIP) indicates that a major
source of growth is due to the contribution made by the consumer goods sector.
The growth performance of the consumer durables sector has been the best,
though its contribution to aggregate manufacturing growth remained less
significant due to its low weight.
(p.338)
Figure 8.2 Employment in Organized

Sector Manufacturing (lakh persons)
Source: Economic Survey, 2009–10.
Page 57 of 78
Table 8.24 IIP-based Rates of Growth of Manufacturing

Production (Use-based Classification): 1994–5 to 2004–5 (in per
cent)
Type of Goods Growth Rate Contribution
Basic goods 4.49 1.59
Capital goods 6.92 0.67
Intermediate goods 6.39 1.69
Consumer goods 6.45 1.83
Durables 9.16 0.47
Non-durable 5.65 1.31
General 5.83 5.83

Source: Chandrasekhar (2010).
Moreover, there is a high demand for manufacturing products for those goods
which can be financed through debt. As argued by Chandrasekhar and Ghosh,
an important implication of debt-financed manufacturing demand is that it is
inevitably concentrated in a narrow range of commodities that vary from
construction materials to automobiles and consumer durables. These
commodities, to an extent, are capital and import intensive in nature and so the
domestic employment and linkage effects of this expansion are limited. Not only
is the employment growth in such industries limited, as has been the case, but
sustaining this kind of growth process would require generating more of the
same kind of demand (Chandrasekhar 2010; Chandrasekhar and Ghosh 2007).
Thus, the net effect of this kind of industrial development is that the output
growth in the organized sector has not contributed concomitantly in the
employment generation. While it is known that the manufacturing sector tends
to be far less labour absorbing than agriculture or services, this feature of
growth in organized industry is extremely disturbing and needs correction
(Chandrasekhar 2010).
Trends in Wages
Wage structures in India are complex due to the diversity of the economy and
segmentation of its labour markets. Nonetheless, the broad pattern emerging
since the 1980s suggests that real wages have tended to rise, albeit at very
different rates during particular sub-periods, and across sectors. As regards
wage inequality, it increased (p.339) quite significantly, especially in the urban/
organized sector, and also between regular and casual workers. Table 8.25
presents average daily wage rates for regular and casual workers and for rural
and urban workers at constant (1993) prices for the period 1983 to 2009–10.
Regular workers received two to three times higher wages than casual workers,
Page 58 of 78
while urban workers received almost 50 per cent higher wages than rural
workers during the entire period from 1983 to 2004–5 for both regular and
casual workers. The gap in wages between regular and casual workers tended to
increase in both rural and urban areas in the pre-reform period (1983 to 1993–4)
and in urban areas during the entire period (1983 and 2004–5).
In the recent period between 2004–5 and 2009–10 real wages, both in rural as
well as in urban areas, showed some positive trends. The rate of growth of
casual wage rose faster during this period as compared to earlier mentioned
period for both rural and urban areas. This rise in the growth was more
prominent in rural areas than urban areas. This may indicate that
implementation of MGNREGS to a large scale became successful in setting up a
minimum floor for casual wage in rural areas. However, in urban areas, the rise
in construction
Page 59 of 78
Table 8.25 Wage Patterns and Trends for Regular and Casual Workers (15–59 age group, at 1993 prices)
Sector Wage per Day (Rs) Growth Rate(%)∗
1983 1993–4 2004–5 2009–10 1983–4 1993–2005 1983–2005 2004–10
Regular
Rural 40.0 57.0 78.0 85.0 3.4 2.9 3.2 1.5
Urban 59.0 77.0 101.0 122.0 2.6 2.5 2.5 3.2
Total 51.0 69.0 92.0 107.8 2.9 2.7 2.8 2.7
Urban/Rural 1.5 1.4 1.3 1.4 0.7 0.9 0.8 2.2
Casual
Rural 17.0 21.0 29.0 34.0 2.0 3.0 2.5 2.7
Urban 24.0 30.0 36.0 41.0 2.2 1.7 1.9 2.2
Total 17.0 22.0 30.0 36.0 2.5 2.9 2.7 3.1
Urban/Rural 1.4 1.4 1.2 1.2 1.1 0.6 0.8 0.8

Note: Compound growth rate is calculated for the relevant period starting from the first month of the initial survey year to last month of
the final survey year.
Page 60 of 78
(p.340) activities in the recent period has been successful in raising the level of
casual wage for urban workers during the same period. All these trends related to rise
in the growth of wages undoubtedly show some welcome changes during this period;
however, the rise in the pace of casualization of workers clearly reflects a disturbing
trend for the long-term development process. This is quite visible as there was
deceleration in the growth of regular wage in rural areas in the period between 2004–
5 and 2009–10.
Looking at the recent trends of employment for agricultural labourers, wage
employment has shrunk very substantially during the first half of the last
decade. Total agricultural employment saw some upturn between 1999–2000
and 2004–5; however, it was due to higher self-employment particularly for
women. It may well be the case of increase in self-employment, along with a
contraction in wage employment, which reflects a distress-driven phenomenon.
Such a possibility further gets confirmed by looking at the growth rates of real
agricultural wages.
It is worth emphasizing here that prior to the most recent period for which NSS
data are available, real wage trends in rural area for much of the reform period
were on a declining trajectory in terms of their rate of growth. For instance, in
case of agricultural operations, the rate of growth of earnings for male workers
shows quite a disquieting picture in recent years (Table 8.27). As per the NSS
data, the rate of growth of wages during the period 1983–7 was a little over 60
per cent, which came down to about 28 per cent during 1987–8 to 1993–4; it
further fell to 16 per cent for the period 1993–4 to 1999–2000, and was only 8
per cent for the period 1999 to 2004–5. Several researchers have tracked the
movement of agricultural wages since the 1980s, using a variety of available
data sources, at the all-India level as well as in the states level or even lower
administrative units (for example, Himanshu 2005). The unambiguous
conclusion from the existing literature is that the growth rate of real agricultural
wages showed a declining trend for most of the reform period.
The other major data source on agricultural wages, namely the Agricultural
Wages in India (Ministry of Agriculture, GoI) reaffirms the aforementioned
disquieting picture. In case of male field labourers, 96 per cent of the districts in
India experienced positive growth in real wage during 1980s but in 1990s this
percentage came down to 50. For female field labourers, the respective figures
were 96 per (p.341) cent and 53 per cent of districts for the 1980s and 1990s,
respectively. A similar trend is noticeable for the female and child workers in
agricultural operations. The trends in the movement of real average daily
earnings of workers in non-agricultural operations were along a similar track
(Table 8.26). Essentially, the picture is one of very significant declines in the
rates of growth of average daily earnings since the early 1990s.
In urban areas, the wage gap between regular and casual workers is much
greater than that in rural areas (Table 8.27). It is particularly high in the primary
Page 61 of 78
sector, where it has also been growing, but of course the share of the primary
sector in total urban employment is low. The wages of regular tertiary sector
workers have been growing faster than those of casual workers, leading to
higher wage inequality. This reflects strong dualism in the tertiary sector
(Mazumdar and Sarkar 2007). This was not true of the secondary sector, where
regular wages grew more slowly than casual and distinctly slower than in the
tertiary sector. As a result, the intersectoral wage differentials for regular
workers (between secondary and tertiary sectors) and casual workers (between
primary, secondary, and tertiary) are widening. The widening differential
between regular workers in the secondary and
Table 8.26 Trends in Real Average Daily Earnings
Year Men Women Children
(a) Average Daily Earnings of Workers in Agricultural Operation@
1983 5.5 4.14 2.7
1987–8 8.82 (60.36%) 6.6 (59.4%) 5.6 (107.4%)
1993–4 11.3 (28%) 8 (21%) 6.6 (17.8%)
1999–2000 13.11 (16%) 9.27 (15.8%) 7.9 (19.7%)
2004–5 14.2 (8.3%) 9.9 (6.7%) NA
(b) Average Daily Earnings of Workers in Non-agricultural Operation@
1983 6.0 3.47 3.3
1987–8 9.6 (60%) 7.4 (113.25%) 5.9 (78.8%)
1993–4 14.4 (50%) 8.6 (16.2%) 7.9 (33.9%)
1999–2000 17.7 (22.9%) 11.13 (29.4%) 7.9 (0%)
2004–5 20.2 (14%) 13.3 (19.4%) NA

Source: 5th, 6th, and 7th RLE. Data for 2004–5 is from NSS 61st
Round.
Notes: @ 1986–7 prices; deflator used is the All India Consumer Price Index
for Agricultural Labour; and the figures in brackets refer to percentage
growth over the previous period.
(p.342)
Page 62 of 78
Table 8.27 Trends in Urban Wages by Sector (15–59 age group, at 1993 prices)
Sector Wage per Day (Rs) Growth Rate (%)
1983 1993 2004 1983–2004 1993–2004 1983–2004
Regular
Primary 56 80 139 3.5 5.2 4.3
Secondary 57 70 82 2.0 1.5 1.7
Tertiary 60 80 108 2.8 2.8 2.8
Ratios:
Tertiary/Primary 1.07 1.00 0.78 0.8 0.5 0.6
Tertiary/ 1.05 1.14 1.32 1.4 1.9 1.6

Secondary
Casual
Primary 20 23 26 1.3 1.1 1.2
Secondary 26 33 40 2.3 1.8 2.0
Tertiary 24 29 35 1.8 1.7 1.8
Ratios:
Tertiary/Primary 1.2 1.26 1.35 1.4 1.5 1.4
Tertiary/ 0.92 0.88 0.88 0.8 1.0 0.9

Secondary
Source: Jha (2006).
Page 63 of 78
tertiary sectors may reflect the service-oriented pattern of economic growth. The
emergence of an export-oriented information technology sector based on software and
data processing within the service sector, with relatively high wage rates, is pushing
up the wage rates in upper ranges. At the same time, slow growth of both agriculture
and industry continued to push workers into informal segments of the service sector as
casual workers, widening the wage gap between the secondary and tertiary sectors.
Further, given the dramatic increases in managerial salaries and near stagnation in the
real wage of the majority of workers in the secondary sector, there has been a
dramatic increase in income inequality.14
The labour productivity in manufacturing sector as measured by the net value
added (at constant prices) per worker has shown a sharp and persistent increase
during the period of liberalization (Chandrasekhar 2010; Chandrasekhar and
Ghosh 2007; Mathur and Mishra 2007). Figure 8.3 shows that labour
productivity tripled between 1981–2 and 1996–7 (from 0.81 to 2.42) and it again
started showing an upward trend in the subsequent decade before a slight
decline set in during (p.343)
the years of the global economic

slowdown. However, the benefits
of this labour productivity
increase went largely to those
deriving rent, interest, and profit
incomes, rather than workers.
The share of wages in value
added which was stable through
much of the 1980s (Figure 8.4)
has been declining almost
consistently since the late
1980s till 1996–7 and then after Figure 8.3 Value Added per Worker at
a period of stability fell sharply Constant 1999–2000 Prices
to touch less than half of its
Source: Central Statistical Organisation,
mid-1990s level (Chandrasekhar
Annual Survey of Industries data deflated
2010; Chandrasekhar and
by GDP deflator for manufacturing. Data
Ghosh 2007). The phenomenon
available at www.mospi.nic.in.
observed above can be
attributed to two developments.
While a decline in public sector manufacturing employment was noticed during
the years of liberalization, especially after 1997, the employment in private
organized manufacturing sector remained stagnant barring a very small period
of 1995–7. Secondly, the average real wage of workers in the organized
manufacturing sector was more or less constant right through the 1990s (Figure
8.4). Together, these have ensured that the benefits of the rise in labour
productivity have largely gone to the surplus earners in the sector, who have
been the main beneficiaries in the organized manufacturing sectors of the
policies of liberalization in general and trade liberalization in particular. (p.344)
Page 64 of 78
Some Other Indicators

There are other important
quantitative correlates of well-
being of labour, such as
prospects of mobility in to
decent work and livelihood,
segmentation in labour
markets, access to skill
formation, consumption, and
Figure 8.4 Ratio of Wages to Value Added
indebtedness. In the following
in Organized Sector Manufacturing
we briefly touch on a couple of
these. Source: Central Statistical Organisation,
Annual Survey of Industries data
As is well known, the existing available at www.mospi.nic.in.
data sources for internal
migration in India lack
reliability as they do not capture short-term migration adequately which
constitute a significant proportion of mobility of labour. In any case, most
researchers do agree that internal labour mobility has tended to increase during
the last three decades, aided inter alia, by the development of transportation
and communication; however, these movements have not made any significant
dent on the occupational structure of the country. As per the NSS data during
the period 1993–4 to 2007–8, there was a substantial rise in the rate of internal
migrations in India. For rural areas the rate of migration increased from 228 per
thousand in 1993–4 to 261 per thousand in 2007–8. Similarly, for urban areas
these rates were 307 and 354, respectively. However, most of these migrants are
only being absorbed in the low paid unorganized sector under the self-
employment status. As the NCEUS had reported, using the NSS data, almost 77
per cent of (p.345) the population (836 million) in India fell below a daily per
capita consumption of less than rupees 20. There is hardly any doubt that except
a small section in the organized sector, a huge mass of the country’s labour force
falls under poor and vulnerable category. Therefore, even though the
unemployment rate in the economy, as a whole, on the current daily basis, is
lower than 10 per cent, the challenge of working poor is a stupendous one.
The level of indebtedness of the working population is another important factor

in deciding their disposable income and hence consumption. The average
indebtedness per household for agricultural labour, which constitute the largest
share in the total labour force, increased substantially in the 1990s. Moreover,
the share of non-institutional sources, generally with higher rate of interest, in
total credit has increased in a significant manner during the same period.
With the opening up of the Indian economy to the world, the rapid changes
witnessed in science and technology and the pressing need to improve quality of
life and to reduce poverty, it becomes even more urgent that people acquire
Page 65 of 78
appropriate levels of education and skills. Most accounts seem to suggest that in
several developing countries, including India, considerations of quality of
education at all levels, including at the elementary stage, continue to create a
huge sense of discomfort. India, as is well-known, has the unflattering record of
housing the largest number of illiterates by any country in the world (Jha and
Negre 2007).The average rate of literacy, going by Census, 2001, is still around
65 per cent. The female literacy rate stands at 54 per cent which goes down
further to 47 per cent for the rural female. As per 61st Round of NSS (2004–5),
there were approximately 200 million children in the age group of 6–14 years.
Out of these, only 177 million were enrolled and the percentage of out-of-school
children works out to be 11.5. National Commission for Enterprises in the
Unorganised Sector, using the same data source, estimates that out of a total of
252 million, in the 5–14 years age group, 45.2 million, that is, 17.9 per cent were
out of school. As per NSSO data between 1993–4 and 1999–2000, overall trend
for workers’ literacy level improvement was weak and even regressive in some
sectors. For instance, to take a couple of illustration of this, it may be noted that
there was sluggish improvement in the proportion of literate workers in
agriculture and plantations while the same had fallen noticeably for agricultural
services, hunting-trapping and some other segments.
(p.346) Recent official estimates suggest that only a small proportion of the
labour force is enrolled under different training programmes. For instance, in
2004–5 only around 8 per cent of the workforce reported to have received non-
formal vocational training while the corresponding percentage for formal
training was just about 3.8 per cent of the workforce. In all, a total of about 11.5
per cent of the youth reported to have had vocational training in 2004–5.
Not surprisingly, there are several recent studies/reports that are highly critical
about the available skill base of the Indian labour force. The CII-McKinsey
report, ‘Made in India: The Next Big Manufacturing Export Story’ (October
2004), highlights the fact that viewing the huge gap between the requirements
of skill in the manufacturing sector and the available skilled human resources, it
is urgently necessary to foster the process of building up the human capital in
order to achieve 12 per cent growth rate in the manufacturing sector in the near
future. The report also points out that such growth rate requires at least 1.5
million technically skilled people every year. The recent ‘Teamlease’ report
(2007) also reiterates that there exists a major skill shortage in almost all areas
of manufacturing as well as the major service sub-sectors, such as hospitality,
retail, and construction.
Likewise, a number of important studies on behalf of the government, (for

example, Task Force on Employment Opportunities of the Planning Commission
2001, the Second National Commission on Labour 2002, and the Approach Paper
to the Eleventh Five Year Plan 2007) have repeatedly emphasized that an acute
skill deficit has been a major drag on the economy’s performance. All these
Page 66 of 78
studies emphasize that existing capacity and infrastructure in the areas of skill
development and training are inadequate; further the existing infrastructure
suffers from serious problems.
Among others, segmentation remains one of the prime characteristics of labour

markets in India. Various segments of the labour market such as organized and
unorganized workers, formal and informal workers, regular and casual workers,
men and women workers, and segmentation by caste have been prevalent across
all the sectors of the Indian economy. These segmentations are not only
characterized by immobility of workers among various existing segments but
also by a great deal of wage differentials as well as wage discrimination among
different segments of labour markets. Among these, the (p.347) segmentation
between men and women workers constitutes one of the most important
characteristics of Indian labour markets. The segmentation between men and
women workers takes its worst form in rural India. Women not only get pushed
into low-wage jobs but they are, in general, paid lower wages than their male
counterparts. In agriculture, women often take up jobs which the male workers
usually avoid. Such job segregation has several consequences including creation
of huge disparity in wage rates between the males and females. It is also
instrumental in bringing down the bargaining power of women workers. Thus,
the rural women labourers are among the exploited and their participation in
overall workforce and wages remain significantly below those of men in the rural
labour markets. Similar situation prevails in urban unorganized sector where
low wages and inadequate working environments for women workers have been
widespread.
Weakening of Labour’s Bargaining Power

The neo-liberal policy regime has not only worsened the quantitative indicators
of well-being of labour but also affected the vast pool of workforce qualitatively.
While the curtailment of public investment, growing sickness and closure of sick
units, and exit policy have together accelerated the process of labour
retrenchment in recent times, the guarantees of job security, regular wage
revisions, a variety of protective social and economic provisions including
retirement benefits, which had been gained by small segments of the workforce
through protracted struggles, are being attacked gradually in some cases or
being dismantled rapidly in others. Practices such as subcontracting and
outsourcing have become widespread and temporary and part-time works, long
considered as transitory and ladder to secure employments in the so-called
formal sectors, have become ends in themselves.
The Report of the Second National Labour Commission (SNCL) had noted with
concern that there were ‘a large number of complaints on voluntary retirement
schemes’, including ‘elements of indirect compulsion, pressure tactics,
innovative forms of mental harassment, compelling employed to resign by
seeking to terminate them, and in some cases, physical torture and threats of
Page 67 of 78
violence against themselves or dependents’. The report also makes a few other
general observations (p.348) vis-à-vis industrial relations which are worth
quoting (SNCL Report, Conclusions and Recommendations, Government of India
[GoI] 2002: 27–8):
(1) It is increasingly noticed that trade unions do not normally give a call
for strike because they are afraid that a strike may lead to the closure of
unit. (2) Service sector workers feel they have become outsiders and are
becoming increasingly disinterested in trade union activities. (3) There is a
trend to resolve major disputes through negotiations at bipartite level. The
nature of disputes or demands is changing. (4) The attitude of the
Government, especially of the Central Government, towards workers and
employers seems to have undergone a change. Now, permissions for
closure of retrenchment are more easily granted. (5) Recovery Proceedings
against employers who could not pay heavy dues of workers are not being
seriously pursued by the industrial relations machinery, if the financial
position of the employer is bad. (6) The labour adjudication machinery is
more willing to entertain the concerns of industry.
The inescapable conclusion emerging from these observations of the SNCL is

that there has been a significant shift in the relative bargaining power, in
industrial relation, away from workers, to employers.
In sum, the increase in the hostility of the organs of State towards labour is
intimately and organically linked to the logic of globalization. Right to organize,
right to collective bargaining, right to form trade unions, right to strike—all
these are being scuttled at the work place, with the indirect or direct support
from the State, and the use of physical repression by the State apparatus, to
achieve such ends, has tended to increase in the recent years.
One of the most eloquently hostile organs of the State in recent times, towards
the right of workers, has been the judiciary. A series of verdicts have been
delivered by different courts, including the apex court, restricting the
democratic space of the people (Jha 2005). Thus, different organs of the state
have been working in unison, and a pattern is firmly in place, aimed at
destroying any organized initiatives from the working classes; the responses are
often particularly vicious vis-à-vis those opposed to globalization. Labour laws
are seen by the organs of the state as thorns in the flesh of neo-liberal economic
policies and thus attempts are afoot at their annulment. On the other (p.349)
hand, workers and their unions are engaged in bitter struggle not to give up
their ground.
For almost three decades now, Indian economy has witnessed remarkable and
sustained progress in the overall growth rate of GDP. However, this high growth
in GDP has been characterized by some disturbing trends with respect to both
Page 68 of 78
quantity and quality of employment and well-being of labour in India. For much
of this period, the tertiary sector (rather than manufacturing) has been the
major player in the economic ‘success’ story—both in terms of the value added
and, on a much smaller scale, with respect to quality employment generation
and levels of earnings; in other words, positive employment implications of the
recent growth process have been limited. Further, persistent dualism in the
manufacturing sector, which is largely a result of structural constraints as well
as policy bottlenecks and failures, has limited the prospects of a dynamic role for
this sector in the economy. It is a combination of such factors, inter alia, which
explains why expectation that the high rate of growth would be accompanied
with commensurate growth in employment opportunities has been belied. For
the overwhelming chunk of the working masses, several adverse processes have
been unleashed during the regime of neo-liberal reforms. Hence, it is hardly
surprising that almost all the indicators of well-being of labour in India have
shown relative deteriorating trends during this period.
In contrast to the decade of the 1980s which had witnessed some improvement
in the well-being indicators of the labour in a large measure on account of range
of government policies, the period since the early 1990s emerges in a different
light. The decline in government activities and downsizing of the public
investment has led to the significant squeeze in overall employability of the
economy as whole. The agriculture sector, which continues to be the largest
employment provider, has been among the worst hit and lost its capacity to
absorb labour. Moreover, acceleration in adoption of capital-intensive techniques
across different economic sectors along with increasing tendencies of
casualization and informalization of workforce has aggravated the overall
employment scenario. The unemployment rate has remained high and there are
clear evidences of qualitative (p.350) deterioration of working conditions for
the overwhelming majority of workers. The unorganized sector, largely
characterized by low earnings, job insecurity, lack of social security, and poor
working environment, has tended to increase its share further during the reform
era.
It seems, as suggested by several scholars, neo-liberal trajectory has pushed the

Indian economy increasingly towards ‘jobless growth’. Thus, the benefits of
growth are largely appropriated by the surplus earners (as the share of surplus
in the output has been increasing disproportionately), and the overwhelming
mass of workers has remained largely excluded from current growth process.
Relatively intangible dimensions of the world of work—labour rights and
entitlements in general—have been among the major casualties during the
reform period.
Having discussed the poor condition of labour in India in the recent past, the
point worth emphasizing is that there is an urgent need to adopt a course of
action which can reduce the problems of the working poor. This can be
Page 69 of 78
addressed by reducing the level of underemployment prevalent in the economy

or by raising the real wage rates for casual workers. Also, the main focus of
economic and social policies must be on generating a steady process of transfer
of self-employed and casual workers to regular-wage paid jobs.
There is a strong need of redesigning labour market policies and institutions in a

way that they can speed up the creation and growth of regular wage
employment outside what is currently the domain of organized sector.
Considering the large pool of working poor, merely the transfer of working poor
from one location to another does not address the problem in any sense.
Government must come out with special employment programmes, targeted at
generating wage employment for the poor workers which simultaneously reduce
underemployment and increase real wages for casual workers in agriculture. As
suggested by Ghose (2004), the effectiveness of such programmes can be
increased by targeting geographical areas where the working poor forms a high
share of total employment and also institutionalizing a national minimum wage
for unskilled causal labour (for example, along the lines of MGNREGA).
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Notes:
(1.) See Box 8.1 and Box 8.2 for measures of employment and unemployment and
different types of employment, respectively.
(2.) Reports based on the recent round of NSS data (2009–10) throw up some
surprising results which need to be explored further.
(3.) NSS rounds used in the chapter are 1983 (38th Round), 1987–8 (43rd
Round), 1993–4 (50th Round), 1999–2000 (55th Round), 2004–5 (61st Round),
2007–8 (64th Round; although the 64th Round was for a short span, however, it
shows some significant trends which need to be emphasized), 2009–10 (66th
Round), and 2011–12 (68th Round). 66th round was a quinquennial round based
on a large sample, however, only preliminary findings on employment and
unemployment are available till now which have been included in the chapter.
Page 76 of 78
(4.) These possibilities are corroborated also by the fact that in a good
agricultural year 2007–8, while male participation rates increased marginally,
that of women fell significantly.
(5.) As is well acknowledged, the impact of residual absorption of labour is also

included in this ratio.
(6.) After 2004–5, it is followed by a dip again even below the level of 1983 (37.4
per cent) in 2007–8.
(7.) However, taking the period from 1999–2000 to 2007–8 (a good agricultural
year), this rate declined significantly to 1.27 per cent.
(8.) See Box 8.1.
(9.) In 2007–8, for male workers, it reached the level even higher than that of in
1983.
(10.) Of course, exception to such a trend would be a very small proportion of

self-employed skilled workers who have done extremely well as self-employed,
due to the opening of the new avenues like the expansion of ICT.
(11.) Though community, social, and personal services are also expected to show
a high incidence of informal sector employment, the exclusion of domestic
services from the informal sector survey reduces its share.
(12.) Since then, it seems to have risen sharply and equaled and marginally
exceeded its 1995–6 peak in 2006–7 and 2007–8, respectively.
(13.) However, there had been some recovery in employment in the private
organized manufacturing sector between 2004 and 2007; the persisting decline
of employment in organized manufacturing in the public sector has meant that
the overall increase in organized manufacturing employment has been marginal.
As a result, employment at the end of March 2007 was significantly below the
level that was at the end of March 1997 (Figure 8.2).
(14.) According to the NCEUS report, 85 per cent of all casual workers in rural
areas and 57 per cent of them in urban areas get wages below the minimum
wages. The difference in the proportion of workers below the legal minimum
wage norm in rural areas and urban areas is more marked for the non-
agricultural workers, with urban workers being considerably worse-off. Among
industry groups, the proportion of men below the minimum wage is higher in
trade, whereas among women it is highest in manufacturing in rural and urban
areas. Thus, an overwhelming majority of workers both in the rural as well as
urban areas get wages which are well below the stipulated minimum wage in the
country.
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Page 78 of 78
Index

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
(p.357) Index
agency banking, 189
agrarian economy, 285, 308
agricultural: commodity, 287;
employment, 287, 310, 340;
income, 293–6;
labourers, 313, 340, 345;
wages, growth of, 296, 340
Agricultural Wages in India, 340
Annual Survey of Industries (ASI), 335
asset-liability management, 175
Asset Reconstruction Fund (ARF), 172
available for sale (AFS), 178
badla financing, 127
balance of payments (BoP), 3–4, 6, 8, 17, 127, 147, 289, 293;
indicators of, 49
Bandhan Microfinance, 196
bank assets, investment and loans as a ratio of, 46
bank credits, 129, 159, 168, 179, 310
bank deposits, government’s draft on, 50
bank groups in banking aggregates, shares of, 176
Banking Companies Act (1949), 153
banking consolidation, phase of, 153–7
banking development, social control in, 168
banking laws, review of, 172
banking policy in India: balance sheet indicators and, 178–9;
banking consolidation, phase of, 153–7;
bank nationalization and social control, 157–68;
bank operations, deregulation of, 175;
for branch licensing, 175;
deregulation of interest rates, 171–5;
on differentiated banks, 196;
Page 1 of 15
Index
distributional issues and financial inclusion, 183–92;

evolution of, 119;
financial liberalization era (1992–2011), 168–92;
financial sector reforms, 171;
licensing of new banks, 195–6;
outcomes of, 171–92;
on profitability/productivity, 179–80;
prudential regulations, 175–8;
on public ownership in banks, 180–2;
recent developments in, 195–8;
on secondary market transactions, 182–3;
social control over banks, 156–7;
yester years and the periodization, 150–3
banking system: deposit ratio, 64;
exposure to sensitive sectors, 53;
impact of reducing government’s draft on, 45–50;
Indian, see Indian banking system;
interest rate, impact of, 45–50;
licensing of new (p.358) banks, 195–6;
macro model of, with endogenous money, 58–66;
‘market-determined’ rates for, 135;
non-performing assets (NPAs), 46, 54;
profitability of, 176;
structure of, 156
bank lending, 108, 167, 173, 221;
credit demands and, 221;
interest rate on, 123;
loans, demand for, 31–2;
personal loans, 53;
process of, 219;
rates for, 174;
bank nationalization, 183, 310;
financial intermediation, 162–4;
growth, impact on, 167–8;
impact of, 159–68;
influence of bank deposits and rising savings on, 166;
making a dent on poverty, 167;
objectives of, 159;
policy of, 157–68;
and savings trends, 164–7;
trends of, 168
bank operations, deregulation of, 175
bank rate, 122–3
banks: amalgamation and liquidation of, 153;
autonomy of, 172;
deposits–GDP ratio, 159;
differentiated, 196;
‘directed’ lending programmes, 310;
licensing of, 195–6;
Page 2 of 15
Index
management of, 172;

nationalization of, see bank nationalization;
public sector, 182;
social control over, 156–7; see also commercial banks
Barro, Robert, 234
benchmark prime lending rate (BPLR), 145, 173–4;
movements in, 175;
Working Group on Benchmark Prime Lending Rate, 173
Bombay Stock Exchange (BSE), 51
boom-bust cycles, 107
Bretton Woods system, 4, 25, 131, 313
Buchanan, James, 234
budget deficits, 129, 239
budgeting, rule-based, 215
Business Correspondents (BCs), 189;
Customer Service Points (CSPs) of, 191
Business Facilitators (BFs), 189
Calvo pricing, 91
capital accumulation, 78, 96
capital adequacy ratio, 172
capital as finance, 14
capital flows, 8–10;
implications of post-2002 boom on, 51–5;
international mobility of, 9;
liberalization of, 29;
macroeconomic analysis of, 37, 55;
Mundell–Fleming model of, 8–10, 13
capital in production, 14
capitalist economy, 23–5, 76, 79, 83, 85, 87, 92, 95–6, 111
capital to risk-weighted assets ratio (CRAR), 175–6;
of scheduled commercial banks, 177
cash reserve ratio (CRR), 43–4, 121, 132, 143–4, 229
Central Bank, accumulation of exchange reserves, 17–22
centrally sponsored schemes (CSS), 249
Chakrabarty, K.C., 191
Chakravarty, Sukhamoy, 41, 226;
Chakravarty Committee Report, 134–6
Chicago Quantity Theory of Money, 220
coefficient of variations (CV), 253, 269
College of Agricultural Banking (CAB), Pune, 191
commercial banks: amalgamation of, 155;
asset quality of, 54;
evolution of, 156;
growth and structure of, 159;
prime lending rate (PLR), 224;
scheduled, see scheduled commercial banks (SCBs);
select productivity indicators of, 181
(p.359) Committee on Financial Inclusion, 183
Committee on Financial Sector Reforms, 171, 183, 193
Page 3 of 15
Index
Committee on the Working of Monetary System, 41

Commonwealth Grants Commission, Australia, 252
constant returns to scale (CRS) technology, 286
controlled expansion of monetary policy, strategy of, 127
corporate debt equity ratios, 38
corporate financing, 40
corporate transparency, Anglo-Saxon institutions of, 40
counter cyclical fiscal tactics, 215
credit cards: general, 191;
kisan, 191
credit controls, selective, 124
credit–deposit (C–D) ratio, 127
credit market, 118, 216, 296
‘crowding-in’ phenomenon, 224
currency: base exchange rate, 17;
devaluation of the rupee, 129;
exchange rate of, see exchange rate of currency;
real balance effect, 4
current account deficit, 3–4, 6, 10, 12, 14, 16–19, 22–3, 38, 51, 60, 127, 214, 241
current daily status (CDS), 316;
unemployment rate on, 320
current weekly status (CWS), 320
Customer Service Points (CSPs), 191
de Carvalho, Fernando J. Cardim, 33–4
debt accumulation, 168
Debt Consolidation and Relief (DCRF), 262
debt-financed recession, 14, 17, 20, 23;
fiscal responsibility and, 10–12
debt financing, 232, 235;
approaches of, 232;
Domar model of, 232–3;
expenditure, 232, 234;
manufacturing, 338
debt settlement, roles of money in, 111
debt sustainability: Domar condition for, 236;
equations for, 237;
fiscal deficit to GDP ratio for, 237
deficit financing, 125, 133, 235
‘de-industrializing’ exports, 7
demand for money, 79–80, 139, 218, 220, 222–3, 226, 230, 232;
income elasticity of, 135
demand management, 3, 8, 24–5
demand-pull inflation, 224, 232;
macroeconomic theory of, 225
developmental central banking, concept of, 126
Differential Rate of Interest (DRI) Scheme, 158
direct benefit transfers (DBTs), 198
Director General of Employment and Training (DGET), 335
Domar equation, 233
Page 4 of 15
Index
Domar model, of debt financing, 232–3

economic liberalization, strategy for, 192
economic policy of India, 20-point programme, 130
education: higher education, enrolment ratio in, 319;
school enrollment ratio, 317
Eisner, Robert, 229, 239
electronic trading, 55
employment: in agricultural sector, 287, 340;
casual wage employment programmes, 316;
Current Weekly Status (CWS), 304;
different types of, 305;
‘directly targeted programmes’ of, 309;
diversification of, 307;
elasticity of, 291, 330–5;
‘jobless’ growth and, 295, 350;
Lewis–Ranis–Fei growth–employment linkage, 285, 290;
measures of, 304;
non-agricultural, 312;
opportunities in (p.360) service sector, 295;
quality of, 321;
rural employment, growth of, 316, 319;
rural female employment, 320;
for rural females, 328;
for rural males, 328;
sectoral shares in, 283, 335–8;
sector-wise, 330;
self-employment, 316, 320, 325;
‘trickle down’ approach, 310;
for urban females, 329;
for urban males, 329;
Usual Principal and Subsidiary Status (UPSS), 304;
usual principal status (UPS), 304
entrepreneurial innovations, 285
equity–efficiency trade-off, notion of, 296
European Commission, 39
exchange rate of currency: appreciation of, 13, 18;
depreciation of, 4, 7, 22;
equilibrium, 20
Extended Fund Facility (EFF), 134
external commercial borrowings (ECB), 150
finance capital: globalization of, 24–6, 35–41;
and savings, 32–4;
State intervention in, 25
Finance Commission of India, 232, 249, 252
financial exclusion: amongst farm households, 190;
symptoms of, 186
financial inclusion: goals of, 191;
phases of, 197;
processes of, 189
Page 5 of 15
Index
financial institutions, government, 57

financial liberalization, 183;
impact on savings, 35;
and independence of finance from savings, 32–4;
process of, 29
financial reforms in India: assessment of, 55–8;
process of, 41–5
financial repression: definition of, 30;
in developing countries, 30;
theory of, 30–2
financial savings, through bank deposits, 130
Financial Sector Appellate Tribunal (FSAT), 198
Financial Sector Legislative Reforms Commission (FSLRC), 193
fiscal autonomy, definition of, 269
fiscal deficit, 8, 213–15, 241;
and crowding out, 216–24;
effect on interest rate, 215;
financed by market borrowing, 216;
fixed-pool-of-savings view of, 216;
and inflation, 224–32;
monetization of, 132;
reduction in, 63–5;
treasury view of, 216–17
fiscal equalization transfers: in Canada and Australia, 251–2;
categories of, 250–1;
definition of, 250;
expenditure provisioning and interstate comparison, 253–7;
issues and country experiences, 250–3;
principles of, 250, 274
fiscal imbalance: horizontal, 257, 264–72;
vertical, 257–64
fiscal–monetary nexus, 139, 140, 213
fiscal policy, macroeconomics of, 213
Fiscal Responsibility and Budget Management (FRBM) legislation, 215
Fiscal Responsibility Legislation (FRL), 11–12, 14–16, 18, 262
fiscal transfer in India: Gadgil formula for, 249;
institutional mechanism of, 248;
intergovernmental, 250
floor rate, 17, 174
forced savings, phenomenon of, 4, 214
foreign direct investment (FDI), 11, 14, 18–19, 45
foreign exchange (Forex), 36;
accumulation of, 48;
Central Bank’s intervention in, 18;
domestic currency price of, 15;
liquidity of, 150;
monetary policy and, 146–9;
social cost of, 38;
supply of, 20
Page 6 of 15
Index
foreign institutional investors, 30, 45

(p.361) foreign trade multiplier, idea of, 4–8, 23
Forward Markets Commission (FMC), 198
free capital mobility, 8
Friedmanian equilibrium, 89
Friedman, Milton, 87, 89, 219–20, 227–8, 232;
short-run Phillips curve (SRPC), 87
funding industry, institutional structure for, 55–8
Gandhi, Indira, 129
Generally Accepted Accounting Principles (GAAP), 178
General Theory of Employment, Interest and Money, The (1936), see Keynes, John
Maynard
George, Lloyd, 25
global financial crisis, impact on India, 149–50
global financial system, 54
government borrowing, sustainability of, 233
government expenditure: debt-financed, 234;
Keynes–Kahn multiplier analysis of, 213
government finances, solvency criterion of, 232
government-owned PSBs, definition of, 182
government securities, 124;
demand for, 65;
interest rate on, 62–3;
issuance of, 131
graded lending rates, 127
Great Depression (1929), 76
Greece, financial crisis in, 39
gross national product (GNP), 36
Gupta, S.B.: Debate on Monetary Policy Analysis during the 1970s, 132
held for trading (HFT), 178
held to maturity (HTM), 178
higher education, enrolment ratio in, 319
housing bubble, in USA, 22
human capital, 297, 346;
investment, 296–7
IDFC, 196
Imperial Bank of India, 152, 154
Imperial Bank of India Act (1934), 152
income: agricultural, 295;
compound multiplier, 238;
growth rate versus initial per capita state income, 267;
inflation, 231;
real per capita income, 265–6;
super multiplier, 238
income-tax payers, deposit scheme for, 134
increasing returns to scale (IRS) technology, 286
Index of Industrial Production (IIP), 337
Indian banking system, 45, 54, 153, 169, 172
Indian Companies Act (1913), 152
Page 7 of 15
Index
Indian Companies (Amendment) Act (1936), 152

Indian economy: 20-point programme, 130;
current travails of, 22–4;
governed by foreign trade multiplier, 24;
growing financialization of, 165;
‘jobless growth,’ 350;
liberalization of, 23;
savings behaviour of, 166
Indian economy, performance of, 313
Indian Financial Code, 198
indirect finance, concept of, 44
industrial development, 311, 338
Industrial Development Bank of India (IDBI), 45, 129
industrial finance, sources of, 168
industrial investment, 168
industrial stagnation, in India, 289
inflation, 108;
concept of, 231;
core inflation, 195;
demand-pull, 224–5;
employment–inflation trade-off, 226;
fiscal deficit and, 224–32;
(p.362) income, 231;
inflation targeting, 119, 193–5;
profit, 231;
wage, 226, 228
information and communications technology (ICT), 295
Insurance Regulatory and Development Authority (IRDA), 198
interest rate: on bank lending, 123;
on deposits, 123;
deregulation of, 171–5
Interim LAF (ILAF), 142
International Clearing Union, 4
International Monetary Fund (IMF), 4, 39, 134, 232, 313
inter-sectoral linkages: evidence from India, 289–93;
implications of, 295–7;
Lewis–Ranis–Fei growth–employment linkage, 285, 290;
Murphy, Shleifer, and Vishny model (MSV) of, 286;
theory of, 284–9
Investment–Savings/Monetary–Policy (IS/MP) model, 219
Jan-Dhan Yojana, 197–8
‘jobless’ growth, 295, 350
job opportunities, 298, 315
job security, 347, 350
joint-stock banks, 152
Kahn, Richard, 217, 220
Kaldor, Nicholas, 5–7, 106, 129, 238;
Scourge of Monetarism, The (1986), 90
Kalecki, Michal, 3, 94–6, 101–2, 242, 285, 287, 291
Page 8 of 15
Index
Keynes, John Maynard, 3–4, 25, 94;

general theory and monetary policy, 76–81;
General Theory of Employment, Interest and Money, The (1936), 76, 80–1, 110;
Treatise on Money, The (1930), 33
Keynes–Kahn multiplier, 213, 217, 225, 229, 237
kisan credit cards, 191
labour force participation rate (LFPR), 314–15;
in rural areas, 315;
in urban areas, 315
labour in India, condition of, 350
labour market: characteristics of, 346–7;
employment elasticity and labour productivity, 330–5;
indicators of, 344–7;
labour force participation rate (LFPR), 314–15;
labour’s bargaining power, 347–9;
major challenges, 314–49;
overview of, 308–13;
persistent informality and, 325–30;
and status of employment, 322–5;
trends in wages and, 338–43;
unemployment scenario, 320–2;
worker–population ratio (WPR), 315–20
labour productivity, 333;
in agricultural sector, 285;
employment elasticity and, 330–5;
in manufacturing sector, 342–3
labour’s bargaining power, 347–9
labour supply curve, 226, 232
land reforms, importance of, 308
Lehman Brothers, 144, 149
lending rate structure in India, evolution of, 174
Lewis–Ranis–Fei growth–employment linkage, 285, 290
licensing, of new banks, 195–6
liquidity adjustment facility (LAF), 124–5, 142–3
loan accounts, ‘no-frills,’ 191
loan portfolio, 169, 176
loan pricing, base rate system for, 171
London Interbank Offered Rate (LIBOR), 45
long-run Phillips curve (LRPC), 87
Lucas, Robert, 89–92, 95, 226
Maastricht Treaty of the European Union (1992), 39, 215
(p.363) Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA),
317, 322, 350
Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS), 249;
implementation of, 339
mainstream macroeconomic consensus: criticisms of, 94;
with endogenous money, 90–4;
with exogenous money, 82–90;
IS-LM-PC model, 82–3, 87, 94;
Page 9 of 15
Index
LM curve, 83;
Monetarists’ Phillips Curve, 87–8;
New Classical Phillips Curve, 89–90;
New Keynesian model for, 90
marginal efficiency of investment (MEI), 76–7, 80
Marginal Standing Facility (MSF), 143
marked to market (MTM) investment portfolio, 178
market stabilization scheme (MSS), 52, 125, 147, 148
mark-up pricing, 6
microcredits, 191
monetary macroeconomics, heterodox approach to, 94–106;
capital accumulation and, 96;
cost-determined and demand-determined prices, 105–6;
cost-determined manufacturing prices, 102–4;
demand-determined primary commodities prices, 104–5;
formulation of, 95–9;
Phillips Curve and, 100–6
Monetary Policy Committee (MPC), 195
monetary policy, in closed economy: effectiveness of, 87, 94, 107–10;
mainstream macroeconomic consensus, 82–94;
objectives of, 75;
output stability of, 107;
for price stability, 108–10;
stagflationary, 109
monetary policy, in India: during the 1970s, see Gupta, S.B.;
actuals versus indicative projections of, 151;
cash reserve ratio (CRR), 143–4;
decision-making, 136;
deposit and lending rates, 144–5;
evolution of, 120–1;
forex inflows and, 146–9;
formulation and conduct of, 131;
impact of global financial crisis and, 149–50;
monetary policy instruments, 121–5;
monetary targeting with feedback (1986–97), 134–40;
multiple indicators approach (1998–2011), 140–50;
operating procedure–LAF operations, 142–3;
performance of, 150;
period of controlled expansion (1950–68), 125–8;
recent developments in, 193–5;
structuralist phase of, 128–34
monetary policy, in peripheral economy, 106–7;
central bank’s, 106;
effectiveness of, 107–10;
operability of, 106;
output stability of, 107;
for price stability, 108–10;
stagflationary, 109;
Taylor rule, 106
Page 10 of 15
Index
monetary policy instruments, 121–5;

bank rate, 122–3;
evolving usage of, 126;
interest rate on bank lending, 123;
interest rate on deposits, 123;
market stabilization scheme (MSS), 125;
movements in, 175;
open market operations (OMOs), 124;
quantum and cost of refinance, 123;
repo and reverse repo, 124–5;
reserve requirements, 121–2;
selective credit controls, 124;
statutory liquidity ratio, 122
monetary targeting: with feedback, 134–9;
fiscal–monetary nexus, 139, 140;
Indian experience of, 136;
monetary policy measures and, 140;
operational validity of, 135;
performance of, 137–8
monetization, process of, 222
money, 234;
aggregate demand for, 220;
circulation of, 220;
debt (p.364) settlement, role in, 111;
demand and supply of, 9, 79
money multiplier, concept of, 136
money supply, 218–19, 223;
analysis of, 132;
price effect of, 136;
theory of, 221
multinational corporations (MNCs), 19
Mundell–Fleming model, of capital flows, 8–10, 13, 223
Narasimham Committee on Banking Reforms (1991), 171;
recommendations of, 43–4, 142, 172, 176
National Commission for Enterprises in the Unorganised Sector (NCEUS), 189, 325,
328, 344
National Credit Council (NCC), 157
National Rural Health Mission (NRHM), 249
National Sample Survey (NSS), 306
National Stock Exchange, 55
natural rate of unemployment (NRU), 225, 227–8
‘Nehru-Mahalanobis strategy of development,’ 309
net bank credit, 43–4, 133–4, 139
net demand and time liabilities (NDTL), 132–3
net financial inflow, 11–12, 17
net state domestic product (NSDP), 264
New Keynesian Phillips Curve (NKPC), 91–2, 100
non-banking financial companies (NBFCs), 44, 58, 149–50, 170
non-performing assets (NPAs), 46, 54, 176–7
Page 11 of 15
Index
non-resident Indians (NRIs), 45, 150

oil price shock of 1970s, 25, 215
oligopoly, 102, 107
open market operations (OMOs), 124, 222
Paper Currency Act (1861), 152
penal rates, 127
Pendharkar, V.G., 130
pension, 197, 253, 255–6
petro-dollars, 25
Phelps, Edmund, 227
Phillips, A.W., 226–7; see also Phillips curve
Phillips curve, 84, 95, 100–6, 226, 228;
Friedman’s short-run Phillips curve (SRPC), 87;
horizontal, 106, 108;
long-run Phillips curve (LRPC), 87;
Monetarists’, 87–8;
New Classical, 89–90;
of the New Keynesian framework, 91;
for peripheral countries, 105
Pigou effect, see real balance effect
Planning Commission, 125, 248–9, 269, 306, 346
political inflationary barrier, 7, 15
poverty: eradication, 167–8, 192;
reduction, 296, 308
Presidency Bank Acts, 152
Presidency Bank of Bengal, 152
price–equity ratio, 55
price instability, sources of, 131
price stability, 128, 135;
monetary policy for, 108–10
primary commodities: demand and supply of, 104;
inflation in, 104;
prices, demand-determined, 104–5
prime lending rates (PLRs), 44, 123, 145, 174, 224
Prime Term Lending Rates (PTLRs), 174
priority sector lending, concept of, 44
private investment, crowding-out effect on, 215, 230
privileged borrower, 216
profit inflation, 4, 231
property rights, protection of, 41
public debt, 215;
debt–GDP ratio, 232, 235;
sustainability of, 232–41
public investment, 224, 309, 347, 349
(p.365) public ownership in banks, notion of, 180–2
public sector banks (PSBs), 158;
divested, 182;
government-owned, 182
purchasing power of people, 225, 232
Page 12 of 15
Index
quota-slab system, 127

Radcliffe Committee, 118, 219–20
Rajan, Raghuram, 193
ratchet effect, 15
real balance effect, 4, 85–7, 112n11
recession, debt-financed: see debt-financed recession
regional rural bank (RRB), 158–9, 172, 191
Report of the Central Banking Enquiry Committee (1931), 152
repurchase agreement (repo), 124
Reserve Bank of India (RBI), 19, 21, 30, 41, 104, 121, 129, 154, 193, 222;
anti-inflation measures, 131;
Forex holdings, 52;
government borrowings from, 43;
long-term operation funds, 57;
monetary policy operations, 128, 142;
money supply analysis, 132;
repo/reverse repo operations, 124–5, 143;
Supplemental Agreement, 139;
‘tightness fatigue,’ 130
Reserve Bank of India Act (1935), 154, 170
reserve–deposit ratio, 62;
reduction in, 66
reserve money, 13, 21, 38, 41–2, 48–9, 52, 129, 132, 135–6, 139, 229
resource flows to states, composition of, 263
revenue equalization, principle of, 252
Ricardian equivalence theorem, 232, 234
risk management systems, 58, 175, 183
Robinson, Joan, 94, 218, 220
RuPay Debit Card, 197–8
rupee, devaluation of, 129
Rural Banking Enquiry Committee (1950), 154
rural development, schemes for, 311
rural employment, growth of, 319
Sarva Shiksha Abhiyan (SSA), 249
savings: impact of financial liberalization on, 35;
independence of finance from, 32–4;
relation with interest rate, 34–5;
through bank deposits, 130
Sayers, R.S., 33
scheduled commercial banks (SCBs), 132, 152, 154–7;
distribution of advances of, 162;
distribution of offices of, 161;
indicators of banking penetration of, 186
school enrollment ratio, 317
Scourge of Monetarism, The (1986), see Kaldor, Nicholas
Second National Labour Commission (SNCL), 347–8
Securities and Exchange Board of India (SEBI), 55, 198
self-employment, 316, 320, 325, 340, 344
self-help groups (SHGs), 191
Page 13 of 15
Index
Small Industrial Development Bank of India (SIDBI), 45

small-scale industry (SSI), 45, 159–60, 189, 311
Social Accounting Matrix (SAM), 290, 292
social learning, 285
sound finance, principle of, 25, 215, 242
specialized banks, creation of, 196
stagflation, 104, 110
State Bank of India (SBI), 152
state-level banking committees (SLBCs), 198
statutory liquidity ratio (SLR), 43–4, 121–2, 222
stock markets: development of, 40, 55–8;
expansion of, 55
(p.366) strategic entrepreneur, role of, 309
Subbarao, D., 191, 193
tax: collection of, 213;
devolution, 252;
direct and indirect, 272;
value added, 272
Taylor rule, 91, 106, 229–30
Tenor-linked Prime Lending Rates (TPLRs), 174
total factor productivity, 168
trade deficit, 36–7;
non-zero, 60;
zero, 60–1
treasury bills, 131, 139, 144, 148, 170
treasury, solvency of, 232
Treatise on Money, The (1930), see Keynes, John Maynard
unemployment, 320–2;
age-group-wise, 323;
and inflation, 226;
measures of, 304;
natural rate of, 227–8;
in urban areas, 321
Unit Trust of India (UTI), 129
Urjit Patel Committee Report, 194
US Federal Reserve Board, 117
Usha Thorat Committee on Lead Bank Scheme, 189
value added tax, 272
Vickery, William, 240
wage–goods constraint, 289, 295
wages: inflation, 226, 228;
for regular and casual workers, 339;
trends in, 338–43;
for unskilled workers, 310
Wal-Mart, 19
Washington Consensus (1989), 215
worker–population ratio (WPR), 315–20;
Page 14 of 15
Index
in urban areas, 316;

in various age groups, 318
World Bank, 232, 313
world capitalist economy, 23–4
Page 15 of 15
About the Editor and Contributors

Prabhat Patnaik

Print ISBN-13: 9780199458950
DOI: 10.1093/acprof:oso/9780199458950.001.0001
(p.367) About the Editor and Contributors

Editor
Prabhat Patnaik
is Emeritus Professor at the Centre for Economic Studies and
Planning (CESP), Jawaharlal Nehru University, New Delhi. He was
previously the Sukhamoy Chakravarty Chair at the CESP. His areas of
interest are macroeconomics and political economy. His books include
Accumulation and Stability under Capitalism (1997), The Value of
Money (2009), and Re-envisioning Socialism (2011).
Contributors
Rohit Azad
is Assistant Professor at the Centre for Economic Studies and
Planning (CESP), Jawaharlal Nehru University, New Delhi. His
research interests include monetary theory and policy with a special
focus on the developing countries, and the growth trajectory of
countries like India and China. He has authored It’s Not Over:
Structural Drivers of the Global Economic Crisis (2013).
Pinaki Chakraborty
is Professor at the National Institute of Public Finance and Policy,
New Delhi, and an Honorary Research Scholar at Levy Economics
Institute, New York. He was the Economic Adviser to the Fourteenth
Finance Commission of India. He has worked in the areas of fiscal
federalism, tax policy and resource mobilization, applied
macroeconomics, public expenditure management, decentralization,
and gender and fiscal policy.
(p.368) Surajit Das
is Assistant Professor at the Centre for Economic Studies and
Planning (CESP), Jawaharlal Nehru University, New Delhi. He has
also taught at the Ambedkar University, New Delhi, and worked as an
Page 1 of 3
economist at the National Institute of Public Finance and Policy

(NIPFP), New Delhi. He has been a consultant to the Kerala State
Planning Board, as well as the Planning Commission of India.
Mausumi Das
is Associate Professor of Economics at the Delhi School of Economics,
University of Delhi. She has also taught at the Jawaharlal Nehru
University and the Indian Statistical Institute, New Delhi. Her areas
of interest are macroeconomics and economic growth and
development. She has published research articles in several
international journals like Journal of Economic Growth and Journal of
Development Economics. She is an associate editor of Indian Growth
and Development Review.
Praveen Jha
is Professor of Economics at the Centre for Economic Studies and
Planning (CESP), Jawaharlal Nehru University, New Delhi. He has
also been an Honorary Visiting Professor at Rhodes University, South
Africa, and at the African Institute for Agrarian Studies, Zimbabwe.
He is an editor of the journal Agrarian South: Journal of Political
Economy. His areas of research and teaching include development
economics and political economy.
Vineet Kohli
is with the Tata Institute of Social Sciences, Mumbai. He teaches
courses on macroeconomics, development economics, and the Indian
economy in the development studies programme of the institute. His
research interests include contemporary Indian economy, banking
and financial issues in less-developed countries, and heterodox
macroeconomics.
Partha Ray
is Professor of Economics at the Indian Institute of Management
Calcutta. Earlier, he worked as an Adviser to the Executive Director
(India) at the International Monetary Fund, Washington, DC, and as a
Director of Economic and Policy Research at the Reserve Bank of
India, Mumbai. His recent publications include Monetary Policy
(2013) and Financial and Fiscal Policies: Crises and New Reality, co-
authored with Y.V. Reddy and N. Valluri (2014).
(p.369) C. Saratchand
is Assistant Professor, Department of Economics at the Satyawati
College, University of Delhi. His research interests include growth
theory and the macroeconomics of centrally planned economies.
S.L. Shetty
served at the Reserve Bank of India for about 24 years and retired as
adviser in charge of its Department of Economic Analysis and Policy.
Subsequently, he served as Founder Director of EPW Research
Foundation for 17 years and now he continues to be an adviser there.
Page 2 of 3
Amongst many of his research studies, the latest ones are

Microfinance in India (2012) and Agricultural Credit in India: Trends,
Regional Spreads and Database Issues (2014).
Page 3 of 3

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Title Pages

Economics: Volume 3: Macroeconomics

Print publication date: 2015

(p.iii) ICSSR Research Surveys and Explorations

Oxford University Press is a department of the University of Oxford.

© Indian Council of Social Science Research 2015

The moral rights of the authors have been asserted

First Edition published in 2015

All rights reserved. No part of this publication may be reproduced,

You must not circulate this work in any other form

Typeset in Minion Pro 10.5/12.7

Economics: Volume 3: Macroeconomics

Print publication date: 2015

(p.vii) Tables, Figures, and Boxes

4.21 Extent of Financial Exclusion amongst Farm Households: Region-

8.20 Poverty Ratios among Non-agricultural Workers by Nature of

5.2 Movement of Prime Lending Rate Bank/Repo Rate in India: 1993–4 to

Economics: Volume 3: Macroeconomics

Print publication date: 2015

Economics: Volume 3: Macroeconomics

Print publication date: 2015

Prabhat Patnaik (p.xviii)

Economics: Volume 3: Macroeconomics

Print publication date: 2015

Open Economy Macroeconomics and the

Abstract and Keywords

John Maynard Keynes had advocated State intervention in demand management

Foreign Trade Multiplier

The problem, however, assumed an entirely different magnitude once imported

This argument put forward by Nicholas Kaldor (1978a) can be explained as

from which we get

A real effective exchange rate depreciation means an increase in pf/p, which is

However, there is a problem with this vision of international harmony. It ignores

But while Kaldor’s specific use of it in the international context as a description

To see this, let us take the two relations,

which is the internationally prevailing interest rate.

where N(.) represents net exports.

which is a standard Keynesian description of money market equilibrium.

In both the cases considered by Mundell–Fleming, it should be noted that

The Mundell–Fleming model, however, was flawed because it had a peculiar

Now, if we introduce the autonomy of cross-border capital flows and an equation

Fiscal Responsibility and Debt-financed Recession

(p.12) The reason is simple. An increase in net financial inflow, since it is

Let us consider investment first, which, in accordance with simple Keynesian

Investment, let us remind ourselves, is not assumed to be constrained by any

However, this argument too is far-fetched. A nominal exchange rate appreciation

A More Comprehensive Discussion

(p.15) In the previous section we talked of an exchange rate appreciation

It follows from these floors that there is a minimum non-inflationary exchange

Let us denote the domestic currency price of foreign exchange, corresponding to

Central Bank’s Accumulation of Exchange Reserves

Equations 1, 2, 3, 5′, 6′, and 7′ together determine the six variables,

Government expenditure in this latter case is reduced to a level below (t + d)Y,

The basic point here is of asymmetry: while finance comes into an

Current Travails of the Indian Economy on the External Front

government expenditures to rein in the fiscal deficit, while it may be attractive

In any case, what is likely in the coming months is a combination of some

Here too there is an intermeshing of factors since peasant agriculture-based

Finance Capital and Globalization

The opposition of finance capital to State intervention in demand management,

globalization of finance to the agenda of intervention by the nation state in

Ghosh, J. and C.P. Chandrasekhar. 2001. Crisis as Conquest. Delhi: Orient

Kaldor, N. 1978a. ‘What is Wrong with Economic Theory?’ in N. Kaldor (ed.),