UNIT-2:

MACRO ECONOMICS
NATIONAL INCOME:
To simply understand what National Income is, it can be represented
as - National Income defines a country's wealth. This income depicts
the value of goods and services which are produced by an economy.
This gives effect to the net result of all the economic activities
performed in the country.
Imagine how you would define a country’s wealth without any
economic term?In that case, there would be no accountability and
responsibility linked with the production in the country. The resources
would go uncalculated and there would be a vague economic
atmosphere. Thus, let us indulge in this study which talks about
National Income. 
Understanding National Income
National income is the sum total of the value of all the goods and
services manufactured by the residents of the country, in a year.,
within its domestic boundaries or outside. It is the net amount of
income of the citizens by production in a year. To be more precise,
national income is the accumulated money value of all final goods
and services produced in a country during one financial year.
Computation of National Income is very vital as it indicates the
overall health of our economy for that particular year.The aggregate
economic performance of a nation is calculated with the help of
National income data. The basic purpose of national income is to
throw light on aggregate output and income and provide a basis for
the government to formulate its policy, programs, to maximize the
national welfare of the people. Central Statistical Organization
calculates the national income in India.
Traditional Definition of National Income-According to Marshall:
“The labor and capital of a country acting on its natural resources
produce annually a certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true net annual
income or revenue of the country Modern Definition 
This definition has two subparts
GDP
Gross Domestic ProductGross Domestic Product, abbreviated as
GDP, is the aggregate value of goods and services produced in a
country. GDP is calculated over regular time intervals, such as a
quarter or a year. GDP as an economic indicator is used worldwide to
measure the growth of countr Goods are valued at their market prices,
so:
All goods measured in the same units (e.g., dollars in the U.S.)
Things without exact market value are excludedies economy.

Constituents of GDP Wages and salaries Rent Interest Undistributed

profits Mixed-income Direct taxes Dividend Depreciation
The Formula for Calculation of GDP
GDP = consumption + investment + government spending + exports -
imports.

GNP
Gross National ProductGross National Product (GNP) is an estimated
value of all goods and services produced by a country’s residents and
businesses. GNP does not include the services used to produce
manufactured goods because its value is included in the price of the
finished product. It also includes net income arising in a country from
abroad.
Components of GNP
 Consumer goods and services
 Gross private domestic income
 Goods produced or services rendered
 Income arising from abroad.
Formula to Calculate GNP
GNP = GDP + NR (Net income from assets abroad or Net Income
Receipts) - NP (Net payment outflow to foreign assets).

Importance of  National Income

Setting Economic Policy
National Income indicates the status of the economy and can give a
clear picture of the country’s economic growth. National Income
statistics can help economists in formulating economic policies for
economic development.
Inflation and Deflationary Gaps
For timely anti-inflationary and deflationary policies, we need
aggregate data of national income. If expenditure increases from the
total output, it shows inflammatory gaps and vice versa.
Budget Preparation
The budget of the country is highly dependent on the net national
income and its concepts. The Government formulates the yearly
budget with the help of national income statistics in order to avoid
any cynical policies.
Standard of Living
National income data assists the government in comparing the
standard of living amongst countries and people living in the same
country at different times.

Defense and Development

National income estimates help us to bifurcate the national product
between defense and development purposes of the country. From such
figures, we can easily know, how much can be set aside for the
defense budget.
Sets of methods for measuring National Income
There are four methods of measuring national income. The type of
method to be used depends on the availability of data in a country and
the purpose which is attempted for.
Income Method
In this method, we add net income payments received by all citizens
of a country in a particular year. Net incomes that result in all the
factors of production like net rents, wages, interest, and profits are all
added together, but income received in the form of transfer payments
are omitted.
Product Method
According to this method, the aggregate value of final goods and
services produced in a country during a financial year is computed at
market prices. To find out GNP, the data of all the productive
activities-agricultural products, Minerals, Industrial products, the
contributions to production made by transport, insurance,
communication, lawyers, doctors, teachers. Etc are accumulated and
assessed.
Expenditure Method
The total expenditure by the society in a financial year is summed up
together and includes personal consumption expenditure, net domestic
investment, government expenditure on goods and services, and net
foreign investment. This concept is backed by the assumption that
national income is equal to national expenditure.
Value Added Method
The distinction between the value of material outputs and material
inputs at every stage of production is Value added.

GDP Vs GNP
The Gross Domestic Product and the Gross National Product are the
two most widely used measures in a country’s calculation of
aggregate economic unit. GDP is the measure of the value of goods
and services that are being produced within a country's borders, by the
citizens and the non-citizens. While GNP determines the value of
goods and services that are being produced by the country's citizens in
the domestic and abroad spectrum. GDP is popularly used by the
global economies at large. While, the United States eliminated the use
of GNP in the year 1991, thereby adopting GDP as the measure to
compare their economy with other economies.
What is Economic Collapse?

Economic collapse refers to a period of national or regional economic

breakdown where the economy is in distress for a long period, which
can range from a few years to several decades. During periods of
economic distress, a country is characterized by social chaos, social
unrest, bankruptcies, reduced trade volumes, currency volatility, and
breakdown of law and order.

Causes of Economic Collapse

The following are some of the causes of economic collapse:

1. Hyperinflation

Hyperinflation occurs when the government allows inflationary

pressure to build up in the economy by printing excessive money,
which leads to a gradual rise in the prices of commodities and
services. Governments resort to creating excess money and credit
with the goal of managing an economic slowdown. Hyperinflation
occurs when the government loses control of the price increases and
raises the interest rates as a way of managing the
accelerating inflation.

2. Stagflation

Stagflation refers to a situation in which the economy is growing at a

slow rate while simultaneously experiencing high rates of inflation.
Such an economic situation causes a dilemma among policymakers
since the measures implemented to reduce the rise in inflation may
increase unemployment levels to abnormally high levels. Stagflation
and its effects on the economy may last for several years or decades.

For example, the United States experienced stagflation from the

1960s to the 1970s. During said period, economic growth was
stagnant, and the inflation peaked at 13% per annum while the
inflation rate in the United Kingdom was at 20% per annum. Once
stagflation occurs, it is usually difficult to manage, and governments
must incur huge costs to bring balance to the economy.

3. Stock market crash

A stock market crash occurs when there is a loss of investor

confidence in the market, and there is a dramatic decline in stock
prices across different stocks trading in the stock market. When a
stock market crash occurs, it creates a bear market (when prices drop
20% or more from their highs to hit new lows), and it drains capital
out of businesses.

Crashes occur when there is a prolonged period of rising stock prices,

price earning ratios exceed long-term averages, and there is excessive
use of margin debt by market participants.

Scenarios that Define an Economic Collapse

The following are some of the things that characterize an economic

collapse:

1. Rising interest rates

During periods of economic collapse, interest rates peak at

abnormally high levels, and it limits the amount of money that is
available for investors to invest. High interest rates hinder economic
growth since investors, corporations, and the government find it
costly to service existing debt obligations and take out new loans due
to the high cost of capital.
When a major company declares its inability to finance its debt
obligations and resorts to disposing of its assets to pay creditors,
investors lose confidence in the company and will be hesitant to trade
their money during periods of financial distress.

2. Sovereign debt crisis

Sovereign debts are debts taken up by a government to finance

capital-intensive infrastructural projects. However, when the
government takes on too many debts and is unable to pay principal
and interest obligations when they fall due, it increases the risk of
defaulting on its existing debt obligations and going bankrupt.

A sovereign debt crisis occurs during periods of slow economic

growth, wars, political instability, drought, and when investors lose
confidence in the government. Due to the large size of sovereign
debts, a default by the government is likely to affect the global
economy and cause spill-over effects on other jurisdictions.

3. Local currency crisis

A local currency crisis occurs when the currency depreciates in value

due to a loss of investor confidence. This occurs when foreign
investors who have invested in a country and advanced credit to the
government lose confidence in the government’s ability to meet debt
obligations or generate the agreed-upon returns.

In such situations, the foreign investors withdraw their investments in

the country. The move increases the selling of the borrowing
country’s currency in the international market, resulting in currency
devaluation. In return, the currency devaluation increases the
country’s international debts, resulting in the loss of the country’s
purchasing power.

4. Global currency crisis

A global currency crisis involves the loss of value of a major currency

that is used in cross-border trade transactions between individuals,
corporations, and governments. For example, the US dollar is used as
the world reserve currency in the Bretton Woods institutions, which
means that if the US dollar depreciates in value, it may trigger a
global economic crisis.

ECONOMIC RESILIENCE:
The National Association of Counties (NACO) describes economic
resilience as a community's ability to foresee, adapt to, and
leverage changing conditions to their advantage
.
INTERNATIONAL TRADE;

If you can walk into a supermarket and find Costa Rican bananas,
Brazilian coffee, and a bottle of South African wine, you're
experiencing the impacts of international trade.

International trade is the purchase and sale of goods and services by

companies in different countries. Consumer goods, raw materials,
food, and machinery all are bought and sold in the international
marketplace.

International trade allows countries to expand their markets and

access goods and services that otherwise may not have been available
domestically. As a result of international trade, the market is more
competitive. This ultimately results in more competitive pricing and
brings a cheaper product home to the consumer.

KEY TAKEAWAYS

 Trading globally gives consumers and countries the opportunity

to be exposed to goods and services not available in their own
countries, or more expensive domestically.
 The importance of international trade was recognized early on
by political economists such as Adam Smith and David
Ricardo.
 Still, some argue that international trade can actually be bad for
smaller nations, putting them at a greater disadvantage on the
world stage.
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Watch Now: What Is International Trade?
Understanding International Trade
International trade was key to the rise of the global economy. In the
global economy, supply and demand—and thus prices—both impact
and are impacted by global events.

Political change in Asia, for example, could result in an increase in

the cost of labor. This could increase the manufacturing costs for an
American sneaker company that is based in Malaysia, which would
then result in an increase in the price charged for a pair of sneakers
that an American consumer might purchase at their local mall.

Imports and Exports

A product that is sold to the global market is called an export, and a
product that is bought from the global market is an import. Imports
and exports are accounted for in the current account section of a
country's balance of payments.

Global trade allows wealthy countries to use their resources—for

example, labor, technology, or capital—more efficiently. Different
countries are endowed with different assets and natural resources:
land, labor, capital, technology, etc.

This allows some countries to produce the same good more

efficiently; in other words, more quickly and at a lower cost.
Therefore, they may sell it more cheaply than other countries. If a
country cannot efficiently produce an item, it can obtain it by trading
with another country that can. This is known as specialization in
international trade.

ISLM MODEL:
 What Is the IS-LM Model?
The IS-LM model, which stands for "investment-savings" (IS) and
"liquidity preference-money supply" (LM) is a
Keynesian macroeconomic model that shows how the market for
economic goods (IS) interacts with the loanable funds market (LM)
or money market. It is represented as a graph in which the IS and LM
curves intersect to show the short-run equilibrium between interest
rates and output.

KEY TAKEAWAYS

 The IS-LM model describes how aggregate markets for real

goods and financial markets interact to balance the rate of
interest and total output in the macroeconomy.
 IS-LM stands for "investment savings-liquidity preference-
money supply."
 The model was devised as a formal graphic representation of a
principle of Keynesian economic theory.
 On the IS-LM graph, "IS" represents one curve while "LM"
represents another curve.
 IS-LM can be used to describe how changes in market
preferences alter the equilibrium levels of gross domestic
product (GDP) and market interest rates.
  The IS-LM model lacks the precision and realism to be a useful
prescription tool for economic policy.
Understanding the IS-LM Model
British economist John Hicks first introduced the IS-LM model in
1936,1 just a few months after fellow British economist John
Maynard Keynes published "The General Theory of Employment,
Interest, and Money."2 Hicks's model served as a formalized
graphical representation of Keynes's theories, though it is used
mainly as a heuristic device today.

The three critical exogenous, i.e. external, variables in the IS-LM

model are liquidity, investment, and consumption. According to the
theory, liquidity is determined by the size and velocity of the money
supply. The levels of investment and consumption are determined by
the marginal decisions of individual actors.

The IS-LM graph examines the relationship between output, or gross

domestic product (GDP), and interest rates. The entire economy is
boiled down to just two markets, output and money; and their
respective supply and demand characteristics push the economy
towards an equilibrium point.

Characteristics of the IS-LM Graph

The IS-LM graph consists of two curves, IS and LM. Gross domestic
product (GDP), or (Y), is placed on the horizontal axis, increasing to
the right. The interest rate, or (i or R), makes up the vertical axis.

The IS curve depicts the set of all levels of interest rates and output
(GDP) at which total investment (I) equals total saving (S). At lower
interest rates, investment is higher, which translates into more total
output (GDP), so the IS curve slopes downward and to the right.

The LM curve depicts the set of all levels of income (GDP) and
interest rates at which money supply equals money (liquidity)
demand. The LM curve slopes upward because higher levels of
income (GDP) induce increased demand to hold money balances for
transactions, which requires a higher interest rate to keep money
supply and liquidity demand in equilibrium.
The intersection of the IS and LM curves shows the equilibrium point
of interest rates and output when money markets and the real
economy are in balance. Multiple scenarios or points in time may be
represented by adding additional IS and LM curves.

In some versions of the graph, curves display limited convexity or

concavity. Shifts in the position and shape of the IS and LM curves,
representing changing preferences for liquidity, investment, and
consumption, alter the equilibrium levels of income and interest rates.

MONETARY POLICY:

What Is Monetary Policy?

Monetary policy is a set of tools used by a nation's central bank to
control the overall money supply and promote economic growth and
employ strategies such as revising interest rates and changing bank
reserve requirements.

In the United States, the Federal Reserve Bank implements monetary

policy through a dual mandate to achieve maximum employment
while keeping inflation in check.

KEY TAKEAWAYS

 Monetary policy is a set of actions to control a nation's overall

money supply and achieve economic growth.
 Monetary policy strategies include revising interest rates and
changing bank reserve requirements.
 Monetary policy is commonly classified as either expansionary
or contractionary.
 The Federal Reserve commonly uses three strategies for
monetary policy including reserve requirements, the discount
rate, and open market operations.
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Monetary Policy
Understanding Monetary Policy
Monetary policy is the control of the quantity of money available in
an economy and the channels by which new money is supplied.

Economic statistics such as gross domestic product (GDP), the rate

of inflation, and industry and sector-specific growth rates influence
monetary policy strategy.

A central bank may revise the interest rates it charges to loan money
to the nation's banks. As rates rise or fall, financial institutions adjust
rates for their customers such as businesses or home buyers.

Additionally, it may buy or sell government bonds, target foreign

exchange rates, and revise the amount of cash that the banks are
required to maintain as reserves.

Types of Monetary Policy

Monetary policies are seen as either expansionary or contractionary
depending on the level of growth or stagnation within the economy.

Contractionary

A contractionary policy increases interest rates and limits the

outstanding money supply to slow growth and decrease inflation,
where the prices of goods and services in an economy rise and reduce
the purchasing power of money.

Expansionary

During times of slowdown or a recession, an expansionary policy

grows economic activity. By lowering interest rates, saving becomes
less attractive, and consumer spending and borrowing increase.

Goals of Monetary Policy

Inflation
Contractionary monetary policy is used to target a high level of
inflation and reduce the level of money circulating in the economy.

Unemployment

An expansionary monetary policy decreases unemployment as a

higher money supply and attractive interest rates stimulate business
activities and expansion of the job market.

Exchange Rates

The exchange rates between domestic and foreign currencies can be

affected by monetary policy. With an increase in the money supply,
the domestic currency becomes cheaper than its foreign exchange.

Tools of Monetary Policy

Open Market Operations

In open market operations (OMO), the Federal Reserve Bank buys

bonds from investors or sells additional bonds to investors to change
the number of outstanding government securities and money
available to the economy as a whole.

The objective of OMOs is to adjust the level of reserve balances to

manipulate the short-term interest rates and that affect other interest
rates.1

Interest Rates

The central bank may change the interest rates or the

required collateral that it demands. In the U.S., this rate is known as
the discount rate. Banks will loan more or less freely depending on
this interest rate.

3
The Federal Reserve commonly uses three strategies for monetary
policy including reserve requirements, the discount rate, and open
market operations.
Reserve Requirements

Authorities can manipulate the reserve requirements, the funds that

banks must retain as a proportion of the deposits made by their
customers to ensure that they can meet their liabilities.

Lowering this reserve requirement releases more capital for the banks
to offer loans or buy other assets. Increasing the requirement curtails
bank lending and slows growth.

Monetary Policy vs. Fiscal Policy

Monetary policy is enacted by a central bank to sustain a level
economy and keep unemployment low, protect the value of the
currency, and maintain economic growth. By manipulating interest
rates or reserve requirements, or through open market operations, a
central bank affects borrowing, spending, and savings rates.

Fiscal policy is an additional tool used by governments and not

central banks. While the Federal Reserve can influence the supply of
money in the economy, The U.S. Treasury Department can create
new money and implement new tax policies. It sends money, directly
or indirectly, into the economy to increase spending and spur growth.

Both monetary and fiscal tools were coordinated efforts in a series of

government and Federal Reserve programs launched in response to
the COVID-19 pandemic.

FISCAL POLICY:
What Is Fiscal Policy?
Fiscal policy refers to the use of government spending and tax
policies to influence economic conditions,
especially macroeconomic conditions. These include aggregate
demand for goods and services, employment, inflation, and economic
growth.

During a recession, the government may lower tax rates or increase

spending to encourage demand and spur economic activity.
Conversely, to combat inflation, it may raise rates or cut spending to
cool down the economy.

Fiscal policy is often contrasted with monetary policy, which is

enacted by central bankers and not elected government officials.

KEY TAKEAWAYS

 Fiscal policy refers to the use of government spending and tax

policies to influence economic conditions.
 Fiscal policy is largely based on ideas from British economist
John Maynard Keynes.
 Keynes argued that governments could stabilize the business
cycle and regulate economic output rather than let markets right
themselves alone.
 An expansionary fiscal policy lowers tax rates or increases
spending to increase aggregate demand and fuel economic
growth.
 A contractionary fiscal policy raises rates or cuts spending to
prevent or reduce inflation.
Understanding Fiscal Policy
U.S. fiscal policy is largely based on the ideas of British
economist John Maynard Keynes (1883-1946). He argued that
economic recessions are due to a deficiency in the consumer
spending and business investment components of aggregate demand.

Keynes believed that governments could stabilize the business

cycle and regulate economic output by adjusting spending and tax
policies to make up for the shortfalls of the private sector.1

His theories were developed in response to the Great Depression,

which defied classical economics' assumptions that economic swings
were self-correcting. Keynes' ideas were highly influential and led to
the New Deal in the U.S., which involved massive spending on
public works projects and social welfare programs.

In Keynesian economics, aggregate demand or spending is what

drives the performance and growth of the economy. Aggregate
demand is made up of consumer spending, business investment
spending, net government spending, and net exports.

Variable Private Sector Behavior

According to Keynesian economists, the private sector components

of aggregate demand are too variable and too dependent on
psychological and emotional factors to maintain sustained growth in
the economy.1

Pessimism, fear, and uncertainty among consumers and businesses

can lead to economic recessions and depressions. What's more,
excessive public sector exuberance during good times can lead to an
overheated economy and inflation.

However, Keynesians believe that government taxation and spending

can be managed rationally and used to counteract the excesses and
deficiencies of private sector consumption and investment spending
in order to stabilize the economy.1

Corrective Government Fiscal Action

When private sector spending decreases, the government can spend

more and/or tax less in order to directly increase aggregate demand.
When the private sector is overly optimistic and spends too much, too
fast on consumption and new investment projects, the government
can spend less and/or tax more in order to decrease aggregate
demand. 

This means that to help stabilize the economy, the government should
run large budget deficits during economic downturns and run budget
surpluses when the economy is growing. These are known
as expansionary or contractionary fiscal policies, respectively.  

Fiscal Policy Example

During the Great Depression of the 1930s, U.S. unemployment rose
to 25% and millions stood in bread lines for food. The misery seemed
endless. President Franklin D. Roosevelt decided to put an
expansionary fiscal policy to work. He launched his New Deal soon
after taking office. It created new government agencies, the WPA jobs
program, and the Social Security program, which exists to this day.
These spending efforts, combined with his continued expansionary
policy spending during World War II, pulled the country out of the
Depression.2
Types of Fiscal Policies

Expansionary Policy and Tools

To illustrate how the government can use fiscal policy to affect the
economy, consider an economy that's experiencing a recession. The
government might issue tax stimulus rebates to increase aggregate
demand and fuel economic growth. 

The logic behind this approach is that when people pay lower taxes,
they have more money to spend or invest, which fuels higher
demand. That demand leads firms to hire more,
decreasing unemployment, and causing fierce competition for labor.
In turn, this serves to raise wages and provide consumers with more
income to spend and invest. It's a virtuous cycle or positive feedback
loop. 

Alternately, rather than lowering taxes, the government may seek

economic expansion by increasing spending (without corresponding
tax increases). Building more highways, for example, could increase
employment, pushing up demand and growth.

Expansionary fiscal policy is usually characterized by deficit

spending. Deficit spending occurs when government expenditures
exceed receipts from taxes and other sources. In practice, deficit
spending tends to result from a combination of tax cuts and higher
spending.

Contractionary Policy and Tools

In the face of mounting inflation and other expansionary symptoms, a

government can pursue contractionary fiscal policy, perhaps even to
the extent of inducing a brief recession in order to restore balance to
the economic cycle.

The government does this by increasing taxes, reducing public

spending, and cutting public sector pay or jobs.

Where expansionary fiscal policy involves spending deficits,

contractionary fiscal policy is characterized by budget surpluses. This
policy is rarely used, however, as it is hugely unpopular politically.

Public policymakers thus face differing incentives relating to whether

to engage in expansionary or contractionary fiscal policy. Therefore,
the preferred tool for reining in unsustainable growth is usually a
contractionary monetary policy. Monetary policy involves
the Federal Reserve raising interest rates and restraining the supply of
money and credit in order to rein in inflation.

INDIAN TRADE POLICY:

What is the Significance of a Foreign Trade Policy?

 The Foreign Trade Policy is a legal document, issued by the
Government of India, enforceable under the Foreign Trade
Development and Regulation Act 1992.
o Revisited and notified quinquennially since the 1991
economic reforms, the FTP has been the guiding beacon for
all stakeholders.
 The prime objective of a foreign trade policy is to facilitate trade
by reducing transaction and transit costs and time.
 A FTP sets out the regulations for cross-border trade and reveals
the government's position on a host of concomitant yet crucial
policy variables such as technology flow, intangibles, and so on.
Why is a New Foreign Trade Policy Important?
 Clarifying India’s Stand at Global Level: It is essential to
clarify India’s position and alignment with flagship programmes
like ‘Local for Global’ and PLI (Production Linked Incentive)
schemes, WTO’s ruling against India’s export incentive
 schemes, an overdue review of the Special Economic Zone
(SEZ) scheme, changing geographical profiles of India’s export
basket, and implications of the FTAs.
o In 2019, a dispute resolution panel of WTO had held that the
export incentives under the FTP are violative of India’s WTO
Commitment.
 Impact on Export-Oriented Businesses: Another reason for
overhauling the FTP is some export-oriented businesses have
been adversely impacted by certain ad hoc, mistimed, and
contradictory changes to the 2015 FTP
o The 2015 FTP incentivised exports by issuing duty-credit
scrips directly in proportion to exports. However, in 2020 the
government limited the maximum export incentives for
goods to Rs. 20 million, and in 2021, limited them to Rs. 20
million for services.
 Moreover, the changes for service incentives were
retrospectively notified in September 2021 to be applied
from April 2019.
 Reduction in Outlays and Incentives: The annual export
incentives — the Merchandise Exports from India Scheme
(MEIS) and Services Exports from India Scheme (SEIS) of Rs.
51,012 crore were replaced with the RoDTEP scheme incentive
of Rs.12,454 crore.
o The remaining Rs. 38,558 crore has been diverted into
PLI to give benefit to a few sectors.
o Also, earlier there was a 3% export incentive on agriculture
implements like tractors, which has been reduced to 0.7%.
 Infrastructural Setbacks:Due to inadequate upgraded export
infrastructure such as ports, warehouses and supply chains,
the average turnaround time for ships in India is about three
days while the world average is 24 hours.
 Crisis of MSMEs: With a contribution of about 29% to the GDP
and 40% to international trade, MSMEs are the key players in
 achieving the ambitious export targets. However, the surge in
input and fuel costs are hitting the bottom lines of MSMEs.
o The rise in prices of raw materials such as steel, and
plastics along with a shortage of shipping containers and
labour are making it difficult for the MSMEs to take full
advantage of the global increase in demand.
o

What Is an Exchange Rate Mechanism (ERM)?

An exchange rate mechanism (ERM) is a set of procedures used to
manage a country's currency exchange rate relative to other
currencies. It is part of an economy's monetary policy and is put to
use by central banks.

Such a mechanism can be employed if a country utilizes either

a fixed exchange rate or one with a constrained floating exchange
rate that is bounded around its peg (known as an adjustable peg or
crawling peg).

KEY TAKEAWAYS

 An exchange rate mechanism (ERM) is a way that governments

can influence the relative price of their national currency in
forex markets.
 The ERM allows the central bank to tweak a currency peg in
order to normalize trade and/or the influence of inflation.
 More broadly, ERM is used to keep exchange rates stable and
minimize currency rate volatility in the market.
Understanding the Exchange Rate Mechanism
Monetary policy is the process of drafting, announcing, and
implementing the plan of actions taken by the central bank, currency
board, or other competent monetary authority of a country that
controls the quantity of money in an economy and the channels by
which new money is supplied. Under a currency board, the
management of the exchange rate and money supply is given to a
monetary authority that makes decisions about the valuation of a
nation’s currency. Often, this monetary authority has direct
instructions to back all units of domestic currency in circulation with
foreign currency. 

An exchange rate mechanism is not a new concept. Historically, most

new currencies started as a fixed exchange mechanism that tracked
gold or a widely traded commodity. It is loosely based on
fixed exchange rate margins, whereby exchange rates fluctuate within
certain margins.

An upper and lower bound interval allows a currency to experience

some variability without sacrificing liquidity or drawing additional
economic risks. The concept of currency exchange rate mechanisms
is also referred to as a semi-pegged currency system.

CRR SLR:

 CRR is a reserve maintained by banks with the RBI.

 It is a percentage of the banks' deposits maintained in cash form.
 SLR is an obligatory reserve that commercial banks must
maintain themselves.
 It is a percentage of commercial banks' net demand and time
liabilities, maintained as approved securities.
 While CRR maintains cash flow in the economy, SLR keep
banks solvent.
A crucial sector of any economy is its banking sector. It often serves
as a mirror to the overall economy, with banking activity enabling
investment decisions. Along with repo rate, reverse repo rate, etc.,
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are
crucial components of banking operations. The two ratios help
determine the liquidity in the banking system and indicate national
inflation and growth fluctuations. So let us understand what CRR and
SLR rate means and how are they different.
CRR – Meaning

As mentioned above, CRR stands for Cash Reserve Ratio. It is a

compulsory reserve that the central bank of the country – The Reserve
Bank of India (RBI), must maintain. Every commercial bank is
obligated to maintain CRR, which is a specified percentage of their
net demand and time liabilities.
Commercial banks must maintain the CRR in the form of cash
balances with the RBI. These banks are not allowed to use the money
for economic or commercial purposes.
Essentially, CRR represents the minimum percentage of deposits that
a commercial bank must keep as a cash reserve with the RBI. The
RBI uses CRR to maintain liquidity and cash flow in the economy.
SLR – Meaning

SLR stands for Statutory Liquidity Ratio. It is an obligatory reserve

that commercial banks must maintain. Commercial banks may
maintain this reserve requirement in the form of approved securities
per a specific percentage of the net demand and time liabilities.
SLR can also be defined as a tool used to maintain the stability of the
banks by restricting the credit facility they offer to their customers.
Banks usually hold more than the required SLR, per RBI norms
stating that they must maintain a certain amount of money as liquid
assets. This helps banks fulfil their depositors' demands as and when
they arise.
REPO REVERSE REPO:

Key Takeaways

 The RBI charges the repo rate when commercial banks borrow
funds by leveraging securities.
 The reverse repo rate is the rate at which banks earn interest
when they park surplus funds with the RBI.
 The repo rate helps control inflation, and the reverse repo rate
increases liquidity.
 The repo rate set by the RBI is always higher than the reverse
repo rate.
  You can check the repo rate and reverse repo rate on the RBI
website.
When you deposit money in a bank, the bank pays you interest.
Conversely, when you borrow money, the bank levies interest on the
funds borrowed. But where does the bank find the funds to loan you
the money? Banks utilise the deposits in their custody or borrow
funds from the central bank of the country – The Reserve Bank of
India. The interest rates levied on the transactions between the RBI
and commercial banks are known as repo rate and reverse repo rate.
This article explains these terms and the difference between repo rate
and reverse repo rate.
What is a Repo Rate?

The repo rate is the rate the RBI levies when commercial banks
borrow funds from it. Usually, commercial banks borrow money from
the RBI by using government securities like treasury bills and bonds
as collateral. Thus, the repo rate is the lending rate charged by the
RBI.
Essentially, the word ‘repo’ stands for repurchasing agreement/option.
It is an agreement wherein both the RBI and the bank agree to
repurchase securities at a predetermined price and date. The RBI
relies on the repo rate to control inflation in the economy of the
country.
What is a Reverse Repo Rate?

The reverse repo rate is contrary to RBI’s repo rate. It is applied to the
interest paid by the RBI. When banks have surplus money, they
deposit funds with the RBI and earn interest. This rate is the reverse
repo rate.
In turn, the RBI uses those excess funds to create liquidity in the
economy. Lowering the reverse repo rate also helps the RBI increase
the purchasing power in the nation.