Eco Marathon Notes by Ca Nitin Guru

EDU91 | Where Learning Happens BY CA NITIN GURU
CHAPTER 1: UNIT-I: NATIONAL INCOME ACCOUNTING
Question 1:
Define National Income.
Answer:
➢ National Income is defined as the net value of
• all economic goods and services produced
• within the domestic territory of a country
• in an Accounting Year
• plus the Net Factor Income from Abroad (NFYA).
Question 2:
Explain the usefulness and significance of National Income estimates.
Answer:
National income accounts are extremely useful, for following:
(i) Evaluating the Short-Run Performance:
• Provide a comprehensive, conceptual and accounting framework for analyzing and evaluating the
short-run performance of an economy.
• The level of national income indicates the level of economic activity and economic development.
(ii) Determines Present and Future Demand:

• The distribution pattern of National Income determines the pattern of demand for goods and
services, and
• Enables businesses to forecast the future demand for their products.
(iii) Measure of Economic Welfare

• Economic welfare demand on the magnitude and distribution of national income, size of per capita
income and the growth of these over time.
(iv) Possible to Make Temporal and Spatial Comparisons:

• National Income shows the composition and structure of national income in terms of different
sectors of the economy, the periodical variations in them and the broad sectoral shifts in an
economy over time.
• The governments can fix various sector-specific development targets for different sectors.
(v) Evaluation of governments’ Economic Policies:

• National income statistics also provide a quantitative basis for macroeconomic modeling and
analysis.
• These figures often influence popular and political judgments about the relative success of
economic programmes.
To get the best out of these notes visit www.edu91.org

Join Us on YouTube www.youtube.com/neerajarora
Join Us on Telegram https://t.me/neerajaroraclasses
(vi) Study of Inequality:

• National income estimates throw light on income distribution and the possible inequality in the
distribution among different categories of income earners.
(vii) International Comparisons:

• International comparisons in respect of incomes and living standards assist in determining
eligibility for loans, and/or other funds or conditions on which such loans, and/or funds are
made available.
(viii) Economic Forecasting:

• National income or a relevant component of it is an indispensable variable considered in
economic forecasting and to make projections about the future development trends of the
economy.
Question 3:
What is UN System of National Accounts (SNA)?
Answer:
UN System of National Accounts (SNA) developed by United Nations to provide a comprehensive conceptual
and accounting framework for compiling and reporting macroeconomic statistics for analyzing and evaluating the
performance of an economy.
Question 4:
Explain three sides of NIA.
Answer:
National income accounts have three sides: a product side, an expenditure side and an income side:
(i) Product Side:

The product side measures production based on concept of value added.
(ii) Expenditure Side:

The expenditure side looks at the final sales of goods and services.
(iii) Income Side:

The income side measures the distribution of the proceeds from sales to different factors of production.
National income is the sum total of all the incomes accruing over a specified period to the residents of a
country and consists of wages, salaries, profits, rent and interest.

➢ Important Points:
(i) Only Final Goods and Services:

• The value of only final goods and services or only the value added by the production process
would be included in GDP.
• By ‘value added’ we mean the difference between value of output and purchase of intermediate
goods.
(ii) Intermediate Consumption:

• Intermediate consumption consists of the value of the goods and services consumed as inputs
by a process of production, excluding fixed assets whose consumption is recorded as
consumption of fixed capital.
• Intermediate goods used to produce other goods rather than being sold to final purchasers are
not counted as it would involve double counting.
• The intermediate goods or services may be either transformed or used up by the production
process.
(iii) Economic Activities:

• Economic Activities and Non-Economic Activities include all human activities which create goods
and services that are exchanged in a market and valued at market price.
• Non-economic activities are those which produce goods and services, but since these are not
exchanged in a market transaction they do not command any market value; for e.g. hobbies,
housekeeping and child rearing services of home makers and services of family members that
are done out of love and affection.
(iv) ‘Flow’ Concept:

• National income is a ‘flow’ measure of output per time period—for example, per year—and
includes only those goods and services produced in the current period.
• The value of market transactions such as exchange of goods which already exist or are
previously produced, do not enter into the calculation of national income.
• The value of assets such as stocks and bonds which are exchanged during the pertinent period
are not included in national income.
• However, the value of services that accompany the sale and purchase (e.g. fees paid to real
estate agents and lawyers) represent current production and, therefore, is included in national
income.
(v) Inventory Investment:

• The net change in inventories of final goods awaiting sale or of materials used in the
production which may be positive or negative.
• Additions to inventory stocks of final goods and materials belong to GDP because they are
currently produced output.

Question 5:
Explain Gross National Product (GNP).
Answer:
• Gross National Product (GNP) is a measure of the market value of all final economic goods and services,
gross of depreciation, produced within the domestic territory of a country by normal residents during
an accounting year including net factor incomes from abroad.
• Gross National Product (GNP) is evaluated at market prices.
GNPMP = GDPMP + Net Factor Income from Abroad
GDPMP = GNPMP – Net Factor Income from Abroad
• Note:
NFIA is the difference between the aggregate amount that a country's citizens and companies earn
abroad, and the aggregate amount that foreign citizens and overseas companies earn in that country.
• If Net Factor Income from Abroad is positive, then GNPMP would be greater than GDPMP.
National = Domestic + Net Factor Income from Abroad
Question 6:
Explain Net Domestic Product at market prices (NDPMP).
Answer:

Net domestic product at market prices (NDP MP) is a measure of the market value of all final economic goods
and services, produced within the domestic territory of a country by its normal residents and non residents
during an accounting year less depreciation.
NDPMP = GDPMP –Depreciation
NDPMP = NNPMP – Net Factor Income from Abroad
Gross = Net + Depreciation

OR
Net = Gross – Depreciation
Question 7:
Explain Net National Product at Market Prices (NNPMP).
Answer:
Net National Product at Market Prices (NNP MP) is a measure of the market value of all final economic goods
and services, produced by normal residents within the domestic territory of a country including Net Factor
Income from Abroad during an accounting year excluding depreciation.
NNPMP = GNPMP – Depreciation

NNPMP = NDPMP + Net Factor Income from Abroad
NNPMP = GDPMP + Net Factor Income from Abroad – Depreciation
Question 8:
Explain Net Indirect Tax.
Answer:
➢ Indirect Taxes:

The market value of the goods and services will include indirect taxes which are:
• Product Taxes:
Product taxes like excise duties, customs, sales tax, service tax etc., levied by the government on
goods and services, and
• Taxes on Production:
Taxes on production, such as, factory license fee, taxes to be paid to the local authorities, pollution
tax etc. which are unrelated to the quantum of production.
➢ Subsidy:
• The government gives subsidy to many goods and services. The market price will be lower by the
amount of subsidies on products and production which the government pays to the producer.
• For example if the factor cost of a unit of good X is Rs.50/, indirect taxes amount to ` 15/per
unit and the government gives a subsidy of ` 10/per unit, then market price will be Rs.55/-
Market Price = Factor Cost + Net Indirect Taxes

= Factor Cost + Indirect Taxes – Subsidies
Factor Cost = Market Price – Net Indirect Taxes

= Market Price – Indirect Taxes + Subsidies
Question 9:
Explain Per Capita Income.
Answer:
• The GDP per capita is a measure of a country's economic output per person.
• It is obtained by dividing the country’s gross domestic product, adjusted by inflation, by the total
population. It serves as an indicator of the standard of living of a country.

Question 10:
Explain Measurement of National Income in India.
Answer:
• National Accounts Statistics (NAS) in India are compiled by National Accounts Division in the Central
Statistics Office, Ministry of Statistics and Programme Implementation.
• Annual as well as quarterly estimates are published.
• As per the mandate of the Fiscal Responsibility and Budget Management Act 2003, the Ministry of
Finance uses the GDP numbers (at current prices) to determine the fiscal targets.
• Now, the base year has revised from 2004-05 to 2011-12.
Question 11:
Explain the Circular Flow of Income.
Answer:
Circular flow of income refers to the continuous circulation of production, income generation and expenditure
involving different sectors of the economy.
There are three different interlinked phases in a circular flow of income, namely: production, distribution and
disposition as can be seen from the following figure:
Circular Flow of Income
Production of Goods
and Services
Disposition Distribution as factor

Consumption/ incomes (rent, wages,
Investment interest, profit)
➢ Production Phase:
In the production phase, firms produce goods and services with the help of factor services.
➢ Income/ Distribution Phase:

In the income or distribution phase, the flow of factor incomes in the form of rent, wages, interest
and profits from firms to the households occurs.
➢ Expenditure/ Disposition Phase:

In the expenditure or disposition phase, the income received by different factors of production is spent
on consumption goods and services and investment goods.
Question 12:
Explain the Value Added Method or Product Method.
Answer:
• also called Industrial Origin Method or Net Output Method.
• National income by value added method is the sum total of net value added at factor cost across all
producing units of the economy.
• measures the contribution of each producing enterprise in the domestic territory of the country in an
accounting year
• shows the unduplicated contribution by each industry to the total output
Step 1:
• Identifying the producing enterprises and classifying them into different sectors according to the nature
of their activities
• three main sectors namely:
(i) Primary sector,
(ii) Secondary sector, and
(iii) Tertiary sector or service sector
Step 2:
Estimating the gross value added (GVA MP) by each producing enterprise
Gross value added (GVA MP) = Value of output – Intermediate consumption

= (Sales + change in stock) – Intermediate consumption
Step 3:
Estimation of National income
∑ (GVA MP) – Depreciation = Net value added (NVA MP)

• Adding the net value-added by all the units in one sub-sector, we get the net value added by the sub-
sector.
• We subtract net indirect taxes and add net factor income from abroad to get national income.
Net value added (NVA MP) – Net Indirect taxes = Net Domestic Product (NVA FC)
Net Domestic Product (NVA FC) + (NFIA) = National Income (NNP FC)
➢ Note:
The values of the following items are also included:
(i) Own account production of fixed assets by government, enterprises and households.
(ii) Production for self- consumption, and
(iii) Imputed rent of owner occupied houses.
Question 13:
Explain Income Method.
Answer:
• Under Factor Income Method, also called Factor Payment Method or Distributed Share Method, national
income is calculated by summation of factor incomes paid out by all production units within the domestic
territory of a country as wages and salaries, rent, interest, and profit.
• It includes factor payments to both residents and non- residents.
• Thus,
NDP FC = Sum of factor incomes paid out by all production units within the domestic territory of a
Country
NNP FC or National Income = Compensation of employees + Operating Surplus (rent + interest+

profit) + Mixed Income of Self- employed + Net Factor Income from Abroad
➢ Note:
• Only incomes earned by owners of primary factors of production are included in national income.
• Transfer incomes are excluded from national income.

• Labour income includes, apart from wages and salaries, bonus, commission, employers’ contribution to
provident fund and compensations in kind.
• Normally, it is difficult to separate labour income from capital income because in many instances people
provide both labour and capital services.
Question 14:
Explain Expenditure Method.
Answer:
In the expenditure approach, also called Income Disposal Approach, national income is the aggregate final
expenditure in an economy during an accounting year. In the expenditure approach to measuring GDP, we add
up the value of the goods and services purchased by each type of final user mentioned below.
1. Final Expenditure Method
a) Private Final Consumption Expenditure (PFCE):

• The volume of final sales of goods and services to consumer households and nonprofit
institutions serving households acquired for consumption (not for use in production) are
multiplied by market prices.
b) Government Final Consumption Expenditure (GFCE):

• Since the collective services provided by the governments such as defense, education,
healthcare etc. are not sold in the market, the only way they can be valued in money
terms is by adding up the money spent by the government in the production of these
services.
• This total expenditure is treated as consumption expenditure of the government.
2. Gross Domestic Capital Formation

• Gross domestic fixed capital formation includes final expenditure on machinery and equipment and
own account production of machinery and equipments, expenditure on construction, expenditure on
changes in inventories, and expenditure on the acquisition of valuables such as, jewelry and works
of art.
3. Net Exports
• Net exports are the difference between exports and imports of a country during the accounting year.
It can be positive or negative.
Step 1:

We first find the sum of final consumption expenditure, gross domestic capital formation and net
exports. The resulting figure is gross domestic product at market price (GDP MP).
Step 2:
We add the net factor income from abroad and obtain Gross National Product at market price (GNP MP).
Step 3:
Subtracting indirect taxes from GNPMP, we get Gross National Product at factor cost (GNPFC).
Step 4:
National income or NNP FC is obtained by subtracting depreciation from Gross national product at
factor cost (GNPFC).
Question 15:
Explain the system of regional accounts in India.
Answer:
The system is as explained below:
• Regional accounts provide an integrated database on the innumerable transactions taking place in the
regional economy and help decision making at the regional level.
• All the states and union territories of India compute state income estimates and district level estimates.
State income or Net State Domestic Product (NSDP) is a measure n monetary terms of the volume of
all goods and services produced in the state within a given period of time.
• Per Capital State Income is obtained by dividing the NSDP (State Income) by the midyear projected
population of the state.
• The state level estimates are prepared by the State Income Units of the respective State Directorates
of Economics and Statistics (DESs).
Question 16:
What are Supra-regional sectors?
Answer:
The Supra-regional sectors are explained as below:
• Certain activities such as railways, communications, banking and insurance and central government
administration, that cut across state boundaries, and thus their economic contribution cannot be
assigned to any one state directly and are known as the 'Supra-regional sectors' of the economy.
• The estimates for these supra regional activities are compiled for the economy as a whole and allocated
to the states on the basis of relevant indicators.

Question 17:
Explain the limitations and challenges of National Income computation.
Answer:
The limitations are explained as below:
GDP measures ignores the following -
a) Inadequate measure of welfare - Countries may have significantly different income distributions and,
consequently, different levels of overall well-being for the same level of per capital income.
b) Ignores Qualitative data - Quality improvements in systems and processes due to technological as well
as managerial innovations which reflect true growth in output from year to year.
c) Doesn't count hidden transactions - Productions hidden from government authorities, either because
those engaged in it are evading taxes or because it is illegal (drugs, gambling etc).
d) Doesn't count non - market production - Nonmarket production and Non-economic contributors to well-
being for example: health of a country’s citizens, education levels, political participation, or other social
and political factors that may significantly affect well-being levels are ignored.
e) Economic bads are not accounted for - Economic ’bads’ for example: crime, pollution, traffic congestion
etc which make us worse off are not considered in GDP.
f) Volunteer work excluded - The volunteer work and services rendered without remuneration undertaken
in the economy, even though such work can contribute to social well-being as much as paid work.
g) Things that contribute to economic welfare - Many things that contribute to our economic welfare such
as, leisure time, fairness, gender equality, security of community feeling etc.,
h) Better off or preventing worse off -
• The distinction between production that makes us better off and production that only prevents us from
becoming worse off, for e.g. defense expenditures such as on police protection.
• Increased expenditure on police due to increase in crimes may increase GDP but these expenses only
prevent us from becoming worse off.
• No reflection is made in national income of the negative impacts of higher crime rates.
Question 18:
Explain conceptual difficulties in measurement of GDP?
Answer:
There are many conceptual difficulties related to measurement which are difficult to resolve, such as:
a) lack of an agreed definition of national income,
b) accurate distinction between final goods and intermediate goods,
c) issue of transfer payments,
d) services of durable goods,
e) difficulty of incorporating distribution of income

f) valuation of a new good at constant prices, and

g) valuation of government services.
Question 19:
Differentiate between :
1. Factor Income and Transfer Income.
2. Final Goods and Intermediate Goods
3. Consumption Goods and Capital Goods
4. Domestic Income (NDPFC) and National Income (NNPFC)
5. Depreciation and capital loss
6. Personal Income and Private Income
7. Personal Income and National Income
Answer:
Factor Income and Transfer Income
Basis Factor Transfer Income
Meaning It refers to income received by It refers to income received without
factors of production for rendering rendering any productive service in
factor services in the production return.
process.
Nature It is included in both National It is neither included in National
Income and Domestic Income. Income nor in Domestic Income.
Concept It is an earning concept. It is a receipt concept.
Final Goods and Intermediate Goods

Basis Final Goods Intermediate Goods
Meaning Final goods refer to those goods Intermediate goods refer to those
which are used either for goods which are used either for
consumption or for investment. resale or for further production in
the same year.
Nature They are included in both national They are neither included in national
and domestic income. income nor in domestic income.
Value addition They are ready for use by their final They are not ready for use, i.e.
users i.e. no value has to be added some value has to be added to the
to the final goods intermediate goods.
Production boundary They have crossed the production They are still within the production
boundary. boundary.
Example Milk purchased by households for Milk used in dairy shop for resale,
consumption, car purchased as an coal used in factory for further
investment. production.
Consumption Goods and Capital Goods

Basis Consumption Goods Capital Goods

Satisfaction of human These goods satisfy human wants Such goods satisfy human wanted
wants directly. So, such goods have direct indirectly. So, such goods have
demand. derived demand.
Production capacity They do not promote production They help in raising production
capacity. capacity.
Expected life Most of the consumption goods Capital goods generally have an
(except durable goods) have limited expected life of more than one year.
expected life.
Domestic Income and National Income

Basis Domestic Income National Income
Nature of concept It is a territorial concept as it It is a national concept as it includes
includes the value of final goods and the value of final goods and services
services produced within domestic produced in the entire world.
territory of a country.
Category of Producers It considers all producers within the It considers all producers who are
domestic territory of the country. normal residents of the country.
NFIA It does not include NFIA It includes NFIA
Depreciation and Capital Loss

Basis Depreciation Capital Loss
Meaning It refers to fall in the value of fixed It refers to loss in value of the fixed
assets due to normal wear and tear, assets due to unforeseen
passage of time or expected obsolescence, natural calamities,
obsolescence. thefts, accidents, etc.
Provision for loss Provision is made for replacement of No such provision is made in case of
assets as it is an expected loss. capital loss as it is an unexpected
loss.
Production process It does not hamper the production It hampers the production process.
process.
Personal Income and Private Income

Basis Personal Income Private Income
Meaning It refers to income actually received It refers to the income which
by households from all sources. accrues to private sector from all
sources.
Concept It is a narrower concept as it is a It is a broader concept as it includes
part of private income. personal income.
Formula Personal Income = Private income - Private income = Personal income +
Corporate tax - Retained earnings Corporate tax + Retained earnings
Personal Income and National Income

Basis Personal Income Private Income

Meaning It is the sum total of all incomes
that are actually received by
households from all the sources.
Nature of Income It includes both factor incomes as It includes only the factor incomes.
well as transfer incomes.
Public sector income It does not include income earned by It includes income earned by public
public sector. sector.
Domestic Income (NDPFC)
Income from Domestic Product Income from Domestic Product

accruing to Private Sector accruing to Public Sector
Income from Property and

Savings of Non-Departmental
Entrepreneurship accruing to
Enterprises
Government Administrative
Question 20: Departments
What does private income refer to?
Answer:
Private income refers to the income which accrues to private sector from all the sources within and outside
the country.
Private Income includes:
Factor Income earned: Transfer Income received:
within Domestic from Rest of the

within Domestic from Rest of the
territory World (ROW)
territory World (ROW)

Income from
Join Us on YouTube www.youtube.com/neerajarora Interest on Net current
Domestic product National Debt + transfers from
accruing to private Current transfers ROW (d)
Net Factor Income

from Abroad (NFIA)
(b)
Private Income = a + b + c + d
GDPMP
Less: Depreciation
Less: Net Indirect Taxes
=
Domestic Income (NDPFC)
Less: Income from Property and Entrepreneurship accruing to Government Income from Domestic Product
Administrative Departments accruing to Public Sector
Less: Saving of Non-Departmental Enterprises
=
Income from Domestic Product accruing to Private Sector Factor income earned
Add: Net Factor Income from Abroad (NFIA)
Add: National Debt Interest Transfer income received
Add: Current transfers from Government
Add: Net current transfers from ROW
=
PRIVATE INCOME
Question 21:
What is the meaning of Personal Disposable Income?
Answer:
Personal Disposable Income (PDY) refers to that part of personal income which is actually available at the
disposal of households.
Personal Disposable Income = Personal Income - Personal Taxes - Miscellaneous receipts of government
NATIONAL INCOME

(+) income from property and entrepreneurship accruing (-) income from property and entrepreneurship accruing
to government administrative departments to government administrative departments
(+) savings of non - departmental enterprises (-) savings of non - departmental enterprises
(-) current transfers from government (+) current transfers from government
(-) national debt interest (+) national debt interest
(-) net current transfers from the rest of the world (+) net current transfers from the rest of the world
PRIVATE INCOME PRIVATE INCOME
(+) Corporate tax (-) Corporate tax

(+) Retained earnings (-) Retained earnings
PERSONAL INCOME PERSONAL INCOME
(+) Personal tax (-) Personal tax

(+) Misc. receipts of the (-) Misc. receipts of the
Government Government
PERSONAL DISPOSABLE INCOME
Question 22:
Explain National Disposable Income (Net and Gross).
Answer:
National Disposable Income (NDY) refers to the income which is available to the whole country for disposal.
National Disposable Income = National Income + Net indirect taxes + Net current transfers from rest of
the world
National Disposable Income (NDY) = National Consumption Expenditure + National Savings

Gross National Disposable Income

When depreciation is added to the net National Disposable Income, we get Gross National Disposable
Income.
Gross National Disposable Income = Net National Disposable Income + Depreciation
National Income
(+) Net Indirect Taxes
(+) Net Current Transfers from rest of the world
Net National Disposable Income
(+) Depreciation
Gross National Disposable Income
Question 23:
Give formulae for determination of Nominal GDP and Real GDP.
Answer:
The formulae are as follows:
Nominal GDP and Real GDP can be determined in the following manner:
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷
Real GDP = x 100
𝑷𝒓𝒊𝒄𝒆 𝑰𝒏𝒅𝒆𝒙
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 𝒙 𝑷𝒓𝒊𝒄𝒆 𝑰𝒏𝒅𝒆𝒙

Nominal GDP =
𝟏𝟎𝟎
Question 24:
Explain GDP Deflator (or Price Index).
Answer:
The concept is explained as follows:
GDP deflator measures the average level of prices of all the goods and services that make up GDP.
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷
GDP Deflator (or Price Index) = x 100
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷

Question 25:
Explain Net Factor Income from Abroad (NFIA).
Answer:
The concept is explained as follows:
It refers to the difference between factor income received from rest of the world and factor income paid
to rest of the world.
NFIA = Factor income earned from abroad - Factor income paid abroad
The components of NFIA are as follows:

1. Net Compensation to Employees - It refers to difference between income from work received by
resident workers living or employed abroad for less than one year and similar payments made to non -
resident workers staying or employed within the domestic territory of the country for less than one
year.
2. Net income from property and entrepreneurship - It refers to difference between income from
property and entrepreneurship (in the form of rent, interest and dividend) received by residents of
the country and similar payments made to non - residents.
3. Net retained earnings - It refers to difference between retained earnings of resident companies
located abroad and retained earnings of non - resident companies located within the domestic
territory of the country.

CHAPTER 1: UNIT-II: THE KEYNESIAN THEORY OF

DETERMINATION OF NATIONAL INCOME
Question 1:
Who first explained determination of equilibrium income and output.
Answer:
• The factors that determine the level of national income and the determination of equilibrium aggregate
income and output in an economy.
• A comprehensive theory to explain these phenomena was first put forward by the British economist
John Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest and Money’
published in 1936.
Question 2:
Explain circular flow in a simple two sector model.
Answer:
• The simple two sector economy model assumes that there are only two sectors in the economy viz.,
households and firms, with only consumption and investment outlays.
• Households own all factors of production and they sell their factor services to earn factor incomes
• The business firms are assumed to hire factors of production from the households; they produce and
sell goods and services to the households.
• All prices (including factor prices), supply of capital and technology remain constant.
• The government sector does not exist
• The economy is a closed economy, i.e., foreign trade does not exist; there are no exports and imports
and external inflows and outflows
• National income equals the net national product
• Circular flow in a two sector economy

• The circular broken lines with arrows show factor and product flows and present ‘real flows’ and the
continuous line with arrows show ‘money flows’.
• Factor Payments = Household Income= Household Expenditure = Total Receipts of Firms = Value of
Output.
Question 3:
Define equilibrium.
Answer:
• ‘Equilibrium’ (defined as a state in which there is no tendency to change; or a position of rest).
• Equilibrium output occur when the desired amount of output demanded by all the agents in the economy
exactly equals the amount produced in a given time period.
• An economy can be said to be in equilibrium when the production plans of the firms and the expenditure
plans of the households match.
Question 4:
Explain the aggregate demand function: Two sector model.
Answer:
In a simple two-sector economy aggregate demand (AD) or aggregate expenditure consists of only two
components:
(i) aggregate demand for consumer goods (C), and
(ii) aggregate demand for investment goods (I)

AD = C + I
The short-run aggregate demand function can be written as:

AD = C + ̅𝑰
Where ̅𝑰 = constant investment.
Question 5:
Explain the consumption function.
Answer:
1. Consumption function expresses the functional relationship between aggregate consumption expenditure
and aggregate disposable income, expressed as:
C = f (Y)
2. The positive relationship between consumption spending and disposable income is described by the
consumption function.
3. According to Keynes, the total volume of private expenditure in an economy depends on the total current
disposable income of the people and the proportion of income which they decide to spend on consumer
goods and services. Consumption function, proposed by Keynes is as follows:
C = a + bY
Where C = aggregate consumption expenditure; Y = total disposable income; a is a constant term, value
of consumption at zero level of disposable income; and b is the marginal propensity to consume (MPC).
4. The consumption function shows the level of consumption (C) corresponding to each level of disposable
income (Y) and is expressed through a linear consumption function. When income is low, consumption
expenditures of households will exceed their disposable income and households dissave.

5. The Keynesian assumption is that consumption increases with an increase in disposable income, but that
the increase in consumption will be less than the increase in disposable income (b < 1). i.e. 0 < b < 1.
Question 6:
Explain Marginal Propensity to Consume (MPC).
Answer:
The concept of MPC describes the relationship between change in consumption (∆C) and the change in income
(∆Y). The value of the increment to consumer expenditure per unit of increment to income is termed the
Marginal Propensity to Consume (MPC).
∆𝑪
MPC = = b
∆𝒀
MPC tends to decline at higher income levels.
Question 7:
Explain Average Propensity to Consume (APC).
Answer:
The ratio of total consumption to total income is known as the average propensity to consume (APC).
𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏
APC = = C/Y
𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
• APC falls with increase in income:

APC falls continuously with increase in income because the proportion of income spent on consumption
keeps on decreasing.
• APC can never be zero:

APC can be zeo only when consumption becomes zero. However, consumption is never zero at any level
of income. Even at zero level of national income, there is Autonomous Consumption (𝒄).
Comparison between APC and MPC

Basis APC MPC
Meaning It is the ratio of consumption expenditure It is the ratio of change in consumption
(C) to the corresponding level of income expenditure (∆Y) over a period of time.
(Y) at a point of time.
Value more than one APC can be more than one as long as MPC cannot be more than one as change
consumption is more than national income, in consumption cannot be more than
i.e. till the break even point. change in income.
Response to change When income increases, APC falls but at When income increases, MPC also falls
in income a rate less than thatof MPC. but at a rate more than that of APC.
Formula APC= C/Y MPC = ∆C / ∆Y

Relationship between Income and Consumption

Income (Y) Consumption (C ) APC (C/Y) MPC (∆C / ∆Y) MPS (∆S / ∆Y)
(1 - MPC)
0 500 500/0 = ∞ - -
1000 1250 1250/1000 = 1.25 750/1000 = 0.75 0.25
2000 2000 2000/2000 = 1.00 750/1000 = 0.75 0.25
3000 2750 2750/3000 = 0.92 750/1000 = 0.75 0.25
6000 5000 5000/6000 = 0.83 2250/3000 = 0.75 0.25
10000 8000 8000/10000 = 3000/4000 = 0.75 0.25
0.80
The proportion of income spent on consumption decreases as income increases
Question 8:
Explain Savings Function (Propensity to Save).
Answer:
• Saving is also a function of income, i.e., saving also depends upon the level of income.
• Saving is the excess of income over consumption expenditure.
• Saving function refers to the functional relationship between saving and national income.
S = f (Y)
Where, S= Saving, Y = National Income, f = Functional Relationship
• Saving function or Propensity to save, shows the saving of households at a given level of income during
a given time period.
Relationship between saving and income:

Income (Y) Consumption (C) Savings (S=Y-C)
(Rs. in crores) (Rs. in crores) (Rs. in crores)
0 40 -40
100 120 -20
200 200 0
300 280 20
400 360 40
500 440 60
600 520 80

Important observations from Saving Schedule and Saving Curve:

➢ Starting Point of Saving Curve:
Savings Curve (SS) starts from point S on the Y-axis, indicating that there is negative saving, when
National Income is zero.
➢ Slope of Saving Curve:

SS has a positive slope, which indicates the positive relationship between saving and income.
➢ Break-Even Point (S=0):

Saving curve crosses the X-axis at a point which is known as break-even point as at that point, savings
is zero.
➢ Positive saving:
After the Break-even Point, saving is positive.
Question 9:
Explain the Marginal Propensity to Save (MPS).
Answer:
The marginal propensity to save is the increase in saving per unit increase in disposable income:
∆𝑺
MPS = = 1 - b
∆𝒀
• Marginal Propensity to Consume (MPC) is always less than unity,

• but greater than zero, i.e., 0 < b < 1
• MPC + MPS = 1; we have MPS 0 < b < 1.
• Thus, saving is an increasing function of the level of income because the marginal propensity to save (MPS)
= 1- b is positive, i.e. saving increase as income increases.
Question 10:
Explain the Average Propensity to Save (APS).
Answer:
The ratio of total saving to total income is called average propensity to save (APS). Alternatively, it is that
part of total income which is saved.
𝑻𝒐𝒕𝒂𝒍 𝑺𝒂𝒗𝒊𝒏𝒈 𝑺
APS = =
𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆 𝒀
• The 45° line is drawn to split the positive quadrant of the graph and shows the income-consumption
relation with Y = C (AD = Y) at all levels of income.

• All points on the 45° line indicate that aggregate expenditure equal aggregate output.
• As long as the economy is operating at less than its full-employment capacity, producers will produce any
output along the 45-degree line that they believe purchasers will buy.
Comparison between APS and MPS

Basis APC MPC
Meaning It refers to the ratio of saving (S) to the It refers to the ratio of change in saving
corresponding level of income (Y) at a point (∆S) to change in total income (∆Y) over
of time. a period of time.
Value less than zero APS can be less than zero when there are MPS can never be less than zero as
dissavings, i.e., till consumption is more change in saving can never be negative,
than national income. i.e., change in consumption can never be
more than change in income.
Formula APS = S / Y MPS = ∆S / ∆Y
Question 11:

Explain Investment Function.
Answer:
• Investment refers to the expenditure incurred on creation of new capital assets.
• The investment expenditure is classified under two heads:
(i) Induced Investment
(ii) Autonomous Investment
• Induced Investment:
It refers to investment which depends on the profit expectations and is directly influenced by income
level.
Induced Income vs Autonomous Investment

Basis APC MPC
Motive It is driven by profit motive, i.e., it It is done for social welfare and not for
depends on profit expectations. profit.
Income Elasticity It is income elastic, i.e., increase in It is unaffected by changes in income
income level raises its level. level.
Investment Curve Its curve slopes upwards as it is income Its curve is parallel to X-axis as it is
elastic. income inelastic.
Sector It is generally done by the private sector. It is generally done by the government
sector.
Question 12:
Explain The Two-Sector Model Of National Income Determination.
Answer:
The two-sector model of determination of equilibrium levels of output and income in its formal form using the
aggregate demand function and the aggregate supply function.
(I)
According to Keynesian theory of income determination, the equilibrium level of national income is a situation
in which aggregate demand (C+ I) is equal to aggregate supply (C + S) i.e.
C + I = C + S or I = S

In a two sector economy, the aggregate demand (C+ I) refers to the total spending in the economy i.e. it is
the sum of demand for the consumer goods (C) and investment goods (I) by households and firms respectively.
Aggregate supply represents aggregate value expected by business firms and aggregate demand represents
their realized value.
• At equilibrium, expected value equals realized value.
• Income is measured along the horizontal axis and the components of aggregate demand, C and I, are
measured along the vertical axis.
• The autonomous expenditure component (I) does not depend directly on income, the (C+I) schedule lies
above the consumption function by a constant amount.
• Equilibrium level of income is such that aggregate demand equals output
• At that level of output and income, planned spending precisely matches production.
• Once national income is determined, it will remain stable in the short run.
• If aggregate expenditures exceed aggregate output.
• Excess demand makes businesses to sell more than what they currently produce.
• The unexpected sales would draw down inventories.
• They will react by hiring more workers and expanding production. This will increase the nation’s
aggregate income.
• If the planned expenditures on goods and services are less than what business firms thought they would
be; business firms would be unable to sell as much of their current output as they had expected.
• There will be a tendency for output to fall.
• Since C + S = Y, the national income equilibrium can be written as Y = C + I
(II)
The saving schedule S slopes upward because saving varies positively with income. In equilibrium, planned
investment equals saving.

• Corresponding to this income, the saving schedule (S) intersects the horizontal investment schedule (I).
• At the equilibrium level of income, saving equals (planned) investment.
• The equality between saving and investment can be seen directly from the identities in national income
accounting.
Y = C + S;
Y = C + I;
• The two together, we have C + S = C + I, or S = I.
• An important point to remember is that Keynesian equilibrium with equality of planned aggregate
expenditures and output need not take place at full employment.
• Output will remain at less than the full employment rate as long as there is insufficient spending in the
economy.
Note:
A steeper aggregate demand function—as would be implied by a higher marginal propensity to consume—implies
a higher level of equilibrium income.
Equilibrium by Saving and Investment Approach
Income (Y) Consumption (C) Saving (S) Investment (I) Remarks
0 40 -40 40 S < I
100 120 -20 40 S < I
200 200 0 40 S < I
300 280 20 40 S < I
400 360 40 40 S = I
Equilibrium
500 440 60 40 S > I
600 520 80 40 S > I
Question 13:
Explain Equilibrium Level.
Answer:
• Equilibrium level of income is attained always at full employment level, i.e., there is absence of
unemployment.
• Keynesian Theory, equilibrium level can be achieved at:
(i) Full employment level, or
(ii) Underemployment level, i.e., less than full employmrnt level
(iii) Over full employment level, i.e., more than full employment level.
Question 14:

Explain the concept of Investment Multiplier.
Answer:
• The concept of Investment Multiplier is an important contribution of Prof. J.M. Keynes.
• Keynes believed that an initial increment in investment increases the final income by many times,
Multiplier expresses the relationship between an initial increment in investment and the resulting increase
in aggregate income.
• Multiplier shows how many times the income increases as a result of an increase in investment.
• Multiplier (K) is the ratio of increase in National Income (∆Y) due to an increase in investment (∆I).
K = ∆Y / ∆I
• Suppose an additional investment (∆I) of Rs. 4,000 crores in an economy generates an additional income
(∆Y) of Rs. 16,000 crores.
K = 16,000 / 4,000 = 4
• The concept of Multiplier is based on the fact that one person’s expenditure is another person’s income.
When investment is increased, it also increases the income of people.
• In case of higher MPC, people will spend a large proportion of their increased income on consumption.
• In case of low MPC, people will spend lesser proportion of their increased income on consumption.
K = 1 / (1 - MPC)
Formula of Multiplier (K)

❖ K = ∆Y / ∆I
❖ K = 1 / (1 - MPC)
❖ K = 1 / MPS
Maximum Value of Multiplier:

• The maximum value of multiplier is infinity, when the value of MPC is 1.
Minimum Value of Multiplier:

• The minimum value of multiplier is 1, when the value of MPC is zero.
Working of Multiplier:
One person’s expenditure is another person’s income. When an additional investment is made, then income
increases many times more than the increase in investment.
• Suppose, an additional investment of Rs.100 crores (∆I) is made.

• If MPC is assumed to be 0.90, then recepients of this additional income will spend 90% of Rs.100
crores.
• In the next round, 90% of the additional income of Rs.90 crores, i.e., Rs.81 crores will be spent on
consumption and the remaining amount will be saved.

• This multiplier process will go on and the consumption expenditure in every round will be 0.90 times of
the additional investment.
Effect of changes in Autonomous Investment:
Question 15:
Explain Determination Of Equilibrium Income: Three Sector Model.
Answer:
Aggregate demand in the three sector model of closed economy (neglecting foreign trade) consists of three
components namely, household consumption(C), desired business investment demand(I) and the government
sector’s demand for goods and services(G). Thus in equilibrium, we have Y = C+I+G
• GDP and national income are equal.
• As prices are assumed to be fixed, all variables are real variables and all changes are in real terms.
• Each of the variables in the model is a flow variable.

Question 16:
Explain determination of Equilibrium Income: Three Sector Model
Answer:

• The variables measured on the vertical axis are C, I and G. The autonomous expenditure components
namely, investment and government spending.
• C + I + G schedule lies above the consumption.
• The line S + T in the graph plots the value of savings plus taxes. This schedule slopes upwards because
saving varies positively with income.
• The equilibrium level of income is shown at the point E 1 where the (C + l + G) schedule crosses the
45° line, and aggregate demand is therefore equal to income (Y).
• In equilibrium, it is also true that the (S + T) schedule intersects the (I + G) horizontal schedule.
Question 17:
Explain Determination Of Equilibrium Income: Four Sector Model.
Answer:

• The four sector model includes all four macroeconomic sectors, the household sector, the business
sector, the government sector, and the foreign sector.
• The foreign sector includes households, businesses, and governments that reside in other countries.
In the four sector model, there are three additional flows namely: exports, imports and net capital inflow
which is the difference between capital outflow and capital inflow.
The C+I+G+(X-M) line indicates the total planned expenditures of consumers, investors, governments, and
foreigners (net exports) at each income level.
Y = C + I + G + (X-M)
• Exports are the injections in the national income,

• imports act as leakages or outflows of national income.
• Exports represent foreign demand

• and are part of aggregate demand.

• Since imports are not demands for domestic goods, we must subtract them from aggregate demand.
• The demand for imports has an autonomous component and is assumed to depend on income.
• Imports depend upon marginal propensity to import which is the increase in import demand per unit increase
in GDP.
• The demand for exports depends on foreign income and is therefore exogenously determined.
• Imports are subtracted from exports to derive net exports.
• Equilibrium is identified as the intersection between the C + I + G + (X - M) line and the 45-degree
line.
• The equilibrium income is Y. The leakages(S+T+M) are equal to injections (I+G+X) only at equilibrium
level of income.
• If net exports are positive (X > M), there is net injection and national income increases.
• If X<M, there is net withdrawal and national income decreases.
• When the foreign sector is included in the model (assuming M > X), the aggregate demand schedule
C+I+G shifts downward with equilibrium point shifting from F to E.
• The inclusion of foreign sector (with M > X) causes a reduction in national income from Y0 to Y1.

• Equilibrium income is expressed as a product of two terms: ∆ Y = k ∆I;

• the level of autonomous investment expenditure and the investment multiplier.
• The autonomous expenditure multiplier in a four sector model includes the effects of foreign transactions
and is stated as 1 / (1−𝑏+𝑣), where v is the propensity to import which is greater than zero.
• The multiplier in a closed economy is 1 / (1−𝑏).
1. The greater the value of v, the lower will be the autonomous expenditure multiplier. The more open an
economy is to foreign trade, (the higher v is) the smaller will be the response of income to aggregate
demand shocks, such as changes in government spending or autonomous changes in investment demand.
• The higher the value of v, larger the proportion of this induced effect on demand for foreign, not
domestic, consumer goods.
• Consequently, the induced effect on demand for domestic goods and, hence on domestic income will
be smaller.
• The increase in imports per unit of income constitutes an additional leakage.
2. An increase in demand for exports of a country is an increase in aggregate demand for domestically
produced output and will increase equilibrium income.
If the demand for a country’s exports has an expansionary effect on equilibrium income, whereas an
autonomous increase in imports has a contractionary effect on equilibrium income.


CHAPTER 2: UNIT – I: FISCAL FUNCTIONS: AN OVERVIEW

➢ Steps taken By Government
To control the potential rise in prices: To bring in welfare to the underprivileged To provide incentives for the promotion
sections of production/use of resources
• Crop worry • fortified mid – day • subsidize Smart phones
• Rate Cut • Spend money on rural jobs • No tax on credit, debit card
transactions up to Rs. 2,000
➢ The Government intervenes with the economic variables:

• To direct them to function in particular directions
• Certain goods and services are provided exclusively by the government.
➢ Types of Economic System
TYPES OF ECONOMIC SYSTEM
MARKET GOVERNMENT MIXED
➢ Need of Economic System

• To solve the problem of scarcity
• To answer the basic questions such as what, how and for whom to produce and how many resources should be used.
➢ Role of Government as advocated by Adam Smith.

• Resource allocation role for government in national defence, maintenance of justice and the rule of law, establishment and
maintenance of highly beneficial public institutions and public works.
➢ ‘The Theory of Public Finance’(1959), introduced the three branch taxonomy of the role of government in a market economy.
Functions of Government
Resource Income Macroeconomic

Allocation Redistribution Stabilization

Functions of Government
Allocation Function (Efficiency) Redistribution Function (Fairness) Stabilization Function
MICROECONOMIC FUNCTIONS MACROECONOMIC FUNCTION
• It aims to correct the • It aims at fair distribution of • It aims at maintenance of high levels of employment,
sources of inefficiency. wealth and income. price stability, the problems of macroeconomic
stability, monetary and fiscal policy.
➢ ALLOCATION FUNCTION
Define Problem of Resource Market failures provide the Performance and various instruments
Allocation rationale for Government of Government
• available factors of • Imperfect competition • suitable corrective action For • Fiscal policy
production are and presence of monopoly example: • Budgeting
allocated among the • Failure to provide (a) property rights; • An optimum mix of various social
various uses. collective goods (b) enforces contracts goods (both public goods and merit
• Determines the • Externalities through provision of law goods).
quantity actually to • Factor immobility enforcement and courts. • allocation instruments are are as
be produced. • Imperfect information • Goods involving externalities follows:
• Inequalities in the that are not met by the 1. Production of Economic goods
distribution of income market. 2. Influence private allocation
and wealth • Merit goods also fall under 3. Competition/Merger policies
this purview. 4. Regulatory Activities
• The government acts as a 5. Legal and administrative
complement rather than as a frameworks
substitute. 6. Mixture of intermediate
techniques.
➢ Government failure
• Government is not always infallible
• Cost of measures > Cost of market failure.
Governments may contribute to generate them.
• Inadequate information, conflicting objectives and administrative costs.
• Not always be unbiased and benevolent.
➢ Market economy leads to non – egalitarian because:

• Distribution of income and wealth among individuals is likely to be skewed as few have most of the wealth.
• Intervention required to ensure a more desirable and just distribution.
➢ REDISTRIBUTION FUNCTION
Definition Aims Examples Two edged sword and its
solutions
• For whom to produce. 1. Equitable Distribution 1. Taxation Policies • Conflict between efficiency
• Distribution to ensure 2. Advancement of Well Being 2. Progressive taxes used for and equity.
equity and fairness. of Deprived financing public services, • Efficiency costs or
3. Equality 3. Employment Reservations deadweight losses.
4. Security and preferences ➢ Corrective measures are as
5. Minimal Standard Of Living 4. Regulation of manufacture follows:
and sale of certain • Optimal budgetary policy.
products • Minimal efficiency costs
5. Special schemes for
backward regions
➢ STABILIZATION FUNCTIONS
Definition Need Areas of Work Two major components Stabilization intervention
of Fiscal Policy policies
important for
Stabilization
• Deliberate • Prolonged • Labour employment and 1. Overall Effect 1. Monetary policy
stabilization instabilities capital utilization, Balance between Controlling the size of
policies. • Stagflation • Overall output and the resources and money supply and
• Eliminating • Contagion income, expenditures interest rate.
macroeconomic effect. • General price levels, 2. Microeconomic 2. Fiscal policy
fluctuations arising • The rate of economic Effect By means of
from suboptimal growth, and By Specific Policies expenditure and
allocation. • Balance of international taxation decisions.
payments.
➢ Steps taken by government during:
Inflation Deflation

1. The government cuts down its expenditure or raises taxes. 1. The government increases its expenditure or cuts down taxes
2. Contractionary fiscal policy or adopts a combination of both.
3. Surplus budgets 2. Expansionary fiscal policy

CHAPTER 2: UNIT-II: MARKET FAILURE

➢ Market Failure and its aspects
• Misallocation of scarce resources resulting in overproduction or underproduction.
Aspects of Market
Failure
Demand Side Supply Side
1. Demand side market failures: Demand curves do not take into account the full willingness of consumers to pay.
2. Supply side market failures: Supply curves do not incorporate the full cost of production.
➢ Reasons for Market Failures
Market Power Externalities

Reasons for
Market Failure
Public goods Incomplete Information
➢ Different types of Externalities

TYPES OF
EXTERNALITIES
UNIDIRECTIONAL RECIPROCAL POSITIVE NEGATIVE
➢ Social Cost
Social Cost = Private Cost + External Cost
• Private costs borne by individuals directly

• External costs borne by third parties not directly involved
➢ The problem of harmful externalities does not usually float up much because:

• Producers of harmful externalities not known.

• Cause-effect linkages are so unclear.
Characteristics of Private Goods and Public Goods

Private Goods Public Goods
Utility Utility
Private Property Rights No direct payment
Rivalrous Non – Rival in consumption
Excludable Non – Excludable
No Free Rider Problem Indivisibility
Horizontal Summation of Individual Demand Curves Vulnerable
Rejection Additional Resource cost is zero
Additional Costs
Issues of fairness and justice tend to rise
Efficiently allocated resources
➢ ‘Theory of Public Goods’ - Paul A. Samuelson

• ‘Collective consumption good’ in his path-breaking 1954 paper ‘The Pure Theory of Public Expenditure’.
• A public good (also referred to as collective consumption good or social good) is defined as one which all enjoy in common.
➢ Classification of goods
Excludable Non-excludable
Rivalrous (A) (B)
Private goods food, clothing, cars Common resources such as fish stocks, forest resources, coal

Non-rivalrous (C) (D)

Club goods, cinemas, private parks, satellite Pure public goods such as national defence
television
➢ Impure goods
• Hybrid goods that possess some features of both public and private goods.
• Partially rivalrous or congestible.
• Consumption reduces, but does not eliminate, the benefits of others.
• Impure public goods also differ from pure public goods in that they are often excludable.
❖ The possibility of exclusion from the use of an impure public good has two implications.
1. Elimination of Free Riding
2. Controlled degree of congestion
❖ Two broad classes of goods have been included in the studies related to impure public goods.
1. Club goods; first studied by Buchanan
2. Variable use public goods; first analyzed by Oakland and Sandmo
➢ Quasi – Public goods (Mixed Goods)

• Mix of services from the provision of goods
• Near public good i.e. all qualities of the private goods and some benefits of public good.
• Chargeable
• Some sold through markets and others being provided by government.
• Their markets are called incomplete markets and considered as inefficiency and market failure.
• Example - Vaccinations provide private benefits but also reduce the chances of others getting infected who are in contact
with vaccinated person.
➢ Common Access Resources (or Common pool resources)

• Special class of impure public goods which are non-excludable and rivalrous.
• Their consumption lessens the benefits available for others.
• Free of charge.
• Sustainability threat.
• ‘Tragedy of the commons’ occurs when rivalrous but non – excludable goods are overused, to the disadvantage of the entire
world.
• Examples of common access resources are fisheries, common pastures, rivers, sea, backwaters biodiversity etc.

➢ Global Public Goods

• Widespread impact on different countries and regions, population groups and generations.
• WHO delineates two categories of global public goods namely:
1. Final public good (outcomes), e.g. the eradication of polio and
2. Intermediate public goods, (contribute to the provision of final public goods) e.g. International Health Regulations aimed
at stopping the cross-border movement of communicable diseases and thus reducing cross-border health risks.
• World Bank identifies five areas of global public goods which it seeks to address namely:
1. The environmental commons ,
2. Communicable diseases
3. International trade,
4. International financial architecture, and
5. Global knowledge for development.
• No mechanism (either market or government) to ensure an efficient outcome.
➢ Free rider problem

• ‘Benefiting from the actions of others without paying’.
• A free rider is a consumer or producer who does not pay for a non – exclusive good in the expectation that others will pay.
• Public goods provide a very important example of market failure.
• If every individual plays the same strategy of free riding, the strategy will fail because nobody is willing to pay and therefore,
nothing will be provided by the market. Then, a free ride for any one becomes impossible.
• There is no meaningful demand curve for public goods.
➢ If the free-rider problem cannot be solved, the following two outcomes are possible:
1. No public good will be provided in private markets
2. Private markets will seriously under produce public goods.

CHAPTER 2: UNIT-III: GOVERNMENT INTERVENTIONS TO

CORRECT MARKET FAILURE
➢ Need of Government interventions
• Efficient functioning of markets.
• Creation of the basic framework for fair and open competitive markets.
• Establishment of the ‘rule of law’,
• Government creates and protects property rights.
• Framed competition and consumer law framework.
• The governments adopt various intervention mechanisms to ensure greater welfare of the society as follows:
Public Finance
Government Interventions to correct Market Failure
Minimize Market Correct Merit & Correcting Equitable

Power Demerit Goods Information Distribution
Failure
➢ Different forms of government interventions

As Supplier Public
Goods/Information
Direct
Government As Buyer/ Procurement

Intervention
Taxes/Subsidies to
alter costs
Indirect
Regulation/Influence
➢ Government intervention to minimize Market Power.
• Market power exercised either by seller or buyer

(a) Higher prices than competitive prices.
(b) Restricts output and leads to deadweight loss.
(c) The government intervenes as follows:
1. Competition Laws, e.g. the Competition Act, 2002 etc
2. Exceptions e.g. patent and copyright laws grant exclusive rights of products or processes.
3. Price Regulations e.g. electricity, gas and water supplies.
4. Rate of Return Regulation
5. Setting Price Caps
➢ Government Intervention to correct Negative Externalities.

Government Initiative towards
Negative Externalities
Market Based
Direct Controls
Policies
A. DIRECT CONTROLS
They openly regulate the actions of those involved in generating negative externalities by:
1. Prohibiting specific activities that explicitly create negative externalities, for example smoking is banned in public places.
2. Passing laws to alleviate the effects of negative externalities For example, India has enacted the Environment (Protection)

Act, 1986.
3. Charging an emission fee
4. Forming Special bodies for instance the Ministry of Environment & Forest,
B. MARKET-BASED POLICIES
• They operate through price mechanism to create an incentive for change.
MARKET BASED POLICIES
Setting Prices DIRECTLY through Setting Prices INDIRECTLY through

Pollution Tax Cap - Trade - System
1. Pollution Tax
Market Outcomes of Pollution Tax
2. Cap – Trade System (also known as Tradable Emissions Permits)

(a) These are marketable licenses to emit limited quantities of pollutants and can be bought and sold by polluters.
(b) India is experimenting with cap-and-trade in the form of Perform, Achieve & Trade (PAT) scheme and carbon tax in the
form of a cess on coal.
➢ Problems in administering an efficient pollution tax

1. Difficult to determine and administer
2. Use of complex and costly administrative procedures

3. Does not provide any genuine solutions

4. Shift the tax burden
5. Negative consequences on employment and investments
➢ Advantages and disadvantages of Tradable permits

❖ The advantages of Tradable Permits are as follows:
• Flexibility and efficiency
• Cheap and simple
• Incentives for innovation
• Lower prices
❖ The disadvantages of Tradable Permits are as follows:
• Only provide an incentive but does not completely stop pollution.
• Higher prices to consumers.
➢ Government Intervention to correct Positive Externalities.
1. Subsidy
2. Direct entry by the Government
3. Direct production of Environmental Quality
➢ Government Intervention in the case of Merit Goods.

1. Regulation - For example, the way in which education is to be imparted is government regulated.
2. Subsidies - For example subsidy for windmill or solar panel.
3. Direct Government Provision
4. Combination of Government Provision and Market Provision
➢ Reasons for government provision of Merit goods.

1. Loss of Social Welfare
2. Information Failure
3. Equity Considerations
4. Uncertainty
➢ Government Intervention in the case of Demerit Goods.

A. Steps taken By Government
1. Complete Ban
2. Persuasion
3. Legislations

4. Limitations on Access
5. Regulatory Controls
6. High taxes
7. Fixing Minimum Price
B. Limitations
1. The demand is often highly inelastic.
2. Additional taxation and shift of the taxes to consumers.
3. Stringent regulation resulting in goods traded in a hidden market.
➢ Government Intervention in the case of Public Goods
1. The non-rival nature of consumption provides a strong argument for the government to provide:
(a) Pure public goods
(b) Excludable public goods
2. Governments grant licenses to private firms to build a public good facility.
3. Certain goods are produced and consumed as public goods and services
➢ Price Intervention by Government

• Price interventions are legal restrictions on price.
• The Price interventions of the government are as follows:
1. Price controls may take the form of:
(a) Price floor (a minimum price buyers are required to pay); or
(b) Price ceiling (a maximum price sellers are allowed to charge for a good or service).
✓ Examples of such market intervention are fixing of minimum wages and rent.
a
2. Intervention in Primary markets

(a) For example in India, Minimum Support Price (MSP) programme as well as procurement by government agencies at the
set support prices.

Market Outcome of Minimum Support Price
(b) Price ceilings (also called maximum price)

Market Outcome of Price Ceiling
(c) Maintenance of buffer stocks
➢ Government Intervention for Correcting Information Failure

1. Accurate labeling and Content Disclosure
2. Public Dissemination of Information
3. Regulation of Advertising
➢ Government Intervention for Equitable Distribution.

1. progressive income tax,

2. targeted budgetary allocations,

3. unemployment compensation,
4. transfer payments,
5. subsidies,
6. social security schemes,
7. job reservations,
8. land reforms,
9. gender sensitive budgeting etc.
• Government also intervenes to combat black economy and market distortions associated with a parallel black economy.
Note:
➢ Government failure occurs when:
• intervention is ineffective
• intervention produces fresh and more serious problems
CHAPTER 2: UNIT-IV: FISCAL POLICY

➢ Objectives of Fiscal Policy
• Vary from country to country.
• The most common objectives of fiscal policy are:
(a) Achievement and maintenance of full employment,
(b) Maintenance of price stability,
(c) Acceleration of the rate of economic development, and
(d) Equitable distribution of income and wealth,
• For instance, while stability and equality may be the priorities of developed nations, economic growth, employment and equity
may get higher priority in developing countries.
➢ Automatic Stabilizers and Discretionary Fiscal Policy.

A. Automatic Stabilizers (Non-discretionary fiscal policy)
❖ Definition
• ‘Built-in’ fiscal mechanisms that operate automatically
• Any government programme that automatically tends to reduce fluctuations in GDP is called an automatic stabilizer.
• Tendency for increasing GDP when it is falling and reducing GDP when it is rising.

•Examples - Personal income taxes, corporate income taxes and transfer payments (unemployment compensation, welfare
benefits).
❖ Automatic Stabilizers occur as follows during:
(a) Recession (b) Expansion
1. Reduction in income, less taxes and refunds. 1. Increase in income and taxes lead to less disposable
2. Increase in Government expenditure. income resulting in decline in consumption and aggregate
3. Limiting the decrease in disposable income during the demand.
contraction phase. 2. Higher corporate taxes and lower surplus cause decline
in consumption and investment.
3. all types of incomes rise and the amount of transfer
payments decline.
B. Discretionary Fiscal Policy

❖ Deliberate policy actions on the part of government:
• to change the levels of expenditure,
• taxes to influence the level of national output,
• employment and prices
❖ Governments influence the economy by:
• changing the level and types of taxes,
• the extent and composition of spending,
• the quantity and form of borrowing.
❖ Governments may directly as well as indirectly influence the way resources are used in an economy.
GDP = C + I + G + NX.
• It is evident from the equation that governments can influence economic activity (GDP) by controlling G directly and
influencing C, I, and NX indirectly, through changes in taxes, transfer payments and expenditure.
➢ Instruments of Fiscal Policy
Instruments of Fiscal Policy
Government Government
Public Debt
Expenditure Budget

➢ Government Expenditure as an Instrument of Fiscal Policy.

A. Public Expenditure
• Income generating and include all types of government expenditure such as capital expenditure on public works, relief
expenditures etc.
• It includes governments’ expenditure towards consumption, investment, and transfer payments.
B. Government expenditure
Government expenditure include:
1. Current expenditures
2. Capital expenditures
3. Transfer payments
C. Government expenditure during Recession
1. Steps taken by government
• Directly generate incomes to labour and suppliers of materials and services.
• Indirect effect in the form of working of multiplier.
• Induce secondary and tertiary employment.
2. The two concepts of public spending during depression

(a) Pump Priming (b) Compensatory Spending
• One-shot injection of government expenditure into a • Government spending is deliberately carried out with the
depressed economy. obvious intention to compensate for the deficiency in
• Permanent recovery from a slump. private investment.
3. Public Expenditure used as Policy Instrument

• To reduce the severity of inflation by reducing government expenditure.
• Reduced incomes on account of decreased public spending helps to eliminate excess aggregate demand.
➢ Taxes as an Instrument of Fiscal Policy.

Overview During Recession During Inflation
1. For establishing stability. 1. To encourage private consumption 1. New taxes and existing taxes are
2. Encouraging or restricting private and investment. raised.
expenditures on consumption and 2. Low corporate taxes increase the 2. Excessive taxation usually stifles new
investment. prospects of profits for business and investments.
3. Determine the size of disposable promote further investment.
income.

➢ Public Debt as an Instrument of Fiscal Policy.
Sources of Public Debt
Internal External
(From its Own people) (From Outside Sources)
➢ Public debt takes two forms:
Market loans Small savings
• Govt. issues treasury bills and government securities of • Not negotiable and are not bought and sold in the market.
varying denominations and duration. • National Savings Certificates, National Development
• For capital projects – Long term capital bonds Certificates are few examples.
• For short term expenditures – treasury bills • Borrowing from the public curtails the aggregate demand.
• Repayments by governments increase the availability of money
in the economy and increase aggregate demand.
➢ Budget as an Instrument of Fiscal Policy.
• A statement of revenues earned from taxes and other sources and expenditures made by government in a year.
Balanced Budget Surplus Budget Deficit Budget
• Expenditures = Revenues • Expenditures < Revenues • Expenditures > Revenues
• No net effect on • Negative net effect on aggregate demand • Positive net effect on aggregate demand
aggregate demand since leakages exceed injections. since total injections exceed leakages.
• A nation’s debt is the difference between its total past deficits and its total past surpluses.
• A budget surplus reduces government debt, increases savings and reduces interest rates.
• Higher levels of domestic savings decrease international borrowings and lessen the current account deficit.
➢ Types of Fiscal Policy.

TYPES OF FISCAL POLICY
EXPANSIONARY FISCAL POLICY CONTRACTIONARY FISCAL POLICY
Particulars EXPANSIONARY POLICY CONTRACTIONARY POLICY

When is this policy At the time of Recession At the time of Inflation
needed?
How does the government • Contractionary policy measures so that
uses this policy? The aggregate demand curve (AD) shifts
to the left and the equilibrium may be
established at the full employment level
of real GDP
• This can be achieved either by:
1. Decrease in government spending
2. Increase in personal income taxes
and/or business taxes
3. A combination of the above two
measures
• Real GDP at Y1 level lies below the natural

level, Y2.
• There are two views as follows:
1. Classical Economists’ View
❖ Reduction in wages costs would increase
supply and the short run aggregate supply
curve SAS1 will shift to the right say SAS
2 and bring the economy back to the level of
full employment at Y2.
2. Keynesian View
❖ Wages are not much flexible and are ‘sticky
downward,’

❖ Increase in government expenditures causes

a shift in the aggregate demand curve to the
right from AD 1 to AD 2.
❖ As a response to the shift in AD, output
increases.
❖ More output, and hiring more workers.
❖ The government uses a deficit budget,
financed either through borrowing or through
monetization.
Note: Expansionary fiscal policy will be
successful only if there is accommodative
monetary policy. • As real GDP rises above its natural level
Y, prices also rise, prompting an increase
in wages and other resource prices.
• This causes the SAS curve to shift from
SAS 1 to SAS 2.
• As a result, the price level goes up from
P 1 to P 3.
• The real GDP remains the same at Y.
• The government intervenes to control
inflation by Contractionary fiscal policy,
to reduce aggregate demand so that the
aggregate demand curve (AD1) does not
shift to AD2.
• The government needs to reduce
expenditures or raise taxes.
➢ Recessionary gap (Contractionary gap)

• Existing levels of aggregate production < Levels of Aggregate production with full employment of resources.
• When the aggregate demand is not sufficient to create conditions of full employment.
• Occurs during the contractionary phase of business-cycle and results in higher rates of unemployment.
➢ Few examples of Fiscal Policy for long run economic growth.

• Fiscal policies such as those involving infrastructure spending generally have positive supply-side effects.
• When government supports building a modern infrastructure, the private sector is provided with the requisite overheads it

needs.
• Government provision of public goods such as education, research and development etc. provide momentum for long-run
economic growth.
• A well designed tax policy that rewards innovation and entrepreneurship, without discouraging incentives will promote private
businesses.
➢ Fiscal Policy reduces Inequalities of Income and Wealth.

A few such measures to achieve desired distributional effects are as follows:
1. Progressive Direct Tax System
2. Differential Indirect Taxes
3. Public Expenditure policy
➢ Limitations of Fiscal Policy

1. Existence of Different types of Lags
There are different types of lags involved in fiscal-policy action as follows:
(a) Recognition Lag
(b) Decision Lag
(c) Implementation Lag
(d) Impact Lag
2. Wrong timing
3. Rigid policies
4. Difficult to reduce Government Expenditure
5. Non adjustment of Public works
6. Forecasting Difficulties
7. Conflicts in different Objectives
8. Opinion of Supply side Economists
9. Perpetual Burden
10. Crowding out
11. Price Spiral
➢ Crowding out.
1. Government spending replaces private spending, the latter is said to be crowded out.
2. For example, if government provides free computers to students, the demand from students for computers may not be
forthcoming.
3. Fiscal policy becomes ineffective as the decline in private spending partially or completely offset the expansion in demand resulting
from an increase in government expenditure.
4. During deep recessions, crowding-out is less likely to happen.

CHAPTER 3: UNIT-I: CONCEPT OF MONEY DEMAND

➢ Definition of Money
Assets which are commonly used and accepted as a means of payment or as a medium of exchange or of transferring purchasing
power.
• Purchasing Power
• All Medium of exchange not Money
• Liquid Asset
• No Intrinsic Value of Currency
• Fiat Money
• Electronic records
➢ Money as per economic theory.

In economic theory As a statistical concept
• Set of liquid financial assets Money could include certain liquid liabilities of a particular set
• Its stock variation could impact on aggregate economic of financial intermediaries or other issuers’.(Reserve Bank of
activity. India Manual on Financial and Banking Statistics, 2007).
➢ Functions of Money
1. Convenient medium of exchange
2. Unit of value or unit of account
3. Unit or standard of deferred payment
4. Store of value
➢ General characteristics of money

Money should be:
• generally acceptable
• durable or long-lasting
• effortlessly recognizable.
• difficult to counterfeit i.e. not easily reproducible by people
• relatively scarce, but has elasticity of supply
• portable or easily transported
• possessing uniformity; and
• divisible into smaller parts in usable quantities or fractions without losing value

➢ The demand for money

1. Desire to hold money
2. Demand for liquidity
3. Role of Money
4. Holding Money
5. Opportunity Cost
➢ Classic Theory of Demand for Money (The Quantity Theory ➢ The Neo Classical Approach (The Cambridge Approach)
of Money) by Irving Fisher. Demand for Money.
• There is strong relationship between money and price level ➢ Money increases utility in the following two ways:
1. enabling the possibility of split-up of sale and purchase
to two different points of time (transaction motive), and
2. being a hedge against uncertainty (temporary store of
wealth)
• Also called ‘equation of exchange’ or ‘transaction approach’ • Also called Cash Balance Approach
•
• MV = PT Md = k PY
Where, M= the total amount of money in circulation (on an
d
average) in an economy Where, M = is the demand for money
V= transactions velocity of circulation i.e. the average Y = real national income
number of times across all transactions a unit of P = average price level of currently produced goods
money(say Rupee) is spent in purchasing goods and and services
services PY = nominal income
P = average price level (P= MV/T) k = proportion of nominal income (PY) that people
T = the total number of transactions. want to hold as cash balances
• Later, Fisher extended the equation of exchange to include

demand (bank) deposits (M’) and their velocity (V’) in the
total supply of money as follows:
MV + M’V’ = PT
Where, M’ = the total quantity of credit money

V' = velocity of circulation of credit money.

➢ The Keynesian Theory of Demand for Money (‘Liquidity Preference Theory’)

• People hold money (M) in cash for three motives:
Three Motive to Hold Cash
Transactions Precautionary Speculative

Motive Motive Motive
1. Transaction Motive: The need for cash arises because there is lack of synchronization between receipts and expenditures.
• The transactions demand for money is a direct proportional and positive function of the level of income as follows:
Lr = kY
Where Lr, = the transactions demand for money,
k = ratio of earnings which is kept for transactions purposes
Y = the earnings
2. Precautionary Motive: Everyone keeps a portion of their income to finance such unanticipated expenditures.
3. Speculative Motive: It reflects people’s desire to hold cash to invest in any attractive investment opportunity requiring cash
expenditure. There can be three cases as follows:
Case A: When (rn > rc) i.e. rise in bond prices, then they will convert their cash balances into bonds
Case B: When (rn<rc) i.e. fall in bond prices, then they would have an incentive to hold their wealth in the form of liquid
cash rather than bonds.
Case C: When rn = rc, then they will be indifferent to holding either cash or bonds.
• The speculative demand for money of individuals can be diagrammatically presented as follows:

• The speculative demand for money and current rate of interest are inversely related as shown below
➢ Post Keynesian developments in the Theory of Demand for Money.

Inventory Approach to Transaction Balances
Friedman's Restatement of the Quantity The Demand for Money as Behavior
(Deterministic Theory) Theory toward Risk
• By Boumol and Tobin • By Milton Fredman By Tobin in ‘Liquidity Preference as
Behavior towards Risk’
• Money or ‘real cash balance’ as an • Demand for money is affected by : • Provided the foundation for the liquidity
inventory held for transaction 1. Permanent income. preference and for a negative
purposes. 2. Relative returns on assets. (which relationship between the demand for
incorporate risk) money and the interest rate.
• Inventory models assume that there • Friedman identifies the following four • The optimal portfolio structure is
are two media for storing value: determinants of the demand for money. determined by
1. money and The nominal demand for money: (i) the risk/reward characteristics of
2. an interest-bearing alternative 1. is a function of total wealth, different assets
financial asset. 2. is positively related to the price level, (ii) the taste of the individual in
• People hold an optimum combination of 3. rises if the opportunity costs of money maximizing his utility consistent
bonds and cash balance. holdings (i.e. returns on bonds and with the existing opportunities
• Excess cash will be invested in bonds stock) decline and vice versa. • rational behaviour of a risk-averse
or put in an interest – bearing 4. is influenced by inflation, economic agent holds an optimally
account. structured wealth portfolio which is
comprised of both bonds and money

CHAPTER 3: UNIT-II: CONCEPT OF MONEY SUPPLY

➢ Money supply
• Total quantity of money available to the people.
• It is important to note two things
1. Stock variable i.e. money available at any particular point of time.
2. Change in the stock of money.
• The term ‘public’ includes all economic units (households, firms and institutions) except the producers of money (i.e. the
government and the banking system).
➢ Rationale of measuring Money Supply

1. Deeper Understanding
2. Framework to Evaluate
➢ Sources of Money Supply
Sources Of Money Supply
Credit Money
High Powered Money
(Responses of Commercial Banks to
(Decision of Central Bank)
Changes by Central Bank)
➢ Measurement of Money Supply

• Four alternative measures of money supply denoted by M1, M2, M3 and M4 besides the reserve money.
• The respective empirical definitions of these measures are given below:
M1 = Currency notes and coins with the people + demand

deposits of banks (Current and Saving deposit accounts)
+ other deposits with the RBI.
M2 = M1 + savings deposits with post office savings banks.
M3 = M1 + net time deposits with the banking system.
M4 = M3 + total deposits with the Post Office Savings
Organization (excluding National Savings Certificates).

• M1 is the most liquid and M4 is the least liquid of the four measures.
• M1 is also called Narrow Money.
• The new monetary aggregates are:
Reserve Money = Currency in circulation + Bankers’ deposits

with the RBI + Other deposits with the RBI
= Net RBI credit to the Government + RBI credit to

the Commercial sector + RBI’s Claims on banks +
RBI’s net Foreign assets + Government’s Currency
Liabilities to the public – RBI’s net non - monetary
Liabilities
NM1 = Currency with the public + Demand deposits with the banking
system + ‘Other’ deposits with the RBI.
NM2 = NM1 + Short-term time deposits of residents (including and up to
contractual maturity of one year).
NM3 = NM2 + Long-term time deposits of residents + Call/Term funding
from financial institutions
✓ M1 includes the demand deposits and reserve money includes the cash reserves of banks.
✓ Reserve money is also known as central bank money, base money or high-powered money.
✓ The central bank also measures ‘liquidity’ aggregates in addition to the monetary aggregates.
✓ Close substitutes of money issued by the non-banking financial institutions are also included.
L1 = NM3 + All deposits with the post office savings banks (excluding National Savings
Certificates).
L2 = L1 +Term deposits with term lending institutions and refinancing institutions (FIs) +
Term borrowing by FIs + Certificates of deposit issued by FIs.
L3 = L2+ Public deposits of non-banking financial companies
➢ Determinants of Money Supply

There are two alternate theories in respect of determination of money supply.

✓ First View: Money supply is determined exogenously by the Central bank.
• Second View: Money supply is determined endogenously by changes in the economic activities i.e.joint behaviour of the central
bank, the commercial banks and the public.
➢ Money Multiplier
• The money supply is defined as
M = m X MB
Where,
M is the money supply, m is money multiplier and MB is the monetary base or high powered money.
• From the above equation we can derive the money multiplier (m) as
Money supply
Money Multiplier (m)=
Monetary base
• A ratio that relates the changes in the money supply to a given change in the monetary base.
➢ The Money Multiplier Approach to Supply of Money.

• The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, (1963) considers three
factors as immediate determinants of money supply, namely:
(i) the stock of high-powered money (H) i.e. Behaviour of Central Bank
(ii) the ratio of reserves to deposits, e = {ER/D} i.e. behaviour of Commercial Bank
(iii) the ratio of currency to deposits, c ={C/D} i.e. behaviour of Public
(i) Behaviour of Central Bank

• Supply of the nominal high-powered money.
• If the behaviour of the public and the commercial banks remains unchanged over time, the total supply of nominal money
in the economy will vary directly with the supply of the nominal high-powered money issued by the central bank.
(ii) Behaviour of Commercial Bank
• The behaviour of the commercial banks in the economy is reflected by Reserve Ratio.
• There are two cases, where required reserve ratio changes and other variables remain same as follows:
Case A – Required Reserve ratio increases, more reserves would be needed.
Case B – Required reserve ratio falls, there will be expansions of deposits
• The banking system's excess reserves ratio is negatively related to the market interest rate.
(iii) Behaviour of Public

• The behaviour of the public influences bank credit through the decision on ratio of currency to the money supply known
as the ‘currency ratio’.
• Currency in public hands causes multiple expansion to decline, and therefore, money multiplier also falls.
• Money multiplier and the money supply are negatively related to the currency ratio c.
• An increase in TD/DD ratio means that greater availability of free reserves and thus increase in volume of multiple
deposit expansion and monetary expansion.
➢ The effect of Government Expenditure on Money Supply.

• The excess reserves created because of lending by RBI to government, potentially lead to an increase in money supply through
the money multiplier process
➢ The Credit Multiplier (the deposit multiplier or the deposit expansion multiplier)
• How much new money will be created by the banking system for a given increase in the high- powered money.
• Bank's ability to increase the money supply.
• The credit multiplier is the reciprocal of the required reserve ratio.
𝟏
Credit Multiplier =
𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐑𝐞𝐬𝐞𝐫𝐯𝐞 𝐑𝐚𝐭𝐢𝐨
➢ Are Deposit multiplier and money multiplier same?

• The deposit multiplier and the money multiplier though closely related are not identical because:
a) Generally banks do not lend out all of their available money but instead maintain reserves at a level above the minimum
required reserve.
b) All borrowers do not spend every Rupee they have borrowed. They are likely to convert some portion of it to cash.

CHAPTER 3: UNIT-III: MONETARY POLICY

➢ Monetary Policy
• the use of monetary policy instruments to regulate
(a) the availability, cost and use of money and credit to promote economic growth,
(b) price stability,
(c) optimum levels of output and employment,
(d) balance of payments equilibrium and stable currency etc.
• all actions of the central bank aimed at:
(a) directly controlling the money supply and; (b) indirectly at regulating the demand for money.
➢ Monetary Policy Framework

A. The Objectives of monetary policy B. The Analytics of monetary policy C. The Operating procedure which
which focus on the transmission focuses on the operating targets
mechanisms and instruments
1. General Objectives are as follows: The process or channels through which the • day-to-day implementation of
(a) Balance between price stability and change of monetary aggregates affects monetary policy.
economic growth. the level of product and prices is known as
(b) rapid economic growth, ‘monetary transmission mechanism’.
(c) debt management,
(d) moderate long-term interest
rates,
(e) exchange rate stability
(f) external balance of payments
equilibrium
2. The monetary policy of Developing • Four different mechanisms are: • The direct instruments comprise of:
countries has objectives of: (a) The interest rate channel (a) Cash reserve ratios and liquidity
(a) Economic growth, (b) The exchange rate channel reserve ratios
(b) Adequate flow of credit to the (c) The quantum channel (e.g., relating to (b) Directed credit
productive sectors, money supply and credit) (c) Administered interest rates
(c) sustaining - a moderate structure ✓ Two distinct channels under quantum • The indirect instruments mainly consist
of interest rates of:
channel:
(d) creation of an efficient market for (a) Repos
1. The Bank lending channel
government securities. (b) Open market operations
2. The balance sheet channel
(c) Standing facilities, and
(d) The asset price channel i.e. via equity

and real estate prices (d) Market-based discount window.

➢ Operating Framework.
• All aspects of implementation of monetary policy.
• It primarily involves three major aspects, as follows:
1. Choosing the operating target
2. Choosing the intermediate target
3. Choosing the policy instruments
➢ Cash Reserve Ratio (CRR) and Monetary Policy

• Fraction of the total net demand and time liabilities (NDTL) of Bank.
• To be maintained as cash deposit with the Reserve Bank.
• Uniform to all scheduled banks.
• Does not apply to Non – Bank Financial Institution (NBFIs)
• The Reserve Bank does not pay any interest on the CRR balances
• Higher the CRR, lower will be the liquidity and vice versa.
• During slowdown in the economy, the RBI reduces the CRR in order to enable the banks to expand credit and increases the
supply of money available in the economy.
• The cash reserve ratio as on 16th February, 2020 was 4.0 per cent.
➢ Statutory Liquidity Ratio (SLR) and Monetary Policy

• Prudential measure.
• Stipulated percentage of their total Demand and Time Liabilities (DTL) / Net DTL (NDTL) in one of the following forms:
❖ Cash
❖ Gold, or
❖ Investments in un-encumbered Instruments that include:
(a) Treasury-bills of the Government of India.
(b) Dated securities including those issued by the Government of India
(c) State Development Loans (SDLs) issued by State Governments
(d) Other instruments as notified by the RBI
• SLR on 15th February, 2020 was 19%.
• A powerful tool for controlling liquidity.
• Influences the availability of resources in the banking system.
• During high liquidity period, SLR is raised.
• Provides a market for government securities.
➢ Liquidity Adjustment Facility (LAF) and Monetary Policy

• Central Bank (Bankers bank) provides liquidity to banks through its discount window.
• Banks can borrow from the discount window against the collateral of securities like commercial bills, government securities,
treasury bills, or other eligible papers.
• From June 2000, the RBI has introduced Liquidity Adjustment Facility (LAF).
• Following are under Liquidity Adjustment Facility (LAF).
(i) Repurchase Option (REPO)
• An instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually
agreed future date at an agreed price which includes interest for the funds borrowed’.
• Report on the electronic platform called the Negotiated Dealing System (NDS).
• The rate charged is called the ‘repo rate’. Repo operations thus inject liquidity into the system.
• If the RBI wants to make it more expensive for banks to borrow money, it increases the repo rate.
• REPO rate reported in February 2020 was 5.15%
(ii) Reverse REPO
• ‘Reverse Repo’ is defined as an instrument for lending funds by purchasing securities with an agreement to resell the
securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.
• Reverse repo operation takes place when RBI borrows money from banks by giving them securities.
• The interest rate paid by RBI for such transactions is called the ‘reverse repo rate’.
• Reverse repo operation in effect absorbs the liquidity in the system.
❖ There are three types of repo markets operating in India namely:
(i) Repo on sovereign securities
(ii) Repo on corporate debt securities ,and
(iii) Other Repos
❖ ‘Term Repo’ (repos of duration more than a day) is for 14 days and 7 days tenors.
➢ Marginal Standing Facility (MSF) and Monetary Policy?

• RBI acts as a lender of last resort.
• Scheduled commercial banks can borrow additional amount of overnight money from the central bank over and above what is
available to them through the LAF window by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a
penal rate of interest.
• Safety valve against unexpected liquidity.
• Banks can borrow through MSF on all working days except Saturdays, between 7.00 pm and 7.30 pm, in Mumbai. The minimum
amount which can be accessed through MSF is Rs. 1 crore and more will be available in multiples of Rs. 1 crore.
• The MSF rate was 5.65% in February, 2020.
➢ Market Stabilization Scheme (MSS) and Monetary Policy?

• MOU between the Reserve Bank of India (RBI) and the Government of India (GOI).
• The primary aim of aiding the sterilization operations of the RBI.
• Under this scheme, the Government of India borrows from the RBI and issues treasury-bills/dated securities for absorbing
excess liquidity from the market arising from large capital inflows.
➢ Bank Rate and Monetary Policy

• Bank Rate is the standard rate at which the Reserve Bank is prepared to buy or re- discount bills of exchange or other
commercial paper eligible for purchase under the Act.
• Used only for calculating penalty on default in the maintenance of CRR and SLR.
➢ Open Market Operations and Monetary Policy

• Market operations conducted by the Reserve Bank of India by way of sale/ purchase of Government securities to/ from the
market with an objective to adjust the rupee liquidity conditions in the market.
• When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby reducing out the rupee
liquidity.
➢ The Organisation Structure for Monetary Policy Decisions

I. The Monetary Policy Framework Agreement II. The Monetary Policy Committee (MPC)
• Agreement reached between the Government of India and • Six-member Monetary Policy Committee (MPC) constituted
the Reserve Bank of India (RBI) on the maximum tolerable in September, 2016
inflation rate for price stability. • determine the policy rate required to achieve the inflation
target.
• Inflation targeting. • The new system is intended to incorporate:
• Once in every five years. Accordingly, ✓ diversity of views,
✓ Consumer Price Index (CPI) for the period from August ✓ specialized experience,
5, 2016 to March 31, 2021 is 4% with the upper ✓ independence of opinion,
tolerance limit of 6 per cent and the lower tolerance ✓ representativeness, and
limit of 2 per cent. ✓ accountability.
✓ Monetary Policy Report every six months is mandatory. • Assisted by The Reserve Bank’s Monetary Policy
✓ The following factors are notified:
Department (MPD)
(a) the average inflation > the upper tolerance level
• The Financial Markets Operations Department (FMOD)
(b) the average inflation < the lower tolerance level
operationalises the monetary policy.


CHAPTER 4: UNIT-I :
THEORIES OF INTERNATIONAL TRADE
➢ International Trade And the complexities involved
❖ International Trade:
• Exchange of goods and services as well as resources between countries.
• Transactions between residents of different countries.
• Involves transactions in multiple currencies.
❖ Complexities Involved:
• heterogeneity of customers and currencies,
• differences in legal systems,
• more elaborate documentation,
• diverse restrictions in the form of taxes, regulations, duties, tariffs, quotas, trade barriers,
• standards, restraints to movement of specified goods and services and issues related to shipping and transportation.
➢ Arguments supporting International Trade.

• Economic efficiency and contribution to economic growth
• Cheaper raw material, new material and foreign exchange
• Increases the scope for mechanization and specialization
• Raising standards of livelihood
• Trade strengthens bond between nations
➢ Arguments against Trade Openness

• Unhealthy occupational environments
• Not equally beneficial to all nations
• Exhaustion of natural resources
• Threat to domestic industries
• Welfare of people may be ignored
• Severe competition
➢ The Mercantilists’ view of International Trade (Policy of Europe’s great powers)

• Based on increasing exports and collecting precious metals in return.
• The more gold and silver a country accumulates, the richer it becomes.
• Advocated maximizing exports and minimizing imports.

• This view argues that trade is a ‘zero-sum game’, and one country’s gain is equal to another country’s loss.
➢ The Theory of Absolute Advantage.

• International trade is not a zero-sum game.
• Exchange of goods between two countries will take place only if each of the two countries can produce one commodity at an
absolutely lower production cost than the other country.
• Principle of division of labour constitutes the basis for his theory of international trade.
• By specializing and trading freely, global output is maximized and more of both goods are available to the consumers in both
the countries.
➢ The Theory of Comparative Advantage (By David Ricardo in ‘Principles of Political Economy and Taxation)
• Even if one nation is less efficient than (has an absolute disadvantage with respect to) the other nation in the production of
all commodities, there is still scope for mutually beneficial trade.
• It is based on ‘labour theory of value’, which assumes that the value or price of a commodity depends exclusively on the
amount of labour going into its production.
• The above assumption is quite unrealistic because there are other factors of production also.
➢ Haberler’ Solution:
• Haberler introduced the opportunity cost concept from Microeconomic theory to explain the theory of comparative advantage
in which no assumption is made in respect of labour as the source of value.
• According to the opportunity cost theory, the cost of a commodity is the amount of a second commodity that must be given
up to produce one extra unit of the first commodity.
• Opportunity Cost of Producing X = Labour required for 1 Unit of X/ Labour required for 1 Unit of Y
Note: international differences in relative factor-productivity are the cause of comparative advantage and a country exports goods
that it produces relatively efficiently.
➢ Limitations of Ricardian Theory:

• Its emphasis is on supply conditions and excludes demand patterns.
• The theory does not examine why countries have different costs.
➢ The Heckscher-Ohlin Theory of Trade (Factor-Endowment Theory of Trade or Modern Theory of Trade)
• The immediate cause of inter-regional trade is that goods can be bought cheaper in terms of money than they can be
produced at home.
• If a country is a capital abundant one, it will produce and export capital-intensive goods.
• The Heckscher-Ohlin theory of foreign trade can be stated in the form of two theorems:

(i) Heckscher-Ohlin Trade Theorem (ii) Factor-Price Equalization Theorem

• a country tends to specialize in the export of • A corollary to the Heckscher-Ohlin trade theory.
a commodity whose production requires • International trade tends to equalize the factor prices between the trading
intensive use of its abundant resources; and nations.
• imports a commodity whose production • Whichever factor receives the lowest price before two countries integrate
requires intensive use of its scarce economically and effectively become one market, will therefore tend to
resources. become more expensive relative to other factors.
➢ Comparison of Theory of Comparative Costs and Modern Theory:

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

• Developed and big countries are trade partners when they are trading similar goods and services.
• This is particularly true in key economic sectors such as electronics, IT, food, and automotive.

•NTT argues that, because of substantial economies of scale and network effects, it pays to export phones to sell in another
country. Those countries with the advantages will dominate the market, and the market takes the form of monopolistic
competition.
• According to NTT, two key concepts give advantages to countries that import goods to compete with products from the home
country:
Economies of Scale Network Effects:
• As a firm produces more of a product its cost per unit • The value of the product or service is
keeps going down. So if the firm serves domestic as well enhanced as the number of individuals using
as foreign market instead of just one, then it can recap it increases.
the benefit of large scale of production consequently the • This is also referred to as the ‘bandwagon
profits are likely to be higher. effect’.
• Consumers like more choices, but they also
want products and services with high
utility, and the network effect offers
increased utility from these products over
others.
• A good example will be Mobile App such as
Whats App and software like Microsoft
Windows.

CHAPTER 4: UNIT-II: THE INSTRUMENTS OF TRADE POLICY

➢ Trade Policy and its instruments
• All instruments that governments may use to promote or restrict imports and exports.
• The instruments of trade policy can be classified as:
1. Price- related measures such as tariffs, and
2. Non-price measures or non-tariff measures (NTMs).
➢ Tariff as Trade Policy Instrument and its various types.

❖ Tariffs (Custom Dues)
• Taxes or dues imposed on goods and services which are imported or exported.
• Import dues being pervasive than export dues, tariffs are often identified with import dues.
Aim Forms of Import Tariffs Other variations of the these two
tariffs,
• Alter the relative prices, (i) Specific Tariff: a) Mixed Tariffs
so as to contract the • Assigns a fixed monetary tax b) Compound Tariff or a Compound
domestic demand. per physical unit of the good Duty
• Regulate the volume of imported. It is calculated on c) Technical/Other Tariff
their imports. the basis of a unit of measure, d) Tariff Rate Quotas
• World market price of such as weight, volume, etc., of e) Most-Favored Nation Tariffs
the goods unaffected; the imported good. f) Variable Tariff
while raise their prices in • Its protective value varies g) Preferential Tariff
the domestic market. inversely with the price of the h) Bound Tariff
• Raise revenue for the import. i) Applied Tariffs
government, and (ii) Ad Valorem Tariff: j) Escalated Tariff
• protect the domestic • A constant percentage of the k) Prohibitive Tariff
import-competing monetary value of one unit of l) Import Subsidies
industries. the imported good. m) Tariffs as Response:
• Protective value of tariff on • The following sections relate to
home producer. such tariff responses to
• Gives incentives to deliberately distortions related to foreign
undervalue the good’s price on dumping and export subsidies:
1) Anti-Dumping Duties

invoices and bills of lading to 2) Countervailing Duties

reduce the tax burden
➢ Effects of Tariff on the World Economics

• Obstacles to Trade
• Domestic consumers suffer a loss in consumer surplus
• Encourage Domestic Consumption
• Increases consumer surplus
• High Profits and Increase in Employment
• Tariffs discourage efficient production in the rest of the world
• Increase Government Revenues
➢ Non-Tariff Measures and it’s Two Categories?
• Potentially have an economic effect on international trade in goods, changing quantities traded, or prices or both.
• Alter the conditions of international trade.
• NTMs are not the same as non-tariff barriers (NTBs) as they encompass a broader set of measures.
❖ Two categories of NTMs:

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

1) Import-related measures
2) Export-related measures
3) Procedural Obstacles
➢ Technical Measures

Sanitary and Phytosanitary (SPS) Measures ➢ Technical Barriers to Trade (TBT):

• Protect human, animal or plant life from risks • Both food and non-food traded products refer to
arising from additives, pests, contaminants, mandatory ‘Standards and Technical Regulations’.
toxins or disease-causing organisms and to • It defines the specific characteristics that a
protect biodiversity. product should have, such as its size, shape,
• Ban or prohibition of import of certain goods, all design, labeling / marking / packaging,
measures governing quality and hygienic functionality or performance and production
requirements, production processes, and methods, excluding measures covered by the SPS
associated compliance assessments. Agreement.
• For example: prohibition of import of poultry • Compulsory quality, quantity and price control of
from countries affected by avian flu etc. goods before shipment from the exporting
country.
• Some examples of TBT are: food laws, quality
standards, industrial standards, organic
certification, eco-labeling, marketing and label
requirements.
➢ Non-Technical measures
• Neutralize the possible adverse effects of imports in the market of the importing country.
• Following are the most commonly practiced measures in respect of imports:
1. Import Quotas:
(a) Binding Quotas
(b) Non-Binding Quotas
(c) Absolute Quotas
2. Price Control Measures ('para-tariff' measures):

3. Non-Automatic Licensing and Prohibitions:
4. Financial Measures:
5. Measures Affecting Competition:
6. Government Procurement Policies:
7. Trade-Related Investment Measures:
8. Distribution Restrictions:
9. Restriction on Post-sales Services:

10. Administrative Procedures:

11. Rules of Origin:
12. Safeguard Measures:
13. Embargos:
➢ Export-related measures.
(i) Ban on Exports:
(ii) Export Taxes:
(iii) Export Subsidies and Incentives:
(iv) Voluntary Export Restraints:

CHAPTER 4: UNIT-III: TRADE NEGOTIATIONS

➢ Introduction
• Intense bilateral and multilateral negotiations among different nations.
• India has already become part of 19 such agreements and currently negotiating more than two dozens of such proposals.
➢ International Trade Negotiations

• Complex interactive processes.
• Stakeholders are not national governments alone but many interest groups, lobbying groups, pressure groups and-Non Governmental
Organizations (NGO) exert their influence on the process.
➢ Taxonomy of Regional Trade Agreements

❖ Regional Trade Agreements
• Groupings of countries, which are formed with the objective of reducing barriers to trade between member countries.
❖ Different Types of Agreements
1. Unilateral Trade Agreements
2. Bilateral Agreements
3. Regional Preferential Trade Agreements
4. Trading Bloc
5. Free-Trade Area
6. Customs Union
7. Common Market
8. Economic and Monetary Union
➢ Few Political Institutions that help in International Trade

• Former General Agreements on Tariffs and Trade (GATT) and the World Trade Organization (WTO).
➢ Development of GATT and Reasons for its failure
❖ General Agreement on Tariffs and Trade (GATT):

• Provided the rules for much of world trade for 47 years, from 1948 to 1994.
• It was only a multilateral instrument governing international trade or a provisional agreement along with the two full-
fledged “Bretton Woods” institutions, the World Bank and the International Monetary Fund.
• Eight rounds of multilateral negotiations known as “trade rounds” held under the GATT resulted in international trade
liberalization.
❖ Reasons for Failure:

The GATT lost its relevance by 1980s because:

• Obsolete
• Substantial expansion
• Did not cover Intellectual property rights and trade in services
• World merchandise trade was beyond its Scope
• Ambiguities
• Agriculture
• Inadequacies in Dispute Settlement
➢ Uruguay Round and the Establishment of WTO.

• More powerful and comprehensive institution was needed.
• The biggest reform of the world’s trading system.
• Members established 15 groups to work on limiting restrictions in the areas of tariffs, non-tariff barriers, tropical products,
natural resource products, textiles and clothing, etc.
• In December 1993, the Uruguay Round, the eighth and the most ambitious and largest ever round of multilateral trade
negotiations in which 123 countries participated, was completed after seven years of elaborate negotiations.
➢ World Trade Organization (WTO) and its structure.

❖ WTO:
• Has authority not only in trade in industrial products but also in agricultural products and services.
• WTO replaced GATT as an international organization, the General Agreement still exists as the WTO’s umbrella treaty
for trade in goods.
❖ Objectives of WTO:
• raising standards of living
• ensuring full employment and a large and steadily growing volume of real income and effective demand
• expanding the production of and trade in goods and services
❖ Structure of WTO:
• Supported by a Secretariat located in Geneva, headed by a Director General.
• Three-tier system of decision making. The WTO’s top level decision-making body is the Ministerial Conference which can
take decisions on all matters. The Ministerial Conference meets at least once every two years.
• General Council which meets several times a year at the Geneva headquarters. The General Council also meets as the
Trade Policy Review Body and the Dispute Settlement Body.
• At the next level, the Goods Council, Services Council and Intellectual Property (TRIPS) Council report to the General
Council. These councils are responsible for overseeing the implementation of the WTO.

• Numerous specialized committees, working groups and working parties deal with the individual agreements and other areas
such as the environment, development, membership applications and regional trade agreements.
• The WTO accounting for about 95% of world trade currently has 164 members, of which 117 are
developing countries or separate customs territories accounting for about 95% of world trade.
➢ Guiding Principles of World Trade Organization (WTO).

• Trade without discrimination: Most-favored-nation (MFN)
• The National Treatment Principle (NTP)
• Free Trade
• Predictability
• Principle of general prohibition of quantitative restrictions
• Greater Competitiveness
• Tariffs as legitimate measures for the protection of domestic industries
• Transparency in Decision Making
• Progressive Liberalization
• Market Access
• Special privileges to less developed countries
• Protection of Health & Environment
• A transparent, effective and verifiable dispute settlement mechanism
➢ Some main features of WTO.

• Agreement on Agriculture
• Agreement on the Application of Sanitary and Phytosanitary (SPS)
• Agreement on Textiles and Clothing
• Agreement on Technical Barriers to Trade (TBT)
• Agreement on Trade-Related Investment Measures (TRIMS)
• Anti-Dumping Agreement
• Customs Valuation Agreement
• Agreement on Pre-Shipment Inspection (PSI)
• Agreement on Rules of Origin
• Agreement on Import Licensing
• Agreement on Subsidies and Countervailing Measures
• Agreements on Safeguards
• General Agreement on Trade in Services (GATS)
• Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS)

• Understanding on Rules and Procedures Governing the Settlement of Disputes (DSU)

• Trade Policy Review Mechanism (TPRM)
• Plurilateral Trade Agreements:
1. Agreement on Trade in Civil Aircraft
2. Agreement on Government Procurement
➢ “The Doha Round”.

• The Doha Round, formally the Doha Development Agenda, which is the ninth round since the Second World War was officially
launched at the WTO’s Fourth Ministerial Conference in Doha, Qatar, in November 2001.
• To accomplish major modifications of the international trading system through lower trade barriers and revised trade rules.
• The negotiations include 20 areas of trade, including agriculture, services trade, market access for nonagricultural products,
and certain intellectual property issues.
• The most controversial topic in the yet to conclude Doha Agenda has been agriculture trade.
➢ Few concerns of WTO.

• Multilateral Negotiations are very slow
• Regional Agreements introduces Uncertainties
• Difficulty in Liberalizing Agriculture / Textile
• Doha Development Round
• Dissatisfaction among Developing Countries
• Concerns of Developing Countries
• High Tariffs
• Tariff Escalation
• Narrowing Rate Differences
• Least Developed Countries

CHAPTER 4: UNIT-IV:
EXCHANGE RATE AND ITS ECONOMIC EFFECTS
➢ Foreign Exchange and Exchange Rate
Foreign Exchange Exchange Rate:
• Money denominated in a currency other than the • the rate at which the currency of one country
domestic currency, exchanges for the currency of another country.
• Has a price.
➢ Two ways to express nominal exchange rate between two currencies

(i) Direct Quote: (ii) Indirect Quote:
• Number of units of a local currency exchangeable • number of units of a foreign currency
for one unit of a foreign currency. exchangeable for one unit of local currency.
• foreign currency is the base currency; and • domestic currency is the base currency; and
• domestic currency is the counter currency. • foreign currency is the counter currency.
➢ Cross Trade
• Two pairs of currencies with one currency being common between the two pairs.
• For instance, exchange rates may be given between a pair, X and Y and another pair, X and Z. The rate between Y and Z
is derived from the given rates of the two pairs (X and Y, and, X and Z) and is called ‘cross rate’.
➢ Exchange Rate Regimes

• System by which a country manages its currency in respect to foreign currencies.
• It refers to the method by which the value of the domestic currency in terms of foreign currencies is determined.
• There are two major types of exchange rate regimes at the extreme ends; namely:
Floating Exchange Rate Regime (or Flexible Fixed Exchange Rate Regime (or pegged
Exchange Rate) exchanged rate)
• The equilibrium value of the exchange rate of • Country’s Central Bank and/ or government
a country’s currency is market-determined. announces or what its currency will be worth
• Any intervention by the central banks is in terms of either another country’s currency.
intended for only moderating the rate of • Government intervenes in the foreign exchange
change and preventing undue fluctuations in market so that the exchange rate of its
the exchange rate.

currency is different from what the market

would have produced
• In the real world, there is a spectrum of ‘intermediate exchange rate regimes’ which are either inflexible or have varying
degrees of flexibility that lie in between these two extremes (fixed and flexible).
❖ IMF Classifications and Definitions of Exchange Rate Regimes

• Refer the Chapter -4 Unit IV notes
➢ Advantages and limitations of Fixed Rate Regime.

❖ Advantages:
• Eliminates Exchange Rate Risks
• Lower Levels of Inflation
• Greater Trade and Investment
• Credibility of the Country’s Monetary-Policy
❖ Limitations:
• Central Bank Intervention
• Foreign Exchange Reserves
➢ Advantages and limitations of Floating Exchange Rate Regime.

❖ Advantages:
• Independent Monetary Policy
• Policy Tool
• No Obligation and No Intervention
❖ Limitations:
• Uncertainties in relation to International Transactions
• Add a Risk Premium
➢ Nominal Exchange Rate, Real Exchange Rate and Real Effective Exchange Rate (REER).
Nominal Exchange Rate: Real Exchange Rate: Real Effective Exchange Rate
• how much of one • ‘how many’ of a good or service in • the nominal effective
currency (i.e. money) one country can be traded for ‘one’ exchange rate (a measure of
can be traded for a unit of that good or service in a foreign the value of a domestic
of another currency country. currency against a weighted
• It is calculated as : average of various foreign

when prices are • Nominal exchange rate X (Domestic currencies) divided by a price
constant. Price Index / Foreign price Index ) deflator or index of costs.
➢ The Foreign Exchange Market

• Wide-reaching collection of markets and institutions that handle the exchange of foreign currencies.
• The participants use one currency to purchase another currency.
• An electronically linked network.
➢ Various parties participate in foreign exchange market

Major Participants: Other Participants:
• central banks, • individuals who form only a very
• commercial banks, insignificant fraction in terms of volume
• governments, and value of transactions.
• foreign exchange Dealers,
• multinational corporations that engage in international
trade and investments,
• non-bank financial institutions
• insurance companies,
• brokers,
• arbitrageurs, and
• speculators
➢ Arbitrage.
• Practice of making risk-less profits by intelligently exploiting price differences of an asset at different dealing locations.
• When price differences occur in different markets, participants purchase foreign exchange in a low-priced market for resale
in a high-priced market and makes profit in this process.
➢ Two types of transactions

(i) Current Transactions:
Carried out in the spot market and the exchange involves immediate delivery.
(ii) Future Delivery:
Contracts to buy or sell currencies for future delivery which are carried out in forward and/or futures markets.
➢ Define:
(a) Spot Exchange Rates:
Exchange rates prevailing for spot trading (for which settlement by and large takes two days) are called spot exchange rates.

(b) Forward Exchange Rates:

The exchange rates quoted in foreign exchange transactions that specify a future date are called forward exchange rates.
(c) Forward Premium
A forward premium is said to occur when the forward exchange rate is more than a spot trade rates.
(d) Forward Discount:
On the contrary, if the forward trade is quoted at a lower rate than the spot trade, then there is a forward discount.
➢ “Vehicle Currency”
Most transactions involve exchanges of foreign currencies for the U.S. dollars even when it is not the national currency of either
the importer or the exporter. Thus, dollar is often called a ‘vehicle currency’.
➢ Reasons for Demand for Foreign Exchange

• purchase goods and services from another country
• for unilateral transfers such as gifts, awards, grants, donations or endowments
• to make investment income payments abroad
• to purchase financial assets, stocks or bonds abroad
• to open a foreign bank account
• to acquire direct ownership of real capital, and
• for speculation and hedging activities related to risk-taking or risk-avoidance activity
➢ Reasons for supply of Foreign Exchange

The participants on the supply side operate to:
• sell goods and services to another country
• for unilateral transfers such as gifts, awards, grants, donations or endowments
• to make investment income receipts from abroad
• to sell financial assets, stocks or bonds abroad
• to open a foreign bank account
• to sell direct ownership of real capital, and
• for speculation and hedging activities related to risk-taking or risk-avoidance activity.
➢ Determination of Foreign Exchange Rate
• The equilibrium rate of exchange is determined by the interaction of the supply and demand for a particular foreign currency.
Determination of Nominal Exchange Rate

➢ Changes in Exchange Rates

❖ Appreciation
• Currency appreciates when its value increases with respect to the value of another currency or a basket of other
currencies.
❖ Depreciation
• Currency depreciates when its value falls with respect to the value of another currency or a basket of other currencies.
➢ Home Currency Depreciation and Appreciation under Floating Exchange Rates

Home Currency Depreciation under Floating Home Currency Appreciation under Floating
Exchange Rates Exchange Rates
➢ Difference between Devaluation (Revaluation) and Depreciation (Appreciation) of currency.

Basis of Difference Devaluation of currency Depreciation of currency

Meaning It is a deliberate downward adjustment It is a decrease in a currency's value due
in the value of a country's currency to market forces.
relative to another currency, group of
currencies or standard.
Exchange Rate System It is done under fixed exchange rate It is done under floating exchange rate
system. system.
Reason Devaluation takes place due to Depreciation takes place due to market
government policy. forces.
Impact on Economy It affects the economy for a short It affects the economy for a longer
term. term.
Frequency There is no fixed time for it but it It occurs on a daily basis.
doesn’t occur in regularly.
➢ Impacts of foreign exchange rate deprecation on Domestic Economy.

(a) On Country’s Trade
(b) On Price of goods and services in International Markets
(c) On Economic Activity
(d) On Change International Competitiveness
(e) Consumer Price Inflation
(f) Shift in use of factors of production
(g) On Balance of Payment
(h) On Borrowing Companies
(i) On International Investments
❖ The other impacts of currency depreciation are:
(i) Windfall gains for export oriented sectors.
(ii) Remittances to homeland by non – residents and businesses abroad fetches more in terms of domestic currency
(iii) Enhance government revenues from import related taxes, especially if the country imports more of essential goods
(iv) Higher amount of local currency for a given amount of foreign currency borrowings of government.
(v) Positive impact on country’s trade deficit as it makes imports more expensive for domestic consumers and exports cheaper
for foreigners.
(vi) Positive impact on controlling spiraling gold imports (mostly wasteful) and thereby improve trade balance.
➢ Can depreciation of currency lead to Contractionary effects?

• In an under developed or semi industrialized country, where - inputs (such as oil) and components for manufacturing are mostly

imported and cannot be domestically produced, increased import prices will increase firms’ cost of production , push domestic
prices up and decrease real output.
• Therefore, depreciation may also cause contractionary effects.
➢ Impacts of foreign exchange rate appreciation on Domestic Economy

(a) Rise in price of exports
(b) Dependent on stage of business cycle
(c) Reduction in the levels of inflation
(d) Lower International Competitiveness
(e) Deficit Current Account Balance

CHAPTER 4: UNIT-V:
INTERNATIONAL CAPITAL MOVEMENTS
➢ Components/types of Foreign Capital
• includes any inflow of capital into the home country from abroad.
• Some of the important components of foreign capital flows are:
1. Foreign aid or assistance
2. Borrowings which may take different forms such as:
3. Deposits from non-resident Indians (NRI)
4. Investments in the form of :
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and
(ii) Foreign direct investment(FDI) in industrial, commercial and similar other enterprises
➢ Foreign Direct Investment (FDI)

(i) A process whereby the resident of one country (i.e. home country) acquires ownership of an asset in another country (i.e. the
host country).
(ii) According to IMF manual,
Acquisition of more than 10 percent of the shares of the target asset.
(iii) According to the IMF and OECD definitions, the acquisition of at least ten percent of the ordinary shares or voting power in a
public or private enterprise by non- resident investors makes it eligible to be categorized as foreign direct investment (FDI).
India also follows the same pattern of classification.
➢ Types of components of Foreign Direct Investment

• FDI has three components as follows:
1. Equity capital,
2. Reinvested earnings, and
3. Other direct capital in the form of intra-company loans between direct investors (parent enterprises) and affiliate
enterprises.
• The main forms of direct investments are:
(a) the opening of overseas companies, including the establishment of subsidiaries or branches,
(b) creation of joint ventures on a contract basis,
(c) joint development of natural resources, and
(d) purchase or annexation of companies in the country receiving foreign capital.
➢ Categories of Foreign Direct Investment

(a) Horizontal direct investment

(b) Vertical investment
(c) Conglomerate type of foreign direct investment
(d) Two- way direct foreign investments
➢ Foreign Portfolio Investment (FPI)

• Flow of ‘financial capital’ and does not involve ownership or control on the part of the investor.
• Examples of foreign portfolio investment are the deposit of funds in an Indian or a British bank by an Italian company or the
purchase of a bond (a certificate of indebtedness) of a Swiss company etc.
• Not concerned with either manufacture of goods or with provision of services.
• The singular intention is to earn a remunerative return through investment.
• Portfolio investments are characterised by lower stake in companies with their total stake in a firm at below 10 percent.
• Short term nature and speculative.
➢ Difference between Foreign Direct Investment and Foreign Portfolio Investment is as follows:
Basis of Difference Foreign direct investment (FDI) Foreign portfolio investment (FPI)
Investment Investment involves creation of physical Investment is only in financial assets.
assets.
Duration Has a long term interest and therefore Only short term interest and generally
remain invested for long. remain invested for short periods.
Withdrawal Relatively difficult to withdraw. Relatively easy to withdraw.
Nature Not inclined to be speculative. Speculative in nature.
Technology Transfer Often accompanied by technology Not accompanied by technology

transfer. transfer.
Impact on Labour and Direct impact on employment of labour and No direct impact on employment of
wages wages. labour and wages.
Impact on Management Enduring interest in management and No abiding interest in management and
and Control control. control.
Securities held Securities are held with significant degree Securities are held purely as a financial
of influence by the investor on the investment and no significant degree of
management of the enterprise. influence on the management of the
enterprise.
➢ Reasons for Foreign Direct Investment

• Expectation of higher rate of return.

• Firm-specific knowledge or assets (such as superior management skills or an important patent)
• Other reasons are as follows:
(a) Increasing Interdependence
(b) Internationalization of Production and Investment
(c) Economies of Large Scale
(d) Lack of feasibility of Licensing Agreements
(e) Necessity to retain Direct Control of production knowledge
(f) Avoid competition
(g) Retain complete control
(h) Desire to capture markets
(i) Desire to access to minerals or raw materials
(j) Cheaper Labour
(k) Tax Differentials
➢ Host country determinants of Foreign Direct Investment

Refer to the Unit – V of Chapter 4
➢ Few factors that discourage Foreign Direct Investment

(i) infrastructure lags,
(ii) high rates of inflation,
(iii) balance of payment deficits,
(iv) poor literacy and low labour skills,
(v) rigidity in the labour market,
(vi) bureaucracy and corruption,
(vii) unfavourable tax regime,
(viii) cumbersome legal formalities and delays,
(ix) small size of market and lack of potential for its growth,
(x) political instability,
(xi) absence of well- defined property rights,
(xii) exchange rate volatility,
(xiii) poor track-record of investments,
(xiv) prevalence of non-tariff barriers,
(xv) stringent regulations,
(xvi) lack of openness,

(xvii) language barriers,

(xviii) high rates of industrial disputes,
(xix) lack of security to life and property,
(xx) lack of facilities for immigration and employment of foreign technical and administrative personnel,
(xxi) double taxation and
(xxii) lack of a general spirit of friendliness towards foreign investors.
➢ Modes of Foreign Direct Investment.

(i) Opening of a subsidiary or associate company in a foreign country
(ii) Equity injection into an overseas company,
(iii) Acquiring a controlling interest in an existing foreign company,
(iv) Mergers and acquisitions(M&A)
(v) Joint venture with a foreign company.
(vi) Green field investment (establishment of a new overseas affiliate for freshly starting production by a parent company).
➢ Benefits of Foreign Direct Investment

1. Competitive environment
2. Finance more investment
3. Accelerate growth and economic development
4. Political Reforms
5. Direct Employment
6. Indirect Employment
7. Relatively higher wages
8. Access to foreign markets
9. Secure Foreign Exchange
10. Source New Tax Revenue
11. Better work culture and higher productivity
➢ Potential problems associated with Foreign Direct Investment

1. Low employment opportunities
2. Leads to Inequalities
3. Rise in interest rates
4. Instability of Balance of Payment
5. Lack of Quality jobs
6. Anti – Ethical
7. Decreasing Competitiveness of Domestic Companies
8. Exploitation of natural resources

➢ Foreign Direct Investment in India.

• Import substitution policy was followed after independence.
• FERA permitted upto 40% of foreign equity holding in a joint venture.
• The Industrial Policy announcements of 1980 and 1982 and the Technology Policy Statement (1983) provided for a moderately
lenient attitude towards foreign investments by:
(a) Endorsement of manufacturing exports
(b) Modernisation of industries through liberalised imports of capital goods and technology
(c) Tariff reduction
• In 1991, India had an economic liberalisation and reforms and few Initiatives of Government are as follows:
(a) automatic approval of FDI,
(b) simplification of procedures,
(c) setting up of Foreign Investment Promotion Board (FIPB abolished wef May 2017), etc.
• In India, foreign investment is prohibited in the following sectors:
(a) Lottery business including Government / private lottery, online lotteries, etc.
(b) Gambling and betting including casinos etc.
(c) Chit funds
(d) Nidhi company
(e) Trading in Transferable Development Rights (TDRs)
(f) Real Estate Business or Construction of Farm Houses
(g) Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes
(h) Activities / sectors not open to private sector investment e.g. atomic energy and railway operations (other than permitted
activities).
• The FDI regime was liberalized on 20-June-2016, to make India an open economy and provide employment and included:
(a) increase in sectoral caps,
(b) bringing more activities under automatic route and
(c) easing of conditions for foreign investment.
• The liberalized policy 2016, included easing of FDI in:
(a) defence sector,
(b) e-commerce
(c) food products manufactured or produced in India,
(d) pharmaceuticals (Greenfield and Brownfield), etc.
➢ Overseas Direct Investment (ODI) by Indian Companies.

• Overseas direct investments by Indian companies was made possible by:
(a) progressive relaxation of capital controls and
(b) simplification of procedures for outbound investments from India

• ODI have undergone substantial changes in terms of: size, geographical spread and sectoral composition.
• Outward Foreign Direct Investment (OFDI) from India stood at US$ 1.86 billion in the month of June 2016.
• The overseas investments have been primarily driven by resource seeking, market seeking or technology seeking motives.
• Overseas investments are made by Indian companies:
(a) To acquire energy resources in Australia, Indonesia and Africa.
(b) To have higher tax benefits in countries such as Mauritius, Singapore, British Virgin Islands, and the Netherlands
• At present, an Indian investor cannot make ODI in certain real estate activities.


Eco Marathon Notes by Ca Nitin Guru

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Eco Marathon Notes by Ca Nitin Guru

Uploaded by

Copyright:

Available Formats

EDU91 | Where Learning Happens BY CA NITIN GURU

CHAPTER 1: UNIT-I: NATIONAL INCOME ACCOUNTING

(ii) Determines Present and Future Demand:

(iii) Measure of Economic Welfare

(iv) Possible to Make Temporal and Spatial Comparisons:

(v) Evaluation of governments’ Economic Policies:

To get the best out of these notes visit www.edu91.org

(vi) Study of Inequality:

(vii) International Comparisons:

(viii) Economic Forecasting:

(i) Product Side:

(ii) Expenditure Side:

(iii) Income Side:

To get the best out of these notes visit www.edu91.org

(i) Only Final Goods and Services:

(ii) Intermediate Consumption:

(iii) Economic Activities:

(iv) ‘Flow’ Concept:

(v) Inventory Investment:

To get the best out of these notes visit www.edu91.org

GNPMP = GDPMP + Net Factor Income from Abroad

GDPMP = GNPMP – Net Factor Income from Abroad

National = Domestic + Net Factor Income from Abroad

To get the best out of these notes visit www.edu91.org

NDPMP = GDPMP –Depreciation

NDPMP = NNPMP – Net Factor Income from Abroad

Gross = Net + Depreciation

NNPMP = GNPMP – Depreciation

To get the best out of these notes visit www.edu91.org

Market Price = Factor Cost + Net Indirect Taxes

Factor Cost = Market Price – Net Indirect Taxes

To get the best out of these notes visit www.edu91.org

Circular Flow of Income

Disposition Distribution as factor

➢ Income/ Distribution Phase:

To get the best out of these notes visit www.edu91.org

➢ Expenditure/ Disposition Phase:

Gross value added (GVA MP) = Value of output – Intermediate consumption

∑ (GVA MP) – Depreciation = Net value added (NVA MP)

To get the best out of these notes visit www.edu91.org

NNP FC or National Income = Compensation of employees + Operating Surplus (rent + interest+

To get the best out of these notes visit www.edu91.org

1. Final Expenditure Method

a) Private Final Consumption Expenditure (PFCE):

b) Government Final Consumption Expenditure (GFCE):

2. Gross Domestic Capital Formation

To get the best out of these notes visit www.edu91.org

To get the best out of these notes visit www.edu91.org

To get the best out of these notes visit www.edu91.org

f) valuation of a new good at constant prices, and

Final Goods and Intermediate Goods

Consumption Goods and Capital Goods

To get the best out of these notes visit www.edu91.org

Basis Consumption Goods Capital Goods

Domestic Income and National Income

Depreciation and Capital Loss

Personal Income and Private Income

Personal Income and National Income

To get the best out of these notes visit www.edu91.org

Basis Personal Income Private Income

Domestic Income (NDPFC)

Income from Domestic Product Income from Domestic Product

Income from Property and