Economics MV 26032021 May 2021 Updated Compressed 6acc553831774

Table of Content
Chapter 1 - Determination of National Income ............................................ 2

Unit I: National Income Accounting ........................................................ 2
Unit II: The Keynesian Theory of Determination of National Income .............. 26
Chapter 2 – Public Finance .................................................................... 53
Unit I: Fiscal Functions: An Overview .................................................... 53
Unit II: Market Failure ....................................................................... 58
Unit III: Government Interventions to Correct Market Failure ...................... 69
Unit IV: Fiscal Policy ......................................................................... 79
Chapter 3 – Money Market..................................................................... 89
Unit I: The Concept of Money Demand: Important Theories ......................... 89
Unit II: The Concept of Money Supply .................................................. 102
Unit III: Monetary Policy .................................................................. 113
Chapter – 4: International Trade ........................................................... 124
Unit I: Theories of International Trade ................................................ 124
Unit II: The Instruments of Trade Policy ............................................... 134
Unit III: Trade Negotiations ............................................................... 144
Unit IV: Exchange rates and its Economic effects.................................... 154
Unit V: International Capital Movements .............................................. 165
Economics for Finance www.IndigoLearn.com 1

Chapter 1 - Determination of National
Income
Unit I: National Income Accounting
INTRODUCTION
1.1. Structure of the Unit
National Income
Concepts of Methods of Usefullness and System of

National Computation of Limitations of Regional
Income National Income National Income Accoutns in India
1. GDPMP
Product Income Expenditure
2. NDPMP Method Method Method
3. GNPMP
4. NNPMP
5. GDPFC
6. NDPFC
7. NNPFC
8. Per Capital
Income
9. Personal Income
10. Disposable
Income
1.2. System of National Accounts
➢ United Nations has developed concepts of National Income and these concepts
and definitions are adopted by most countries for computation and reporting of
National Income. Such concepts are given in System of National Accounts
(SNA).
➢ National accounts refer to the accounts of the various Macro-economic activities

that nations undertake macro-economic factors and methods of computation

and reporting of such macroeconomic factors and activities. The system given
by United Nations for such National Accounts is known as System of National
Accounts.
Question:
What is the purpose that SNA serves?
Answer:
1. It provides a comprehensive accounting framework
2. For compiling and reporting Macroeconomic statistics
3. It helps in analyzing and evaluating performance of an economy.
1.3. Circular Flow of Income
Production
of Goods
and Services
Distribution
as Factor
Disposition -
Incomes
Consumption
(Rent,
/Investment
wages, int,
profit)
➢ In Production phase, firms employ factors of production for production of goods

and provision of services.
➢ In the next phase of Income distribution, firms pay factor incomes to the factors
of production in the form of rent, wages, interest and profits towards land,
labor, capital and entrepreneurship.
➢ In the expenditure or disposition phase, the income received by factors of

production is spent on various goods and services, and such expenditure leads
to further production of goods and services.
➢ In the circular flow, the same income flows at three different levels and thus
National Income can be computed and analyzed from three different angles,
viz. Flow of Production, Flow of income and Flow of expenditure.

CONCEPTS OF NATIONAL INCOME
2.1. Gross Domestic Product
➢ Gross Domestic Product (GDP) refers to the value of goods and services produced
in a country.
➢ GROSS refers to the value being gross of depreciation. Depreciation represents

the value of Capital Expenditure made for production of goods and provision of
services, which is one the factors of production. As the benefit of capital
expenditure generally extends beyond one year, depreciation is charged every
year as an expense over the years to which the benefit of such capital
expenditure is spread. Such amount of depreciation is included in the value of
GDP which is a measure of National Income, as it represents the value attributed
to one of the factors of production, i.e. Capital Expenditure.
➢ DOMESTIC refers to the goods or services

o being produced within the domestic territory of the country; or
o Produced by Resident Production Units. Resident Production Units are
those units producing goods or providing services having predominant
economic interest in the domestic territory of a country.
o Such units may or may not be citizens of the country or incorporated in
the said country. Such units will be said to have a predominant
economic interest in the domestic territory of the country if the units
have engaged in purchase or sale of goods in the country for a period
of one year or more.
➢ GDP at Market Prices: GDP is a measure of all the goods produced and services
provided in the country. However, the quantities of various goods and services
cannot be summed to arrive at GDP for lack of common unit of measurement.
E.g. Cloth produced is measured in square yards, while crude oil is measured in
barrels.
Hence, the value of all the goods and services produced within the country is
generally determined in terms of money, where the value is determined based
on the money that is to be paid or can be received on purchase or sale of such
goods or services in a market place. Such value us generally known as the Market
Price. Thus, GDP is the value of goods and services generally measured at
Market Prices.

➢ Value of only final goods and services to be considered in computation of GDP.
Example 1:
Production cycle of manufacturing thread involves
• Production of cotton
• Manufacture of thread
Market Price / Value of cotton = INR 50

Market Price / Value of thread = INR 70
At each stage, there is production of goods like cotton, thread and yarn. Hence
while computation of GDP, value of all the three should be included.
However, if value of all the three final products is added up (50+70 = INR 120),
it will result in double counting, as explained below:
Cotton is a raw material used in manufacture of thread, and thread is a raw
material used in manufacture of yarn. These goods which are consumed as inputs
by a process of production are called intermediate goods.
Hence, the value of the thread may be expressed as
INR 70 = INR 50 (value of cotton which is a raw material)

+
INR 20 (other costs of manufacturing thread)
INR 20 is the value added by the process of manufacturing of cloth.
The value of thread is hence included at INR 70 in computing GDP. However, the
value of cotton (INR 50) is already included in the computation of GDP directly,
and if the value is again included as part of thread, it will lead to double
counting.
Hence, we exclude the value cotton while computing GDP. Only goods sold to
the ultimate consumer are counted. These goods which are not intermediate

goods consumed in any production process, and are sold directly to ultimate
consumers for consumption are called as “Final Goods”.
Thus, while computing GDP, only the value of final goods (thread in the given example)
is to be considered.
GDP will be computed as:
Value of total output – Value of Intermediate Output = INR 120 – INR 50 = INR 70
Note: The value of cotton (INR 50) is ignored and is not included in GDP as it is already
included in the value of thread.
GDP = Value of Output in the Domestic Territory – Value of Intermediate
Consumption
GDP = ∑ Value Added
➢ Value of only Economic goods should be considered for computation of GDP
Activities, like child rearing, hobbies like playing guitar, collecting stamps, painting, or
playing football etc., which cannot be assigned a monetary or market value and which
are not generally exchanged in a market place are called Non Economic activities.
Such activities are excluded from GDP.
Hence, GDP is the market value of “Economic” Goods and Services.
Note: According to the production boundary defined in the System of Nation

Accounts, value of production out of activities like agriculture, fishing,
forestry etc. should be included in GDP, even if such goods are consumed by
the producer himself.
➢ The goods and services considered for the purpose of computing GDP must be
produced during a given time interval.
Example 2:
Manufacture and sale of chocolates
Year 0 / Today Year 2
Year 1
Production: 20,000 Units Production: 10,000 Units
Sales: Nil Sales: 5000 Units
At the end of Year 1:

Opening Stock = 0 Units

Production = 20,000 Units
Sales = 0 Units
Closing Stock = 20,000 Units
At the end of Year 2:

Opening Stock = 20,000 Units
Sales = 5000 Units
Closing Stock = 25,000 Units
Points to note:
1. It is the value of goods produced that is included in GDP, irrespective of

value of goods sold or exchanged during the period.
2. Increase in closing stock is generally due to production during the period, and
is hence included in computing GDP. Increase in the closing stock from Year
1 to Year 2 is 5000 Units (25,000 Units – 20,000 Units). Such increase is due
to production during the year of 10,000 Units, however there is a decrease
also of 5,000 Units from the stock due to sale of goods, hence the net increase
is only 5,000 Units.
3. Value of sale of goods produced in earlier period is not included in GDP of

current year.
4. Expenditure incurred for the purpose of production only is included in valuing

the goods produced during the period for inclusion in computing GDP. Other
Monetary transactions like borrowings, investments, stocks and bonds are to
be excluded.
5. Sale of secondhand goods is not included in computing GDP as they were

included when they were produced. Hence, they will not be included again
during sale.
This is known as the “FLOW” concept. Production of goods and services is not a one-
time activity. It’s a flow. And hence GDP is computed for a given period. So GDP is a
“Flow” measure of output per time period.
Question:
Define Gross Domestic Product (GDP)
Answer:
o GDP is a measure of Market value
o Of Final, Economic Goods and Services (Excludes Intermediate goods)
o Gross of Depreciation
o Produced in the Domestic Territory / by Resident Production Units
o During a Given period of time.
➢ Summary of all inclusions and exclusions for computation of GDP –
Inclusions Exclusions
Depreciation Financial Transactions
Includes Non-citizens of the country if Goods produced outside the territory of the
Resident Production Unit country even if by Indian citizens
"Economic" goods and services are Produce out of illegal activities (Like
included Gambling, narcotic drugs)
Intermediate Goods
Non-Economic goods/services
Produced goods, even of not Exchange of goods which were not produced in
sold/exchanged the current period
➢ Real GDP and Nominal GDP
GDP is generally at Market Prices

Value of goods to be included in GDP = Quantity X Market Price
Nominal GDP: The actual average price level subsisting in the country currently
is considered as the Market Price to arrive at the GDP. Hence it is also known as
GDP at current prices.
Real GDP: It refers to the value of Gross Domestic Product in terms of constant
prices of a chosen base year. The average price level of a chosen base year is
considered as the Market Price for computing GDP. In India, 2011-12 is taken as
the base year to compute Real GDP.
Example 3:
In case of a chocolate manufacturer,
In 2011-12,
Market Price = INR 50 per unit.
Contribution to GDP by the Manufacturer = 10,000 Units X INR 50 = INR 500,000
In 2015-16,
There was a strike during the year by the workers and total production fell

Market Price = INR 80 per unit.
Contribution to GDP by the Manufacturer = 7,500 Units * INR 80 = INR 600,000
Points to note:
1. The total contribution to GDP increased from year 2011-12 to year 2015-16
despite there being a strike during the year by the workers.
2. If there was no price rise between 2011-12 and 2015-16, the contribution to
GDP by the manufacturer would have been
7500 units * INR 50 = INR 3, 75,000
3. The increase in contribution to GDP of the chocolate manufacturer in the year

2015-16 despite the strike that took place was because of a rise in prices, but
not because of an increase in the real output.
4. Due to increase in the average price level in the country, the nominal GDP
would rise without any real increase in physical output. In order to depict the
increase in output because of real increase in physical output in the country,
we may choose a base year, and consider average prices of that year to
compute GDP. This is known as Real GDP or GDP at constant prices.
2.2. Net Domestic Product (NDP)

➢ NDP is a measure net of Depreciation.
➢ NDP excludes the cost of capital consumption, which was included in GDP in the
form of Depreciation.
NDP = GDP - Depreciation
2.3. Gross National Product (GNP)
➢ For the computation of GDP, the value of goods and services produced within the
domestic territory of the nation is considered, including production by Resident
Production Units, even if such units are not citizens of the country or
incorporated in the country.
➢ GDP excludes production by Indian citizens outside the country, as the same is
not produced within the domestic territory.

➢ However, GNP includes the earnings of the country’s residents and corporations
incorporated within the country earned overseas. GNP excludes the earnings of
foreign residents or foreign corporations from production within the domestic
territory.
➢ The term “National” in GNP refers to “Normal residents” of the country even if
they are working outside or are set up outside the country.
(India is used to refer to the domestic territory or domestic country for
convenience)
➢ Earnings of Indian Corporations / Indian residents Overseas net of earnings of

foreign residents or corporations in India is known as Net Factor Income from
Abroad (NFIA).
➢ NFIA will be positive if earnings of Indian residents overseas exceed the

earnings of foreign residents in India, and it shall be added while computing
GNP.
➢ NFIA will be negative if earnings of foreign residents in India exceed the

earnings of Indian residents overseas, and it shall be subtracted while
computing GNP.
GNP = GDP + earnings of Indian Corporations / Indian residents Overseas –

earnings of foreign residents or corporations in India
GNPMP = GDP MP + Net Factor Income from abroad (NFIA)
Important:
1. The difference between a measure which is “Gross” and a measure which is
“Net” is Depreciation.
2. The difference between a measure which is “Domestic” and a measure which
is “National” is NFIA.
2.4. Net National Product (at Market Prices)
➢ Net National Product at market prices is a measure of the market value of all the
final economic goods and services produced by the normal residents within the

domestic territory of a country including Net Factor Income from Abroad (NFIA)
during an accounting year excluding depreciation.
NNPMP = NDP +NFIA

= GNP – Depreciation
= GDP – Depreciation + NFIA
2.5. GDP at Factor Cost
➢ The various components generally comprising the market price of goods and
services is depicted below:
Market Price
Factor Indirect
Subsidy
Cost Taxes
Rent Wages Interest Profit Product Production

(Land) (Labor) (Capital) (Entreprenuer) Taxes Taxes
Example 4:
In the example of the chocolate manufacturer referred in Example 3, the value

of the chocolate in the market was INR 50.
Taking the example further, to manufacture the chocolate, the manufacturer

has incurred costs (Payments to factors of production) which amounted to INR
40.
For permitting the manufacturing unit to be set up, the manufacturer paid an
amount which came to be INR 7 per unit. This is also known as taxes on
production (E.g. Factory License, pollution tax etc. unrelated to quantum of
production)
As the manufacturer wanted to sell the chocolates, the Government wanted a

share from such sale and the manufacturer further charged INR 3 per unit to be
collected from the customer which could be paid to the Government. Such taxes
are known as product taxes and may be imposed on manufacture or sale of
goods/services. E.g. Excise Duty, Sales tax, GST etc.
EconomicsThe total price

for Finance of the product which a customer had to pay for purchasing was
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50 = 40 + 7 + 3
Example 5:
Further to Example 4, the Government gives a subsidy to the chocolate

manufacturer of INR 5 per unit of chocolate sold.
In this case the total price to be paid by the customer would reduce to INR 45 as
the balance of INR 5 is given by the Government to the producer.
That is,
Market Price = 45 = 40 + 10 - 5
Market Price = 45
Factor Cost = 40
Difference = Indirect Taxes – Subsidy = 10 – 5 = 5
Hence,
Market Price = Factor Cost + Indirect Taxes – Subsidy

Factor Cost = Market price + Subsidy – Indirect Taxes
➢ GDP measured at Factor Cost instead of Market Prices is known as GDP at Factor
Cost (GDPFC). GDPFC excludes the value of taxes, and also excludes the effect of
subsidy (The amount of subsidy is added back to nullify its effect).
GDPFC = GDP at market prices + Subsidy – Indirect taxes
2.6. Net Domestic Product at Factor Cost (NDPFC)
➢ NDPFC refers to the total factor incomes earned by the factors of production,
excluding depreciation.
NDPFC = GDPFC – Depreciation

= NDP at Market Prices + Subsidy – Indirect Taxes

2.7. Net National Product at Factor Cost (NNPFC)
➢ Net National Product at Factor Cost refers to the factor income accruing to the
normal residents of the country during a year, net of depreciation. NNPFC is also
known as National Income.
NNPFC = NNPMP + Subsidy – Indirect taxes

= NDPFC + NFIA
Question:
Define Nation Income
Answer:
National Income refers to
o The Factor Income
o Accruing to Normal residents of the country
o During a given period in time
o Net of Depreciation
2.8. Per Capita Income (PCI)
➢ Per Capita Income is an indicator of standard of living of a country. While PCI is

a measure of the average income in a country, it may not be an adequate
measure of welfare because it does not reflect the distribution of such income
among people in the country.
Per Capita Income = GDPMP / Population
2.9. Personal Income
➢ Personal Income is the income received by persons from all sources, including
income from non-productive activities.
➢ Personal income includes all income received during the current period, which
may or may not have been earned in the current period.
➢ Incomes not earned only in the current period but received in the current period
to be included. Example – retirement benefits received, family pension, welfare
payments (Known as “Transfer Payments”) etc.

➢ Income received from non-productive activities, for example, scholarship
received by a student, compensation for natural calamities etc. also shall be
included for computing Personal Income.
➢ Income earned during the year but not received shall be excluded for Personal
Income computation. Example – Employer’s contribution to retirement benefits
every year is earned year by year but not received, hence is excluded.
Personal Income = National Income + Income received but not earned –

Income earned but not received
2.10. Disposable Income
➢ Disposable Income is the income that is actually available for an individual for
spending or saving after paying personal income taxes to the Government.
Disposable Income = Personal Income - Personal income taxes
Summary of Measures of National Income:

1. GDPMP
2. NDPMP = GDPMP – Depreciation
3. GNPMP = GDPMP +/- NFIA
4. NNPMP = GNPMP – Depreciation
= NDPMP +/- NFIA
5. GDPFC = GDPMP + Subsidy – Indirect taxes
6. NDPFC = GDPFC – Depreciation
7. NNPFC [National Income] = NDPFC + NFIA
8. Per Capita Income = GDPMP / Population
9. Personal Income = NNPFC + Income received but not earned – Income earned but
not received
10. Disposable Income = Personal income – Direct/ Personal Income taxes

METHODS OF COMPUTATION OF NATIONAL INCOME
The three methods for computing National Income are:

1. Product method – It measures the value of goods and services produced. It
measures National Income at the first phase of Circular flow of Income (Para
1.3), viz. Production phase.
2. Income method – It measures the contribution of various factors of production

and the factor payments made for production of goods and services. It measures
National Income at the second phase of Circular flow of Income, viz. Income
phase.
3. Expenditure method – This method measures the expenditure made by various

persons across the country and is a measure at the third phase of Circular flow
of Income, viz. Expenditure phase.
3.1 Product Method
➢ It is also known as the Value added method or Industrial Origin Method or Net
Output Method. The value added method measures the contribution of each
producing enterprise in the domestic territory of the country in an accounting
year.
➢ Computation of National Income under the Product method:
Step 1 – Identification of all the producers and classification based on sectors
Producers
Primary Secondary Tertiary/Ser

Sector Sector vice Sector
Manufacture of Provision of services

Farming, dairy,
consumer goods, like marketing,
fishing, mining,
pharmaceuticals, advertising, finance,
quarrying etc.
electricity etc. banking etc.

Step 2 – Computation of Gross Value Added (GVA)
➢ The value of intermediate goods and intermediate consumption must be
excluded while computing the National Income. Hence, the value of
intermediate consumption is reduced from the value of all output to arrive at
GVA.
➢ GVAMP = Value of all output – Intermediate consumption
Note: Only the value of goods produced shall be considered, irrespective of the
sales made in the particular year. Hence, the value of output in GVA shall be the
value of goods produced in the given period.
GVAMP = Value of output – Intermediate consumption

= Value of production – Intermediate consumption
= [Value of sales + Closing stock – Opening Stock] – Intermediate
consumption
= Value of sales + changes in stock – Intermediate consumption
Step 3 – Estimation of National Income

➢ Net Value Added (NVAMP) = GVAMP – Depreciation
➢ Net Value Added (NVAFC) = NVAMP + Subsidy – Indirect taxes
➢ Net National Product (NNPFC) = NVAFC + NFIA → NATIONAL INCOME
3.2 Income Method

➢ Under the Income Method, computation of National Income is done at the Flow
of Income angle of the circular flow of income.
➢ Production of goods and services is the combined effort of all the factors of
production. Whatever is earned at the production stage is distributed to all the
factors of production in the form of factor incomes.
➢ The Income method measures the income that is paid to all the factors of
production by all the production units in a country. Since the measure is of
payments to factors of production, the measure we start with under income
method is already at factor cost and is not at market prices.
➢ The sum of all the payments to the Factors of production within the domestic
territory of a country = Net Domestic Product at Factor cost (NDPFC).

➢ When one person provides a combination of various factor services, it may be
difficult to bifurcate and identify each factor income separately. The factor
payments made for various factor services, which cannot be distinguished, is
known as the “Mixed Income for the self-employed”. Example – In case of a
famer working on a piece of land bringing his own capital,
Note: Transfer payments like retirement benefits, scholarships etc. should be
excluded from National Income.
➢ NDPFC
= Compensation of employees + Rent + Interest + Profit + Mixed Income of self-
employed
Operating surplus
➢ NNP FC = NDPFC + NFIA → NATIONAL INCOME
➢ Hence, National Income by Income method = Compensation of employees

+ Rent
+ Interest
+ Profit
+ Mixed Income of self employed
+ NFIA
3.3 Expenditure Method

➢ Under the Expenditure Method, computation of National Income is done at the
Flow of expenditure angle of the circular flow of income.
➢ The broad categories of persons who spend money in an economy are as shown
below:
Persons
spending
money
Producers/Orga
Consumers Government
nsiation
For purchase of raw Expenditure for welfare of

Expenditure on material (intermediary people, military forces,
consumer goods or goods), making payments to education, law and order
assets factors of production etc.

➢ The Gross Domestic Product under Expenditure method shall be the aggregate of
the expenditure made by all the three entities – consumers, organizations and
the government. Since there is an aggregation of expenditure, this measure is at
“market price” (including indirect taxes).
GDPMP
Gross Domestic
Net
PFCE GFCE Capital
Exports
Formation
Assets Change
built and in
used Inventory
3.3.1 Components of GDPMP under the Expenditure method:
1) Private Final Consumption Expenditure (PFCE)
➢ This refers to the consumption expenditure made by the final consumers.
➢ Expenditure made for consumption refers to the money spent on purchase of

goods or services sold in the market. Hence, whatever goods are sold in the
market by a person is bought by another person.
Hence, Consumption Expenditure = Goods sold in the domestic market * the
market price
Note: Even goods produced and consumed by self shall be included.
➢ In PFCE,
“Private” refers to expenditure only by common people and final consumers,
and not the Government.
“Final” refers to expenditure only on final goods and the value of
intermediary goods and services shall be excluded.
“Consumption Expenditure” refers to consumption of goods and services.
Expenditure on capital items (Land, building, car etc.) does not form part of
PFCE.
➢ Investment in foreign financial assets like shares of foreign companies, bonds,

depository receipts shall be included in PFCE. However, only NET Investment
is considered, i.e., any foreign investment made in financial assets in India
shall be reduced, and only the net investment shall be considered.
2) Government Final Consumption Expenditure (GFCE)

➢ GFCE is Similar to PFCE, but it refers to the consumption expenditure made
by the Government for all activities like healthcare, defense, education etc.
Note: The Government also pays people compensation for loss due to natural
calamities, pensions for employees, scholarships to students, unemployment
allowance etc. These are known as Transfer Payments. These payments are an
expenditure to the Government; however, they shall not form part of the GDP.
3) Gross Domestic Capital Formation

➢ Here, we include all that capital expenditure which we excluded from PFCE
and GFCE.
➢ It includes expenditure made on houses, cars, land, valuable items like

diamonds, or a valuable painting etc. by individuals and the Government. It
also includes expenditure made by the Government on roads, bridges, dams,
defense equipment etc.
➢ If any expenditure is made on capital asset to be used, then such expenditure

shall form part of “Gross Domestic Capital Formation”. However, if capital
assets are regularly bought and sold, then the change in inventory (Closing
inventory – Opening inventory) shall form part of “Gross Domestic Capital
Formation”.
Note: Only the value of final goods is included. Value of any intermediate
consumption shall be excluded from Gross Domestic Capital Formation. Further,
only expenditure made in the domestic territory is included.
4) Net Exports
➢ In PFCE and GFCE, only the goods sold in the domestic market are included.
However, GDO should include all the goods produced within the domestic
territory, even if they are sold outside the domestic territory or exported.
Similarly, goods produced outside the domestic territory, which are imported
and sold within the domestic territory, are included in PFCE and GFCE.
However, since these goods are not produced within the domestic territory,
the value of such goods should be excluded for computing National Income.
Hence, as part of Net Exports, all the Exports are added and all the imports
are reduced.
Net Exports = Exports – Imports
3.3.2 Estimation of National Income

➢ National Income refers to the Net National Product at factor cost. Hence,
NNPFC shall be arrived at as follows:

NNPFC = GDPMP - Depreciation + NFIA – Indirect taxes + Subsidy
Question:
Compute National Income
Consumption 750
Investment 250
Government
Purchase 100
Exports 100
Imports 200
Answer: As the question gives PFCE, GFCE, Capital formation and net exports,
National Income shall be computed under the Expenditure method.
National Income = PFCE, GFCE, Capital formation (Investment) + Exports –
Imports
= Consumption (750) + Government expense (100) + Investment (250) + Exports
(100) – Imports (200)
= 1000 = National Income
Question:
Compute
(a) GDPMP
(b) National Income
Inventory Investment 100
Exports 200
Indirect taxes 100
NFIA -50
Personal Consumption Expenditure 3500
Gross residential construction investment 300
Depreciation 50
Imports 100
Government Purchases of goods and
services 1000
Gross public investment 200
Gross business fixed investment 300
Answer: Expenditure Method

Each element given in the question are divided into the following buckets:

PFCE GFCE Gross Domestic Net Exports Relevant for
Capital Formation NNPFC
Personal Govt purchase Inventory Exports (200) Indirect taxes
consumption of goods and investment (100) (-100)
expenditure services
(3500) (1000)
Gross residential Imports (-100) NFIA (-50)
construction
investment (300)
Gross business fixed Depreciation (-
investment (300) 50)
Gross public
investment (200)
3500 1000 900 100 -200
Question:
(a) Compute GDPMP using income method
(b) Compute GNPMP using income method
(c) Compute GDPMP and GNPMP using expenditure method and compare results
Personal Consumption 7314

Depreciation 800
Wages 6508
Indirect business taxes 1000
Interest 1060
Domestic investment 1442
Government expenditures 2196
Rental Income 34
Corporate Profits 682
Exports 1346
NFIA 40
Mixed Income 806
Imports 1408
Answer:
Each element given in the question are divided into the following buckets:
GDP MP (Income method) GDP MP (Expenditure method) GNP MP
Wages (6508) Personal consumption (7314) NFIA (40)

Interest (1060) Domestic investment (1442)
Rental Income (34) Exports (1346)
Corporate profits (682) Imports (-1408)
Mixed Income (806) Government expenditure (2196)

Depreciation (800) - As the total of
factor payments gives us NDP at FC and
we need GDP at FC
Indirect taxes (1000) - As we want to
arrive at MP, and factor payments are at
factor costs
10,890 10,890 40
(a) Computation of GDPMP
GDPMP = PFCE + GFCE + Gross domestic capital formation + Net Exports
= 3500 + 1000 + 900 + 100
(b) = 5500 Computation of National Income
National Income = GDPMP – Indirect taxes – Depreciation +NFIA
= 5500 – 100 – 50 – 50
National Income = 5300
(a) GNPMP as per Income method = 10,890 (Refer table above)
(b) GNPMP as per Income method = GNPMP + NFIA
=10,890 + 40
= 10,930
(c) GDPMP as per Expenditure method = 10,890 (Refer table above)

GNPMP as per Expenditure method = GNPMP + NFIA
=10,890 + 40
= 10,930
With the above computation, it is seen that GDP MP and GNPMP are the same when
computed as per Income method and Expenditure method.
Question:
Compute GNPMP using Value Added Method
Value of output in primary sector 500

NFIA -20
Value of output in tertiary sector 700
Intermediate consumption in secondary
sector 400
Value of output in secondary sector 900
Government transfer payments 600
Intermediate consumption in tertiary
sector 300
Intermediate consumption in primary
sector 250
Answer:
National Income under Value added method –
Step 1:

Total value of output = Value of output in all three sectors = Primary (500) +
Secondary (900) + Tertiary (700) = 2100
Step 2:
GVA = GDPMP = Total Value of output – Intermediate consumption = 2100 –
Intermediate primary (250) – Intermediate secondary (400) – Intermediate tertiary
(300) = 1150
Step 3:
GNPMP = GDPMP + NFIA = 1150 – 20 = 1130.
3.4 Purpose for three methods for computation of National Income
➢ It gives us three different views of the same economy. Ideally, National Income
using all three methods should be the same. However, there may be differences
in National Income when computed using various methods due to the following
reasons:
o Non-availability of information
o Information may escape the attention of the estimator
Such differences may direct towards existence of loopholes in the economy.
➢ The method of computation may depend on the nature of the economy. In case
of an economy which is developed and there is adequate information through
compliance of procedures like filing timely Income tax returns etc., then Income
method may be the easiest method for computation of National Income.
➢ Further, in complex countries like India it may not be possible to use only one
method to estimate National Income. Hence, different methods may be used for
different sectors or industries within the same country. For example, in
Agriculture sector, most producers are exempt from paying income taxes, so
information about their incomes may not be available to compute National
Income under Income method. The best method for such sector may be Product
Method.
USEFULNESS AND LIMITATIONS OF NATIONAL INCOME

1.1 Usefulness and Significance
➢ In understanding the economy –

o National Income is the value of goods and services. It measures the level of
economic activity that takes place in a country, which is a measure of
demand, and that in turn evaluates the performance of the country.
o It helps in analyzing statistics through ratios like Investment to GDP,
Government expenditure to GDP, taxes to GDP. This assists the Government
in making policies for growth.
o National Income measures may help in comparing the standards of living of
various countries, their strength, and economic conditions.
➢ To the businesses –
o National Income talks measures the level of income in an economy, which in
turn determines demand. These statistics help businesses forecast demand.
➢ To the Govt. –
o National Income statistics like GDP, Per Capita Income etc. depict economic
welfare of the country.
o Helps the Government in understanding each sector, evaluate trends in
sectors and their growth for formulating sector wise policy. It also helps in
making projections and development trends of the economy.
o National Income measures help evaluate the performance of Government
policies. Growth in GDP or Per Capita Income on implementation of policies
may be reflective of their success.
1.2 Limitations And Challenges In Computation Of National Income
GDP measures pose the following challenges –
➢ Problems in the computation –

o Difficulty in making distinction between Final goods and Intermediate
goods
o Issue of non-inclusion of transfer payments
o Valuation of new goods at transfer prices
o Issues relating to self-consumption
o Lack of adequate data
o Production and income hidden from Govt. – tax evasion or illegal activities
o Absence of recording of income due to illiteracy
➢ Ignoring other measures of welfare –

o GDP concerns only about output. Technological innovations are ignored
which are true measures of growth
o GDP and Per Capita Income are inadequate measures of welfare, and may
not reflect actual income distribution in the economy.

o Volunteer work done without any remuneration, though it contributes to
social welfare is ignored, as it is not economic activity.
o Non-economic contributors like health of people, education levels,
political participation, gender equality, fairness are ignored.
o Economic “bads” like crime, pollution, traffic congestion, though they
affect people’s wellbeing, are ignored in National Income measures.
o National Income measures do not make a distinction between activities
that make us better off, and those that prevent us from becoming worse
off.
2. SYSTEM OF REGIONAL ACCOUNTS IN INDIA
➢ India being a vast country, with many states and Union Territories, each of these
states assume their own importance, and it is imperative to understand the
performance of each of these states for understanding performance of the
country as whole.
➢ Thus, there exists a system of regional accounts in India.
➢ Each state and Union Territory computes Net State Domestic Product (NSDP),
which is the value of all the goods and services within domestic territory of a
state within a given period, net of depreciation.
➢ Per Capita = NSDP / Mid-Year projected (Average) population of the state
➢ Directorates of Economics and Statistics of the State (DES) do the computation
of measures under the system of regional accounts, with assistance from the
central organization.
➢ DES organization computes Income of the state based on various activities

undertaken in state.
➢ However, activities like defense, railways, banking, and central government

administration, which are undertaken across state boundaries and may not be
assigned to any one state directly, are accumulated for the nation as a whole, and
then allocated to each state separately Such activities are known as Supra Regional
Activities.

Unit II: The Keynesian Theory of Determination of
National Income
INTRODUCTION
➢ While Unit I deals with National Income estimation using different inputs, like
the Product method, Income method and the Expenditure method, this Unit will
deal with the theories propounded by John Maynard Keynes in relation to the
study of the level of National Income in an economy, and the relation between
output, income and expenditure.
➢ In 1936, Keynes put forward the Keynesian theory of determination of National
Income, which was presented in three models for income determination –
o The Two sector model
o The Three sector model
o The Four sector model
Sectors in an
economy
Firm/Business Household Government Foreign

sector sector Sector Sector
Factors of
Produce
production who sell Exports and
goods and
factor services for Imports
services
production of goods
1.4. Structure of the Unit
Keynesian
Theory
Two Two Four

Three sector
sector sector Sector
model
model model model

TWO SECTOR MODEL
1.1. Circular Flow of Income and Assumptions
➢ This model assumes a hypothetical situation where there are only two sectors
in the economy – Firms and the household sector.
➢ The circular flow of income in such an economy is depicted below –
Firms produce goods and services by

employing the factor inputs provided by
the households. For employment of such
factor inputs, the firms pay Factor
Payments to the Households in the form
of Wages, Rent, Interest and Profit (for
labour, land, capital and
entrepreneurship respectively). The
goods are services produced by the
Firms are then bought by the Households by making
consumption expenditure.
➢ Determination of National Income under the Two-sector model has the following
underlying assumptions:
o No existence of Government in the economy and the there is no Government
intervention in the production by forms and earnings by households, hence
no taxes.
o A closed economy, i.e. without any foreign trade.
o The firms distribute everything that is generated through production of
goods and services and the firms do not have any retained earnings.
o All the goods and services produced are purchased by the households.
➢ The above assumptions imply the following:
Value of output = Revenue of the firms

(Since there are no indirect taxes levied on the output)
Revenue of firms = Income of the household

(As the revenue earned by the firms is paid in the form of Factor payments)
Income of the household = Expenditure of the household

(No income taxes are levied in the Two Sector model and the entire income is
spent on consumer and investment goods)

Expenditure of the household = Revenue of the firms
(Households spend everything on purchase of goods and services)
Therefore, Revenue of firms = Income of household = Expenditure of households
1.2. Aggregate Supply
➢ Aggregate Supply refers to the total value of goods and services that all the
producers in an economy are willing to supply.
➢ However, as noted above, the Total value of goods and services = Factor
payments (Total Income)
Hence, Supply = Income
➢ Income earned by factors of production either is spent as consumption

expenditure or is saved.
Therefore, AS = Y = C + S
Where ,
AS refers to Aggregate Supply
Y refers to Income
C refers to Consumption
S refers to Savings
Example 1:
With the following levels of Income and Spending (Consumption + Savings), let’s draw an
aggregate supply curve.
Spending
(Consumption Aggregate Supply
Income (Y) +Savings) 60
0 0 50
10 10 40
C+S
20 20 30
20
30 30
10
40 40
0
50 50 0 10 20 30 40 50 60
Income

Important:
3. The aggregate supply curve is an upward sloping curve.
4. It is also known as the Income Curve and the 45 Degree curve.
5. When Aggregate Supply/Income is 0, the total of consumption expenditure and
Savings is also 0.
Aggregate Demand
➢ Aggregate Demand refers to the expected demand in the economy.
➢ Demand is the demand for goods and services made by the Households. Hence,
Aggregate Demand is the expected expenditure of the households.
➢ Households buy goods and services. These goods may be of two kinds:
o Consumer goods – Goods that have no future productive use. These
satisfy our needs and wants directly without any perpetual benefits.
Example – Groceries, soaps, eatables etc.
o Capital goods/Investment Goods – Goods that are used for increasing
future production or deriving future/perpetual benefits. These
benefits generally extend to more than one year. Example – House,
car, machinery etc.
➢ Hence,
AD = C + I
Where AD refers to Aggregate Demand
C refers to Consumption (Goods)
I refer to Investment (Goods)
Note:
While the consumption differs with the level of income, Investment remains
constant in the short run. Investment is hence an autonomous expenditure,
that which does not vary with levels of income. That implies, Investment
remaining constant, the level of Aggregate Demand depends on Consumption.
1.2.1. Consumption and Marginal Propensity to Consume
➢ The more we earn, the more tend to spend. So, consumption is a function of
Income. It is directly proportional to income. More the income, more the
consumption, and vice versa.
If consumption is “C” and Income is “Y”
C = ƒ(Y)

➢ The relation between consumption and income may be depicted in the form of
the following equation
C = a+bY
➢ In the above equation, “a” is a constant. If Y (Income) was 0, C will be equal to

“a”. That is, even if income is 0, there may still be some amount of consumption
expenditure. Such expenditure may be for necessities, which people spend on
irrespective of their level of income. This constant “a” is also an autonomous
expenditure as it does not vary with levels of income.
In case the Income is zero, such expenditure will be met out of past savings, or
out of borrowings. In such a scenario, people are said to “dis-save” as a constant
expenditure of “a” is being made even when there is no income.
➢ In the above equation, “b” is another constant. This constant is multiplied with
the income to arrive at what the consumption is. Hence, “b” represents a
constant, which determines what is the portion of income that is spent as
consumption expenditure.
Example 2:
In a case where
If Income = 100 Consumption = 30; and
If Income = 150 Consumption = 45
Let’s find out “b”
In this example,
Increase in income = 50
Increase in consumption = 15
If increase in income = 50 Increase in consumption = 15

For every Re. 1 increase income Increase in consumption =?
Increase in consumption for everyone rupee of increase in income is the

constant “b”.
1 x 15
𝑏= = 0.3
50
15 45 − 30 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑜𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝑏= = =
50 150 − 100 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒

➢ This constant “b” is known as the MARGINAL PROPENSITY TO CONSUME (MPC)
➢ In “Marginal Propensity to Consume”, “Marginal” refers to the increase in

consumption for an additional rupee earned as income. “Propensity” means the
tendency to behave in a particular way, here, it refers to the tendency to
consume. In the above Example 2, MPC is 0.3, which means that for every rupee
of additional income earned, 0.3 of it will be spent on consumption expenditure.
➢ As derived in Example 2 above,

MPC = change in consumption/ change in income = ΔC/ΔY [Where Δ symbolizes
change.]
➢ In a case where the entire additional income is earned is spent as consumption

expenditure, MPC (or “b”) will be 1. In Example 2, if the additional income of
50 results in additional expenditure of 50, then
b = 50/50 = 1.
➢ In a case where there is no increase in consumption despite increase in income,

then the increase in consumption would be 0, and hence, MPC will be 0. In
Example 2, if the increase in income was 50 and there was no increase in
consumption, then
b = 0/50 = 0.
➢ Keynesian theory assumes that these extremes, where either the entire
additional income is spent as consumption expenditure, or nothing is spent at
all, are not possible. That is, consumer tends to spend more when his income
increases, but he does not spend the entire additional amount.
So, 0<b<1
Average Propensity to consume
➢ Just as MPC, Average propensity to consume (APC) is another ratio expressing

the relation between the income and consumption.
APC = Total consumption/ Total Income
Example 3:
➢
Consumption expenditure at various levels of income is given below. Let’s take an
example on consumption and plot it on a graph.

Income Total Consumption (a+bY)
0 50
100 125
200 200
300 275
600 500
1000 800
If the above points are plotted on a graph, we would arrive at an upward sloping
curve which is depicted below:
Total Consumption (a+bY)

Total Consumption
Income
The slope of the Consumption curve is “b” (MPC).

Marginal Propensity to Save
➢ While a portion of additional income earned is spent as consumption

expenditure, the balance of additional income earned is saved. In Example 2,
while the additional income was 50, the additional consumption expenditure
was 15. The balance 35 (50-15) is saved.
➢ Increase in savings for every one rupee of increase in income is known as the
Marginal Propensity to Save.
Example 4:
In continuation of Example 2,
When Income = 100 Saving = 100-30 = 70

When Income = 150 Saving = 150-45 = 105

Increase in income = 150 – 100 = 50
Increase in savings = 105 – 70 = 35
Marginal propensity to save = 35/50 = 0.7.
In this example, out of the additional income, Consumption = 0.3 (or 30%), and
Saving = 0.7 (70%)
Important:
➢
1. The entire additional income is either spent as consumption expenditure or
is saved. It implies that the percentage of additional income spent on
consumption expenditure, plus the percentage spent on savings should total
to 100%.
2. MPC + MPS = 1.
MPS = 1 – MPC
MPS = 1 - b
Average Propensity to save
➢ APS = Total Saving (S) / Total Income (Y)
Example 5 (Comprehensive example):
The table below shows computation of APC, MPC and MPS at different levels of income
and consumption.
Total Average Marginal Marginal
Consumption propensity to propensity to propensity to
Income (a+bY) consume (APC) consume (MPC) save (MPS)
(Y) (C) (C/Y) (ΔC/ΔY) (1-MPC)
- 50 50/0 = Infinite - -
100 125 125/100 = 1.25 75/100 = 0.75 0.25
200 200 200/200 = 1.00 75/100 = 0.75 0.25
300 275 275/300 = 0.92 75/100 = 0.75 0.25
600 500 500/600 = 0.83 225/300 = 0.75 0.25
1,000 800 800/1000 = 0.80 300/400 = 0.75 0.25

Points to note:
1. As income increases, the average consumption decreases. That is, as the income
increases, the additional expenditure also increases, but not in the same
proportion.
At the third level of income,
Increase in income in absolute terms = 200-100 = 100

Increase in income in percentage = (New Income – Old Income)/Old Income * 100=
Increase in income/Old income *100 = 100/100 * 100= 100%
Increase in consumption = 200-125 = 75

% Increase in consumption = Increase in consumption/Old consumption *100 =
75/125 *100 = 60%
% Increase in income = 100%

% Increase in consumption = 60%
2. The average consumption decreases as income increases, and the average savings
increase. That means, savings is also a function of Income
S = f(Y)
3. he consumption, savings and Income curves are depicted in the graph below.
Important points to note:
a. The income curve is a 45 Degree curve, where the total spending (Consumption
+ Savings) changes directly with changes in income.
b. The Consumption curve begins at a point on Y-axis. That is, even when the
income is 0, there is consumption expenditure made, which is the constant
consumption expenditure depicted by constant “a”.
c. When consumption curve lies above Income curve, there is negative
savings/dis-savings. This is spent out of old savings or out of borrowings.
d. Where consumption curve meets Income curve, the total savings are 0.
e. Where consumption curve lies below the Income curve, the savings turn
positive.

Consumption and Savings depcited in Graph
1.3. Equilibrium in a Two-Sector economy
➢ According to the Keynesian theory, equilibrium is when supply plans of firms

meet the expenditure plans of the households. Equilibrium lies at the
intersection of Aggregate Supply and Aggregate Demand.

Equilibrium is when:
AS = AD
C+S = C+I
i.e., S = I
Note:
Not just individuals, but firms also make expenditure, consumption expenditure
on intermediate goods and raw materials, and investment expenditure on
capital goods.
➢ In the two-sector economy, when there exists equilibrium, the savings made by
the household sector are borrowed by the firms to make investment
expenditure. Hence, Savings equal Investment.
➢ AD is the aggregate of Consumption and Investment, where Investment is

constant in the short run. Hence, AD curve will be parallel to the Consumption
curve, above it.
AS curve (Income curve) will be a 45 Degree curve cutting through the Origin.
The graph on next page depicts the determination of Equilibrium in a two-sector

model:

➢ Points to note:
1. Until point E, Demand > Supply, so C+I > C+S. That is, investment is greater
than savings. That is, people are demanding more than what firms are
producing.
Since the demand is more than supply, the firms will tend to produce more
to meet the increased demand. That leads to engaging more factors of
production to increase production. As the firms increase production,

income of the households also increases (due to increase in factor
payments to them). That means people will tend to spend more. However,
with increase in income, the average propensity to consume income
reduces, and average propensity to save increases. Hence, the gap
between these two curves reduces.
2. Beyond point E, C+S > C+I, which means supply is more than demand, and
savings are greater than investment.
The firms, as a reaction to this situation tend to reduce the supply. This
will reduce the factor hiring and reduce their income. As a result, their
expenditure also will reduce.
3. Point E, where AD = AS, I = S, is equilibrium. Consequently, there is no

tendency for the production or output to change. At this point, the
National Income is measured.
Equilibrium National Income = C+I

Y = C+I = C+S
4. In the savings graph, investment curve is parallel to the x-axis, because it

is constant irrespective of income. Where investment meets savings, that
point is equilibrium. That is the corresponding point E.
5. The difference between the consumption line and the demand line is a
constant, which is investment.
6. The distance between the consumption line and the supply line increases
as income increases. This increasing distance represents the increasing
savings with increase in income.
7. As long as the total expenditure of people matches total supply, there is

equilibrium. At this point, there may be some resources in the economy
still unemployed. If there were insufficient demand because of low income
or unemployment, the firms would match this level of low demand and
create equilibrium. Keynes argued this happened in the Great Depression
of the 1920s, where there was widespread loss of confidence in the
economy in people, they reduced consumption and demand, it caused
widespread unemployment, as the firms had to cut their production to hit
equilibrium. Keynes explained this to be the reason for the great
depression.

Question:
Given I = 1000, Consumption function C = 100+0.75Y, where a = 100 and b =

0.75,
Find the equilibrium National Income
Answer:
Y=C+I
Y = 100+0.75Y + 1000
0.25 Y = 1100
Y = 1100/0.25
Y = 4400 = National Income
➢ Relationship between aggregate consumption and National Income.
The average consumption reduces with increase in income. However, if the

average consumption increases with increase in income, then the AD curve will
be steeper and the point of intersection of AD curve and AS curve will fall
beyond point E as shown in the above diagram, and the Equilibrium shifts
rightward. That is, with increase in aggregate consumption or spending, the
National Income increases.

1.4. Effects of changes in autonomous investment
An increase in the autonomous investment leads to the AD curve shifting upward

and the point of Equilibrium also shifting forward. That is, with increase in
investment, the National Income increases.
Important:
Increase in the level of equilibrium (level of national income) is higher than the
increase in the level of investment.
1.5. Investment Multiplier
➢ As noted in para 2.5, the quantum of increase in National Income is higher than
the quantum of increase in the Investment. This happens because, when the
economy was in equilibrium, the autonomous investment increased, resulting in
the demand increasing. Consequently, firms increase supply, increasing the
factor incomes and further increasing the spending in the economy, which
creates another round of demand for goods and services. The process continues,
and hence increase in autonomous investment has the impact of increase in
National Income by more than one time.

Example 6:
A firm increases the Investment expenditure by INR 100.
As demand for investment goods increased by INR 100, the supply will also
increase by INR 100, and the factor incomes will increase by INR 100.
Assuming that the marginal propensity to consume of the resources = 0.8.

To find the increase in consumption due to increase in income:
Δ𝐶
𝑀𝑃𝐶 =
Δ𝑌
ΔC = MPC X ΔY = 0.8 X 100 = 80
The increase in consumption = 80.
It implies that the demand for goods increases by 80, and in a cycle similar
to the one explained above, the supply and income also increase by 80.
Out of increase in income of 80, consumption will be = 100 X 0.8 X 0.8 = 64.
So,
Increase in consumption in the second round = 100*0.82
Similarly, increase in consumption in the third round = 100*0.8 3
Increase in investment = 100

Increase in consumption = 100 *0.8 + 100*0.82 and so on.
In all these cycles, the addition to National Income = (C+I)

Therefore,
Increase in National Income
= 100 + 100 *0.8 + 100*0.82 ….
= 100[1+ 0.8 + 100*0.82….]
= 100[1/ (1-0.8)] … Geometric progression
= 100*5
= 500
➢ National Income increases “multiple times” as compared to the increase in

investment. Such an effect on National Income is known as “Investment
Multiplier effect”.
➢ Investment multiplier (generally denoted by “k”) stands for the number of

times the National Income would change due to change in autonomous
investment.

Computation of Investment Multiplier effect:
In continuation to Example 6,
Increase in income = 100 * 1/(1- 0.8)

= ΔI/1- MPC = ΔI/1- b
= ΔI / MPS
Investment Multiplier = 1 / MPS = k
Another way to arrive at the investment multiplier –
Y=C+I
ΔY = ΔC +ΔI ---- 1
C = a+bY
a is constant. So ΔC = bΔY ----2
Substituting value of ΔC (equation 2) in equation 1
ΔY = bΔY + ΔI
ΔI = ΔY – bΔY
ΔI = ΔY (1-b)
ΔY = ΔI/(1-b)
ΔY = ΔI/ (1-MPC) = ΔI/MPS

k = 1/ (1-MPC) = 1/MPS = investment multiplier.
The investment multiplier k is multiplied with the change in investment (ΔI) to
arrive at the change in National Income

Important:
1. When MPC is high, the denominator in “k” reduces, and the resulting figure
of k is higher. Therefore, MPC and investment multiplier are directly
related.
2. MPS and k are inversely related.
3. Note that this multiplier effect reduces with every cycle (increase in
consumption and National Income reduced from 100 to 64 from the first
cycle to the third cycle), and ultimately comes to a halt.
4. If MPC is 1, the entire additional income earned is spent and ΔY = Infinity.
That is, if entire income is spent and no part of additional income is saved,
the multiplier effect will never end and will go on infinitely.
5. If the MPS is 1, then ΔY = ΔI. There will not be any multiplier effect at all,
as people are not spending their extra income and the entire additional
income is saved.
6. When any part of additional income is saved, it is called as a leakage from
the income stream. If leakages are more, the multiplier effect will be
lesser.
Causes for leakages from the income stream that reduce consumption –
1. Taxes. In progressive taxation, as income tax also increases with increase in

income, there may not be appreciable increase in consumption expenditure.
2. Undistributed profits of corporations
3. High propensity to save, people wanting liquidity of money, or they wanting to
pay previous debts, instead of spending.
4. Expenditure on existing wealth. Ideally, expenditure should mean additional
production. However, if spending is on commodities like government bonds,
purchasing shares from an existing shareholder etc., it is only circulation of
money, without additional production. Such increase in demand is met out of
existing stock.
5. Willingness to spend, but scarcity of goods and services.
6. In an economy with full employment, if there is an increase in autonomous
expenditure (investment), it will result in increased demand. However, there
will not be capacity in the economy to increase production and supply. This will
lead to increase in prices and cause inflation, but no increase in production.
Similar is the case when there is no capacity in the economy for production. For
example, in underdeveloped countries, there may not be enough capacity or
infrastructure to produce to meet an increase in demand. In that case, increase
in demand not accompanied by increase in supply may lead to inflation.

Question:
Assume that the consumption function of an economy is C = 500 + 0.8 Y. Find the
consumption, savings, autonomous expenditure and induced expenditure for
disposable income levels of INR 4000, INR 5000 and INR 6000.
Answer:
Autonomous Induced
Consumption expenditure (As expenditure
Disposable (C=500+ Savings per consumption (Depends on
Income (Y) 0.8Y) (S=Y-C) function) income = 0.8Y)
4000 3700 300 500 3200
5000 4500 500 500 4000
6000 5300 700 500 4800
Question:
Find the value of multiplier given MPC
(a) MPC = 0.2

Multiplier = 1/ (1-0.2) = 1/ (0.8) = 1.25
(b) MPC = 0.5

Multiplier = 1/ (1-0.5) = 1/ (0.5) = 2
(c) MPC = 0.8

Multiplier = 1/ (1-0.8) = 1/ (0.2) = 5
Question:
If C = 20 + 0.5Y and increase in income = 100, find increase in consumption.
Answer:
Increase in consumption will only be 0.5 * 100 = 50. 20 is autonomous and will not
increase due to increase in income.
Question:
If autonomous expense = 2000, MPC = 0.8 and disposable income = 10,000,
consumption.
Answer:
C = a + bY = 2000 + 0.8 (10,000) = 10,000

THREE SECTOR MODEL
➢ The third sector included in the three-sector model is the Government. Hence,
the three sectors are Firms, Households and Government.
➢ Recall that in a two-sector economy

o There were factor services and factor payments in “Factor market”
o There was purchase of goods and services in “Product market”; and
o There were savings of households, which were borrowed by firms to make
investments. This happened through the “Financial market”.
1.6. Circular Flow of Income in a three-sector economy
➢ Flow of income:
o The households sell factor services in factor market and firms buy such
services for production of goods and services. Firms pay factor payments and
it becomes personal income of the households.
o In the product market, households purchase goods and services. Firms may
also make expenditure in the form of demand for investment goods. The
revenue from sale of goods and services becomes income for the firms selling
such goods and services.
o Households save a portion of income received and the same passes through
the financial market. The firms borrow such money from the financial
market and spend the same for investment goods.
o Both households and firms pay taxes to the Government.
o Government gives subsidies to the firms. Government pays transfer
payments (unemployment compensation, natural calamities) to the
households.

o The Government purchases goods and services from the Product market
(Government consumption). The Government may also purchase factor
services.
o In case of shortage of funds, the Government may borrow from the Financial
Market.
Points to note:
1. Leakages from the income flow in a three-sector model are savings and
taxes.
2. Injections into the income flow in the three-sector model are additional
demand for investment goods from firms due to borrowings and additional
demand created by the Government.
1.7. National Income under the three-sector model

The National Income under the three-sector model will include Government
consumption in addition to Consumption expenditure and Investment
expenditure.
Y=C+I+G
➢ Keynes assumed that Government consumption is autonomous.

➢ The graphs determining equilibrium in the three-sector economy are depicted
below:

o The AS curve begins from the origin (C+S curve). At the point of intersection
of Consumption curve and the AS curve, Savings = 0
o C+I+G curve is parallel to C+I curve, as G is autonomous and constant.
o Equilibrium is where C+S+T = C+I+G
o At equilibrium S+T = I+G
o Taxes vary with income. Higher the income, higher are the taxes. So as
income increases, savings increases, so would taxes.
o When income is 0, S+T = -a (As taxes will be 0).
o Equilibrium lies at the point of intersection of S+T and I+G curves.
1.8. Government Sector and Income Determination

A comprehensive discussion on the effect of government fiscal policy is
beyond the scope of this unit; and therefore, we shall look into a few
variables.

Government Sector and Income Determination
Income
Income Determination
Income
Income Determination with Tax
Determination
Determination with Lump function,
with tax as a
with Lump Sum Tax and Government
function of
Sum Tax Transfer Expenditure
Income
payments and Transfer
Payments
• Income Determination with Lump Sum Tax

We assume that the government imposes lump sum tax, i.e. taxes that do not
depend on income, has a balanced budget (G=T) and also that there are no
transfer payments. The consumption function is defined as –
C = a + b 𝑌𝑑 ,
Where 𝑌𝑑 = Y –T (disposable income), T = lump sum tax
1
Y= (a-bT+I+G)
(1−𝑏)
• Income Determination with Lump Sum Tax and Transfer payments

The consumption function is defined as –
C = a + b 𝑌𝑑 ,
Where 𝑌𝑑 = Y –T + TR,
Where T = lump sum tax, TR = Autonomous transfer payments
1
Y= (a-bT+bTR+I+G)
(1−𝑏)
• Income Determination with tax as a function of Income

In reality, the tax system consists of both lump sum tax and proportional taxes.
The tax function is defined as;
Tax function T = T̅ + t Y,
Where T̅= autonomous constant tax t = income tax rate T = total tax
The consumption function is defined as –
C = a + b 𝑌𝑑 ,

Where 𝑌𝑑 = Y- T or Y -T̅ - t Y
1
Y= (a-b T̅+I+G)
1−𝑏(1−𝑡)
• Income Determination with Tax function, Government Expenditure and

Transfer Payments
Here consumption function is written as C= a + b(Y- T̅ -tY + TR)
C = a + b 𝑌𝑑 ,
1
Where Y = 1−𝑏(1−𝑡)(a-b T̅+ bTR+I+G)
2. FOUR SECTOR MODEL
➢ The fourth sector introduced in the four-sector model is foreign trade.
2.1. Circular flow of income in a four sector economy:
➢ Goods are imported from outside the domestic territory of the economy and it
leads to outflow of money from the economy. Export of goods and services from
the economy leads to inflow of money in the economy. While exports are
injections, imports are leakages from the economy. Similarly, there may also
be capital inflows and capital outflows.
➢ Exports depend on foreign demand and is not related to the income of within
the economy. Therefore, value of exports is a constant in National Income
computation and does not change with changes in income levels.
➢ Value of exports is added to the C+I+G. C, I and G are represent the demand
within the domestic territory. Though exports are foreign demand, such demand
is met with goods produced within the country. So exports are added to the
National Income.
➢ Imports are similar to consumption. Consumption depends on the marginal

propensity to consume. As already noted, consumption has an autonomous
component also (“a”). Similarly, imports depend on the Marginal propensity to
import: The tendency to spend a portion of the additional income that a person
receives on imports. Imports also have an autonomous component.
➢ Due to the introduction of the foreign sector, the addition to National Income
is Net Exports, which is Exports – Imports.

Circular flow of income in a four-sector economy:
2.2. Determination of National Income in a four-sector economy
Following is the graph depicting the point of equilibrium:

In a four-sector economy,
AD = C+I+G+(X-M)
AS = C+S+T
Equilibrium = AD = AS
C+S+T = C+I+G+(X-M)
That implies,
→ S+T = I+G+(X-M)
→ S+T+M = I+G+X
Note: All the leakages should be equal to the injections.
Equilibrium lies at the point of intersection of S+T+M curve and I+G+X curve.
2.3. Effects on Income when imports are greater than exports
➢ At first, C+I+G lies below the C+I+G+(X-M) curve.
➢ The C+I+G curve will not be parallel to the C+I+G+(X-M), and is steeper, as
imports tend to increase with increase in income, while exports remain
constant, hence reducing the C+I+G+(X-M) function with increase in income.

➢ The point where the exports are equal to imports, the net exports will be zero
and is the point of intersection of two curves. At that point these two curves
intersect.
➢ Beyond the point of intersection, exports remain constant, while the imports
continue to increase. So C+I+G+(X-M) curve falls below the C+I+G curve.
➢ The AS curve first intersects the C+I+G+(X-M) curve [at E], and then the C+I+G
[at F] curve. Note that National Income is lower at the point of intersection with
C+I+G+(X-M).
➢ If there are no imports in the economy, C+I+G+(X-M) will be parallel to the C+I+G
curve as X is constant. Then the C+S+T curve will intersect C+I+G+(X-M) curve
beyond the C+I+G curve. That is, National Income will be higher if there are no
imports.
➢ In a case where exports increase, it will be an increase in autonomous expense,
and the C+I+G+(X-M) curve will increase constantly, and automatically, the
point of intersection with AS curve shifts further, and the National Income would
increase.
2.4. Investment Multiplier in the four-sector model
➢ Recall that in the two-sector model investment multiplier k = 1/MPS.

➢ As savings is a leakage, if it is high, the multiplier reduces and the additional
impact to National Income on account of the multiplier also reduces.
➢ Imports also have a similar effect on the multiplier. Imports are also leakages
from the income stream, and if the marginal propensity to import is high, it will
reduce the multiplier, and consequently, the additional impact on the NI.
➢ Therefore, investment multiplier in a two-sector economy = 1/ (MPS+MPI)
If marginal propensity to import is denoted by “v”,
Investment multiplier = 1/ 1-b+v
➢ Higher the economy’s dependence on foreign trade and imports, higher is “v”.
Any sudden shocks in the economy in the forms of changes in autonomous
expenditure like Investment or Government consumption will not have a large
impact on National Income, as the economy is greatly dependent on foreign
trade and lesser on domestic factors.
Question:
For linear consumption function C = 700 + 0.8Y, if I=1200, and X-M = 100, find
equilibrium output.
Answer:
Y = C+I+X-M
Y = 700+ 0.8Y + 1200 + 100
EconomicsYfor
= Finance
10,000 = National Income
www.IndigoLearn.com 52
CONCLUSION
This unit covered the following aspects:
1. Four sectors in an economy

2. Consumption function
3. Investments
4. Determination of National Income in two, three and four sector economy.
5. Investment multiplier
6. Effects of changes in consumption, exports, imports, investments on
investment multiplier and National Income.
Chapter 2 – Public Finance

Unit I: Fiscal Functions: An Overview
INTRODUCTION
2.1 Structure of the Unit
Fiscal
Functions
Micro Macro
Economic Economic
Functions Functions
Allocatio Stabilizat
Redistribution
n ion
Fuction
Function Function

2.2 Role of Government in an Economic System
➢ The purpose of this lesson is to examine the economic functions of the

government and to understand why the government should invariably perform
them.
➢ An economic system should exist to answer the basic questions such as what,
how and for whom to produce and how much resources should be set apart to
ensure growth of productive capacity.
➢ Different economic systems based on the nature and extent of Government

intervention are:
o System where the direction of the economy is entirely decided by the
Government and market demand and market supply do not play any
role.
o System where the direction of the economy is entirely based on the
market forces of demand and supply. There is no intervention by the
Government.
o Mixed System.
➢ Since the 1930s, more specifically as a consequence of the great depression,

the state’s role in the economy has been distinctly gaining in importance and
therefore, the traditional functions of the state as described above, have been
supplemented with what is referred to as economic functions (also called fiscal
functions or public finance function).
➢ Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959),
introduced the three branch taxonomy of the role of government in a market
economy. Musgrave believed that, for conceptual purposes, the functions of
government are to be separated into three, namely
o Allocation function
o Redistribution function
o Stabilization function
THE ALLOCATION FUNCTION

➢ Resource allocation refers to the way in which the available factors of
production are allocated among the various uses to which they might be put. It
determines how much of the various kinds of goods and services will actually be
produced in an economy. One of the most important functions of an economic
system is the optimal or efficient allocation of scarce resources so that the
available resources are put to their best use and no wastages are there.

➢ Efficient allocation of resources is assumed to take place only in perfectly
competitive markets. In reality, markets are never perfectly competitive.
Market failures which hold back the efficient allocation of resources occur
mainly due to the following reasons:
o Imperfect competition and presence of monopoly power in different
degrees.
o Externalities, which arise when the production and consumption of a
good or service affects people. E.g. Pollution.
o Factor immobility which causes unemployment and inefficiency
o Imperfect information, and
o Inequalities in the distribution of income and wealth.
➢ In the absence of appropriate government intervention, market failures may

occur and the resources are likely to be misallocated by too much production of
certain goods or too little production of certain other goods. The allocation
responsibility of the governments involves suitable corrective action when
private markets fail to provide the right and desirable combination of goods and
services. These interventions do not imply that markets are replaced by
government action.
➢ A variety of allocation instruments are available by which governments can

influence resource allocation in the economy. The resource allocation role of
government’s fiscal policy focuses on the potential for the government to
improve economic performance through its expenditure and tax policies.
o government may influence private allocation through incentives and
disincentives (for example, tax concessions and subsidies may be
given for the production of goods that promote social welfare and
higher taxes may be imposed on goods such as cigarettes and alcohol)
o government may directly produce the economic good(for example,
electricity and public transportation services)
o government may influence allocation through its competition policies
o government sets legal and administrative frameworks
THE REDISTRIBUTION FUNCTION

➢ The redistribution function closely relates to production of goods and services.
Aggregate demand determines the volume of production of goods and services,
and in turn determines the extent of employment of resources. Higher, the
demand, higher will be the employment of resources, and higher will be the
income of the households. Hence, the income of the people in the economy

directly relates to the aggregate demand. The Government generally attempts
to regulate aggregate demand as part of its redistribution function.
➢ The distributive function of budget is related to the basic question of for whom
should an economy produce goods and services.
➢ A few examples of the redistribution function performed by governments are:

o taxation policies of the government whereby progressive taxation of
the rich is combined with provision of subsidy to the poor households
o proceeds from progressive taxes used for financing public services,
especially those that benefit low-income households (example, supply
of essential food grains at highly subsidized prices to BPL households)
o employment reservations and preferences to protect certain
segments of the population
o Government regulates manufacture and sale of commodities like
liquor to regulate health.
o Regulation of manufacture in backward and inaccessible areas.
➢ The distribution function of the government aims at:

o redistribution of income to achieve an equitable distribution of
societal output among households
o advancing the well-being of people
o providing equality in income, wealth and opportunities
o providing security, and
o ensuring that everyone enjoys a minimal standard of living
➢ There is, nevertheless, an argument that in exercising the redistributive

function, there exists a conflict between efficiency and equity. In other words,
governments’ redistribution policies that interfere with producer choices or
consumer choices are likely to have efficiency costs or deadweight losses. For
example, greater equity can be achieved through high rates of taxes on the rich;
but high rates of taxes could also act as a disincentive to work, and discourage
people from savings and investments and risk taking. Consequently, the
potential tax revenue may be reduced and the scope for government’s welfare
activities would get seriously limited.
➢ Redistribution measures should be accomplished with minimal efficiency costs

by carefully balancing equity and efficiency objectives.
STABILIZATION FUNCTION
➢ As explained by the Keynesian theory of National Income, equilibrium may occur
even when the economy is at less than full employment level, which cannot be

corrected by the market on its own. To break cycles like these, the Government
intervenes to performs the stabilization function.
➢ The stabilization function is concerned with the performance of the aggregate

economy in terms of:
o labour employment and capital utilization,
o overall output and income,
o general price levels,
o balance of international payments, and
o the rate of economic growth.
➢ Government’s fiscal policy has two major components:

o an overall effect generated by the balance between the resources the
government puts into the economy through expenditures and the
resources it takes out through taxation, charges, borrowing etc.
Government expenditure injects more money into the economy and
stimulates demand. On the other hand, taxes reduce the income of
people and therefore, reduce effective demand. During recession, the
government increases its expenditure or cuts down taxes or adopts a
combination of both so that aggregate demand is boosted up with
more money put into the hands of the people. On the other hand, to
control high inflation the government cuts down its expenditure or
raises taxes. In other words, expansionary fiscal policy is adopted to
alleviate recession and contractionary fiscal policy is resorted to for
controlling high inflation.
o a microeconomic effect generated by the specific policies it adopts.
On the expenditure side, Government can choose to spend in such a
way that it stimulates other economic activities. For example,
government expenditure on building infrastructure may initiate a
series of productive activities. Production decisions, investments,
savings etc. can be influenced by its tax policies. The Government
may make policies for specific sectors also.
➢ There is often a conflict between the different goals and functions of budgetary
policy. The challenge before any government is how to design its budgetary
policy so that the pursuit of one goal does not jeopardize the other.

Unit II: Market Failure
INTRODUCTION
Market Failure
Market Public Incomplete

Externalities
Power Goods Information
Production Consumption
Positive Negative Positive Negative
➢ Market failure is a situation in which the free market leads to misallocation of

society's scarce resources in the sense that there is either overproduction or
underproduction of particular goods and services leading to a less than optimal
outcome.
➢ There are four major reasons for market failure. They are:
o Market power
o Externalities
o Public goods and
o Incomplete information
MARKET POWER
➢ Market power or monopoly power is the ability of a firm to profitably raise the
market price of a good or service over its marginal cost.
➢ Market power can cause markets to be inefficient because it keeps price higher
and output lower than the outcome of equilibrium of supply and demand.

EXTERNALITIES
➢ Externalities occur when anything that one individual does, has, at the margin,
some effect on others.
➢ For example, if individuals decide to switch from consumption of ordinary

vegetables to consumption of organic vegetables, they would, other things
equal, increase the price of organic vegetables and potentially reduce the
welfare of existing consumers of organic vegetables. However, all these operate
through price mechanism i.e. through changes in prices.
➢ However, sometimes, the actions of either consumers or producers result in

costs or benefits that do not reflect as part of the market price. Such costs or
benefits, which are not accounted for by the market price, are called
externalities because they are “external” to the market. There is an externality
when a consumption or production activity has an indirect effect on other’s
consumption or production activities and such effects are not reflected directly
in market prices.
➢ Externalities are also referred to as 'spillover effects', 'neighborhood effects'

'third-party effects' or 'side-effects', as the originator of the externality imposes
costs or benefits on others who are not responsible for initiating the effect.
➢ Externalities may be:

o Unidirectional – For example, disutility to pedestrians by the smoke
emitted by vehicles.
o Reciprocal – For example, Workshop on the road emitting loud noise
causing difficulty to people around, and people in the workshop
getting disutility with the vehicles on the road.
➢ In this unit, the following types of externalities will be discussed:

o Production externalities: Positive and Negative, affecting
consumption and production
o Consumption externalities: Positive and Negative, affecting
consumption and production

2.4 Production Externalities
Production Externalities
Affecting Negative Positive
➢ A negative externality initiated in
production which imposes an ➢ A positive production externality
external cost on others may be initiated in production that confers
received by another in consumption. external benefits on others may be
Consumption ➢ For example, Factory which received in consumption.
produces aluminum discharged ➢ For example, Individual raises an
untreated wastewater into the river attractive garden and the person
and pollutes it causing health hazard walking by enjoys the garden.
for people who use it
➢ A positive production externality
➢ A negative externality initiated in
initiated in production that confers
production which imposes an
external benefits on others may be
external cost on others may be
received in production.
received by another in consumption.
➢ For example, a firm which offers
Production ➢ For example, pollution of river by
training to its employees for
aluminum discharge into the river by
increasing their skills. The firm
a company also affects fish output as
generates positive benefits on other
there will be less catch for fishermen
firms when they hire such workers
due to loss of fish resources.
as they change their jobs.
2.5 Consumption Externalities
Consumption Externalities
Affecting Negative Positive
➢ Negative consumption externalities ➢ A positive consumption externality
initiated in consumption, which initiated in consumption that
produce external costs on others confers external benefits on others
may be received in consumption. may be received in consumption.
➢ For example, creating litter and ➢ For example, People get immunized
diminishing the aesthetic value of against contagious disease, would
room and playing the radio loudly confer a social benefit to others as
obstructing one from enjoying the well preventing others from getting
Consumption concert. infected.

➢ A positive consumption externality
initiated in consumption that
➢ Negative consumption externalities
confers external benefits on others
initiated in consumption, which
may be received in production.
produce external costs on others
➢ For example, consumption of the
may be received in production.
services of a health club by the
➢ For example, Excessive Consumption
employees of a firm would result in
of alcohol causing impairment in
an external benefit to the firm in
efficiency for work and production
the form of increased efficiency and
Production productivity.
2.6 External Cost and Social Cost
➢ The cost of externalities is called “External Cost. Such costs are not included in
the cost that producers incur directly for production of goods and services, like
labour, material, electricity etc., is known as Private Cost.
➢ Social Cost refers to the aggregate of Private Cost and External Cost.
Social Cost = Private Cost + External Cost
➢ The following diagram depicts the social and external cost curves and the loss
of social welfare, in case of a negative externality:
In case of a negative externality, the External cost will be positive, and the
Social cost would exceed the Private Cost. In the diagram, E is the current
market equilibrium, while Ei is the equilibrium if externalities and external
costs are also considered. The current market output is Q1 and price is P1. If

external costs were considered, the price would be P2 (higher than P1), and the
equilibrium quantity would have been lower. Production of higher quantity at a
lower cost is a loss of social welfare, caused due to the externalities that are
not considered by the market.
➢ The Government intervenes in the market to correct a market failure caused by such
externalities.
➢ The problem of externalities is difficult to identify because of the following reasons:

o The society does not know precisely who the producers of harmful
externalities are
o Even if the society knows it, the cause-effect linkages are so unclear that
the negative externality cannot be unquestionably traced to its producer.
PUBLIC GOODS vs PRIVATE GOODS

➢ A public good (also referred to as collective consumption good or social good) is
defined as one which all enjoy in common
2.7 Characteristics of Private Goods
➢ Anyone who wants to consume them must purchase them.
➢ Owners of private goods can exercise private property rights and can prevent
others from using the good or consuming their benefits.
➢ Consumption of private goods is ‘rivalrous’ that is the purchase and consumption

of a private good by one individual prevents another individual from consuming
it.
➢ Whenever there is inequality in income distribution in an economy, issues of

fairness and justice tend to arise with respect to private goods.
➢ Normally, the market will efficiently allocate resources for the production of
private goods.
2.8 Characteristics of Public Goods
➢ No direct payment by the consumer is involved in the case of pure public goods.
➢ Public goods are non-excludable, because public goods are characterized by

indivisibility. Consumers cannot be excluded from consumption benefits. For

example, national defense once provided, it is impossible to exclude anyone
within the country from consuming and benefiting from it.
➢ Public good is non-rival in consumption.
➢ Public goods are generally more vulnerable to issues such as externalities.
➢ Because of their peculiar characteristics, public goods do not provide incentives

that will generate optimal market reaction.
➢ Producers are not motivated to produce a socially optimal amount of products

if they cannot charge a positive price for them or make profits from them.
➢ Though public goods are extremely valuable for the wellbeing of the society,
left to the market, they will not be produced at all or will be grossly under
produced.
Difference between Private Goods and Public Goods
Private Goods Public Goods

Direct payment No direct payment
Excludable and divisible Non excludable and non-divisible
Rivalrous Non Rivalrous
Affected by inequality in income Not affected by income inequalities
Less externalities, efficient allocation of
resources More externalities
Classification of Goods
Excludable Non-Excludable
Rivalrous Private Goods Common Resources
Non-Rivalrous Club Goods Pure Public Goods
➢ Private Goods like food, clothing, cars etc., which are both excludable and
rivalrous. Such goods are excludable because the owner of such goods can
exclude others from consuming them. They are rivalrous because the same
goods cannot be consumed by the same person.

Classification of Public Goods
➢ Public goods cause high amount of externalities that lead to market failure.
Public goods may be classified as below:
Market Failure
caused by
Pure Impure
Public Public
goods goods
Variable Quasi Common

Club
use public Public Access
Goods
goods goods Resources
Pure Public Goods
➢ Pure Public Goods are generally non-rivalrous and non-excludable. Some argue
that Pure Public Goods, which are generally provided by the Government, like
defense, education, healthcare, law and order etc., are not always non-
rivalrous. For example, education and healthcare are marked by limited number
of schools and hospitals, law and order take quite an amount of time for justice.
These cause reduction in welfare and subtracts consumption for others who are
waiting for their turn.
➢ There are several public goods, benefits of which accrue to everyone in the
world. These are known as Global Public Goods. The WHO delineates two
categories of global public goods:
o Final Public Goods: which are outcomes like eradication of Polio.
o Intermediate Public Goods: which contribute to the provision of final
public goods. For example, Health regulations which contribute in
achieving the outcome.
Club Goods
➢ Club Goods are non rival in consumption but are excludable. A toll booth may
exclude vehicles unless payment is made. Yet, if the road is not congested, one
car may utilize it with no loss of benefit even though the other cars are also

consuming the road service. Similarly, admission to a cinema, swimming pool,
music concert etc. has potential for exclusion, but if there is no congestion,
each individual admitted may consume the services without subtracting from
the benefit of others.
➢ Club goods may become rivalrous also if there is problem of congestion.
Variable use Public Goods
➢ Variable use public goods include facilities such as roads, bridges etc. Once they
are provided, everybody can use it. They can be excludable or non-excludable.
If they are excludable, some people can be discouraged from using it frequently
by making them pay for its consumption. In doing so, the frequency of usage of
the public good can be controlled.
Quasi-Public Goods
➢ Quasi-Public Goods are not goods that are directly provided. The external effect
associated with the consumption of a private good may have the characteristics
of a public good. For example, if one gets inoculated against measles, it confers
not only a private benefit to the individual, but also an external benefit because
it reduces the chances getting infected of other persons who are in contact with
him.
➢ Another kind of quasi-public goods or services, also called a near public good
(for e.g. education, health services) possess nearly all of the qualities of the
private goods and some of the benefits of public good. It is easy to keep people
away from them by charging a price or fee. However, it is undesirable to keep
people away from such goods because the society would be better off if more
people consume them. This particular characteristic namely, the combination
of virtually infinite benefits and the ability to charge a price results in some
quasi-public goods being sold through markets and others being provided by
government. As such, people argue that these should not be left to the market
alone.
Common Access Resources
➢ These are rival in nature and their consumption lessens the benefits available
for others but are non-excludable.

➢ Since price mechanism does not apply to common resources, producers and
consumers do not pay for these resources and therefore, they overuse them and
cause their depletion and degradation.
➢ Examples of common access resources are fisheries, common pastures, rivers,

sea, backwaters biodiversity etc. The earth’s atmosphere is perhaps the best
example. Emissions of carbon dioxide and other greenhouse gases have led to
the depletion of the ozone layer.
➢ Such goods are non-excludable, but their continuous depletion makes them
rivalrous for the future generations.
2.9 The Free Rider Problem
➢ The incentive to let other people pay for a good or service, the benefits of which
are enjoyed by an individual is known as the free rider problem.
➢ In case of public goods, consumers can take advantage of public goods without
contributing sufficiently to their production. The absence of excludability in the
case of public goods and the tendency of people to act in their own self interest
will lead to the problem of free riding. There is no incentive for people to pay
for the good because they can consume it without paying for it. 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.
➢ If the free-rider problem cannot be solved, the following two outcomes are
possible:
o No public good will be provided in private markets
o Private markets will seriously under produce public goods even though
these goods provide valuable service to the society.
INCOMPLETE INFORMATION
➢ Incomplete information, also known as Asymmetric Information, occurs when
there is an imbalance in information between buyer and seller i.e. when the
buyer knows more than the seller, or the seller knows more than the buyer. This
can distort choices.

➢ For example, the landlords know more about their properties than tenants, a
borrower knows more about their ability to repay a loan than the lender, a used-
car seller knows more about vehicle quality than a buyer and some traders may
possess insider information in financial markets. These are situations in which
one party to a transaction knows a material fact that the other party does not.
➢ Asymmetric information has two broad kinds of impact on markets:

o Adverse Selection
o Moral Hazard
2.10 Adverse Selection
➢ Adverse selection is a situation in which asymmetric information about quality

eliminates high-quality goods from a market.
➢ An example is the used car market i.e. the ‘market for lemons’. The owner of
a car knows much more about its quality than anyone else. The buyer’s
willingness to pay for any particular car will be based on the ‘average quality’
of used cars. Anyone who sells a ‘lemon’ (an unusually poor car) stands to gain.
The market becomes flooded with lemons. Eventually the market may offer
nothing but lemons. The good-quality cars disappear because they are kept by
their owners or sold only to friends. Briefly put, buyers expect hidden problems
in items offered for sale, leading to low prices and the best items being kept
off the market.
➢ This causes market distortion through low prices, bad quality of goods, high
quantity of such goods and low quantity of good quality goods. It causes market
failure.
2.11 Moral Hazard
➢ Moral hazard is opportunism characterized by an informed person’s taking

advantage of a less-informed person through an unobserved action. It arises
from lack of information about someone’s future behavior. Moral hazard occurs
when an individual knows more about his or her own actions than other people
do. This leads to a distortion of incentives to take care or to exert effort when
someone else bears the costs of the lack of care or effort.
➢ For example, the more of one’s costs that are covered by the insurance
company, the less a person cares whether the doctor charges excessive fees or
uses inefficient and costly procedures as part of his health care. This causes
insurance premiums to rise for everyone, driving many potential customers out

of the market. This became a big issue in India when the health insurance
providers and big private hospitals came in conflict and the issue was resolved
by putting in place a ‘third party administration’ to settle the medical claims.

Unit III: Government Interventions to Correct Market
Failure
INTRODUCTION
Government intervention
to correct market failure
cause by
Market Public Incorrect

Externalities
Power Goods Information
Public Merit Demerit

Goods Goods Goods
➢ In the previous unit, we have seen that under a variety of circumstances the
market and the price system fail to achieve productive and allocative efficiency
in an economy. The focus of this unit will be the intervention mechanisms,
which governments adopt to ensure greater welfare to the society and the
probable outcomes of such market interventions.
3. GOVERNMENT INTERVENTION TO MINIMIZE MARKET POWER
➢ Market power, exercised by sellers or buyers is an important factor that

contributes to inefficiency because it results in higher prices than competitive
prices.
➢ To correct such market failure, the Government may take two broad steps:
o Competition laws
o Price regulation
3.1 Competition Laws
➢ Governments intervene by establishing rules and regulations designed to

promote. Competition and prohibit actions that are likely to restrain

competition. These legislations differ from country to country. For example, in
India, the Competition Act, 2002, the Antitrust laws in the US and the
Competition Act, 1998 of UK.
3.2 Price Regulation
➢ Price regulation is generally in the form of setting maximum prices that firms
can charge. Price regulation is most often used for natural monopolies that can
produce the entire output of the market at a cost that is lower than what it
would be if there were several firms. If a firm is a natural monopoly, it is more
efficient to permit it serve the entire market rather than have several firms who
compete each other. Examples of such natural monopoly are electricity, gas and
water supplies. In some cases, the government ‘s regulatory agency determines
an acceptable price, so as to ensure a competitive or fair rate of return. This
practice is called rate-of-return regulation. Another approach to regulation is
setting price-caps based on the firm’s variable costs, past prices, and possible
inflation and productivity growth.
GOVERNMENT INTERVENTION TO CORRECT EXTERNALITIES
➢ Freely functioning markets produce externalities because producers and

consumers need to consider only their private costs and benefits and not the
costs imposed on or benefits accrued to others.
➢ The mechanisms that the Government may adopt to correct externalities are
shown below:
Governmen
t
Interventio
n
For
For Positive
Negative
externalitie
externalitie
s
s
Market
Direct
based
Controls
policies
Permits/Lice
Taxation
nses

Government Intervention in case of Negative Externalities
3.2.1 Direct Controls
➢ Direct controls prohibit specific activities that explicitly create negative

externalities or require that the negative externality be limited to a certain
level, for instance limiting emissions. Production, use and sale of many
commodities and services are prohibited in our country. Smoking is completely
banned in many public places. Stringent rules are in place in respect of tobacco
advertising, packaging and labeling etc.
➢ The government may, through legislation, fix emissions standard which is a legal
limit on how much pollutant a firm can emit. For example, India has enacted
the Environment (Protection) Act, 1986.
3.2.2 Market Based Policies
➢ Market based policies provide economic incentives so that the self- interest of
the market participants would achieve the socially optimal solution. The
market-based policies operate through the price mechanism of the market.
➢ Under the market based policies, the cost of externalities is attempted to be

included in the total cost (Private Cost) which the market considers for
determining equilibrium.
➢ The two types of market based policies are:

o Taxes
o Permits/Licenses
Taxation
➢ One method of ensuring internalization of negative externalities is imposing

taxes.
➢ If pollution is taken as an example of externality, the size of the tax depends
on the amount of pollution a firm produces. These taxes are named Pigouvian
taxes after A.C. Pigou who argued that an externality cannot be alleviated by
contractual negotiation between the affected parties and therefore taxation
should be resorted to.
➢ These taxes, by ‘making the polluter pay’, seek to internalize external costs
into the price of a product or activity. More precisely, the tax is placed on the

externality itself (the amount of pollution emissions) rather than on output (say,
amount of steel).
➢ For each unit of pollution, the polluter must choose either to pay the tax or to
reduce pollution through any means at its disposal. Tax increases the private
cost of production or consumption as the case may be, and would decrease the
quantity demanded and therefore the output of the good which creates negative
externality.
➢ The following diagram depicts the market outcome of pollution tax
o When negative production externalities exist, marginal social cost is

greater than marginal private cost. The free market outcome would
be to produce a socially non-optimal output level Q.
o When externalities are present, the welfare loss to the society or dead
weight loss would be the shaded area ABC.
o The tax imposed by government (equivalent to the vertical distance
AA1) would shift the cost curve up by the amount of tax, prices will
rise to P1 and a new equilibrium is established at point B, where the
marginal social cost is equal to marginal social benefit.
o Output level Q1 is socially optimal and eliminates the whole of
welfare loss on account of overproduction.
➢ Following are the problems in administering taxes as a market-based policy:

o It is difficult to discover the right level of taxation that would ensure
that the private cost-plus taxes will exactly equate with the social
cost.
o This method does not provide any genuine solutions to the problem.
It only establishes an incentive system for use of methods which are
less polluting.

o In the case of goods which have inelastic demand, producers will be
able to easily shift the tax burden in the form of higher product
prices. This will have an inflationary effect and may reduce
consumer welfare.
o Taxation may encourage producers to shift their production facilities
to those countries with lower taxes.
Permits and Licenses
➢ The second approach to establishing prices is tradable emissions permits (also

known as cap-and-trade). These are marketable licenses to emit limited
quantities of pollutants and can be bought and sold by polluters. Under this
method, each firm has permits specifying the number of units of emissions that
the firm is allowed to generate. A firm that generates emissions above what is
allowed by the permit is penalized with substantial monetary sanctions.
Generally, these permits are transferable.
➢ By allocating fewer permits than the free pollution level, the regulatory agency
creates a shortage of permits which then leads to a positive price for permits.
This establishes a price for pollution, just as in the tax case.
➢ The high polluters have to buy more permits, which increases their costs, and
makes them less competitive and less profitable. The low polluters receive extra
revenue from selling their surplus permits, which makes them more competitive
and more profitable.
➢ Therefore, firms will have an incentive not to pollute. 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.
➢ The advantages of permits are:

o The system rewards efficiency
o Simple to implement
o Provides strong incentives for innovation
o Consumers may benefit if the extra profits are passed on to them
➢ The main argument in opposition to the employment of tradable emission

permits is that they do not in reality stop firms from polluting the environment;
they only provide an incentive to them to do so. Further, it may result in
charging higher prices to consumers, leading to inflation.
3.3 Government Intervention in case of Positive Externalities

Direct Controls
➢ In the case of products and services whose externalities are vastly positive and
pervasive, government enters the market directly as an entrepreneur to
produce and provide them.
➢ For example, in case of direct production of environmental quality, the

measures that may be undertaken are afforestation, reforestation, protection
of water bodies, treatment of sewage and cleaning of toxic waste sites.
Market Based Approach
➢ The Government may give subsidies as part of market based approach. Subsidies
involve the government paying part of the cost to the firms in order to promote
the production of goods having positive externalities.
➢ A subsidy on goods, which have substantial positive externalities would reduce

their cost and consequently price, shift the supply curve to the right and
increase the output. A higher output that would equate marginal social benefit
and marginal social cost is socially optimal.
GOVERNMENT INTERVENTION IN CASE OF PUBLIC GOODS
1. Public Goods
➢ Public goods, which are non-excludable, are highly prone to free rider problem
and therefore markets are unlikely to get established. Direct provision of a
public good by government can help overcome free-rider problem which leads
to market failure.
2. Merit Goods
➢ In contrast to pure public goods, merit goods are rival, excludable, limited in
supply, rejected by those unwilling to pay, and involve positive marginal cost
for supplying to extra users. Merit goods can be provided through the market,
but are likely to be under-produced and under-consumed through the market
mechanism so that social welfare will not be maximized.
➢ Left to the market, only private benefits and private costs would be reflected
in the price paid by consumers. This means that compared to what is socially

desirable people would consume inadequate quantities. Examples of merit
goods include education, health care, welfare services, housing, fire protection,
waste management, public libraries, museum and public parks.
➢ The following diagram depicts the market outcome for merit goods:
The Marginal Social Cost is lesser than the Marginal Private Cost, as merit goods
provide positive effect on the costs. If the Social Cost is considered, then the
quantity to be produced is Q*, which is more than what is currently being
produced (Q).
➢ The Government may take two broad kinds of steps to encourage consumption
of merit goods:
o Regulation/Subsidies
o Direct Provision by the Government
➢ Regulation: Regulation determines how a private activity may be conducted.

For example, the way in which education is to be imparted is government
regulated. For example, government may make it compulsory to avail insurance
protection. Compulsory immunization may be insisted upon as it helps not only
the individual but also the society at large. Government could also use
legislation to enforce the consumption of goods which generate positive
externalities. E.g. use of helmets, seat belts etc. The Right of Children to Free

and Compulsory Education Act, 2009 which mandates free and compulsory
education for every child of the age of six to fourteen years is another example.
➢ Direct Provision by the Government: When merit goods are directly provided
free of cost by government, there will be substantial demand for the same, as
compared to the demand when people are required to pay the free market
price.
3. Demerit Goods
➢ Demerit goods are goods which are believed to be socially undesirable. Note
that all goods with negative externalities are not essentially demerit goods;
e.g., Production of steel causes pollution, but steel is not a socially undesirable
good.
➢ Examples of demerit goods are cigarettes, alcohol, intoxicating drugs etc. The
consumption of demerit goods imposes significant negative externalities on the
society.
➢ In case of demerit goods, the marginal social cost will exceed the market price
and overproduction and over- consumption will occur, causing misallocation of
society's scarce resources.
➢ The Government may take the following steps to correct the misallocation of
resources in the case of demerit goods:
o The Government may enforce complete ban on a demerit good. E.g.,
intoxicating drugs.
o Through legislations that prohibit the advertising or promotion of
demerit goods
o Strict regulations of the market for the good may be put in place to
limit access to the good.
o Regulatory controls in the form of spatial restrictions e.g. smoking in
public places
o Imposing unusually high taxes on producing or purchasing the good
making them very costly and unaffordable to many. For example, the
GST Council has bracketed four items namely, high end cars, pan
masala, aerated drinks and tobacco products into demerit goods
category and therefore these would be taxed at higher rates.

GOVERNMENT INTERVENTION TO CORRECT INFORMATION
FAILURE
➢ For combating the problem of market failure due to information problems, the
following actions may be resorted to:
o Government makes it mandatory to have accurate labeling and
content disclosures by producers.
o Public dissemination of information to improve knowledge and
subsidizing of initiatives in that direction.
o Regulation of advertising and setting of advertising standards to
make advertising more responsible, informative and less persuasive.
OTHER GOVERNMENT INTERVENTIONS
➢ Besides intervention in the markets to correct information failure, the

Government may intervene for other reasons as well. The Government may
place a floor or a cap on prices of goods.
➢ Government usually intervenes in many primary markets which are subject to

extreme as well as unpredictable fluctuations in price. For example in India, in
the case of many crops the government has initiated the Minimum Support Price
(MSP). The objective is to guarantee steady and assured incomes to farmers. In
case the market price falls below the MSP, then the guaranteed MSP will prevail.
Example 1:
In a case where Current Price = 75, and Floor is placed at 150.

When price floors are set above market clearing price, suppliers are
encouraged to over-supply and there would be an excess of supply over
demand. At a price of INR 150, which is much above the market determined
equilibrium price of INR 75, the market demand is only Q1, but the market
supply is Q2.
In such cases, the Government must also ensure that the excess supply that is
created because of high price is being met with higher demand. For this
purpose, the Government may introduce a procurement program, where the
Government purchases the excess supply and arranges for its storage also.
➢ When prices of certain essential commodities rise excessively, government

may resort to controls in the form of price ceilings (also called maximum
price). A price ceiling, which is set below the prevailing market-clearing
price, will generate excess demand over supply.
Example 2:
In grains market, where Current Price = 150, and a Cap is placed at 75.
When price caps are set below market clearing price, the demand for such
goods increases.
Governments often intervene in grain markets through building and
maintenance of buffer stocks. It involves purchases from the market during
good harvest and releasing stocks during periods when production is below
average.
Another example of Government intervention is through progressive taxation,
unemployment compensation, subsidies, job reservations etc. These measures
are more for ensuring equity in the society than for correction of market
failure.

Unit IV: Fiscal Policy
INTRODUCTION
Fiscal
Policy
Instruments Types of
of Fiscal Fiscal Limitations
Policy Policy
Governme
Expansionar Contractiona
nt Public
Taxes Budget y Fiscal ry Fiscal
Expenditur Debt
Policy Policy
e
➢ Fiscal Policy deals with the aggregate economic activity of governments, say,
aggregate expenditure, taxes, transfers and issues of government debts and
deficits and their effects on aggregate economic variables such as total output,
total employment, inflation, overall economic growth etc.
➢ The Keynesian school is of the opinion that fiscal policy can have very powerful
effects in altering aggregate demand, employment and output in an economy
when the economy is operating at less than full employment levels and when
there is need to offer stimulus to demand.
➢ The most common objectives of fiscal policy are:

o Full employment
o Price stability
o Economic development
o Equitable distribution of income and wealth
While stability and equality may be the priorities of developed nations,

economic growth, employment and equity may get higher priority in developing
countries.
Types of fiscal Policy

➢ Discretionary: When the Government makes fiscal policy with specific
objectives, for example, containing inflation or ensuring employment, such
policy is known as Discretionary Fiscal Policy.
➢ Automatic Stabilizers:
o Non-discretionary fiscal policy or automatic stabilizers are part of the

structure of the economy and are ‘built-in’ fiscal mechanisms that
operate automatically to reduce the expansions and contractions of
the business cycle.
o Any government programme that automatically tends to reduce

fluctuations in GDP is called an automatic stabilizer. Automatic
stabilizers have a tendency for increasing GDP when it is falling and
reducing GDP when it is rising.
o In automatic or non-discretionary fiscal policy, the tax policy and

expenditure pattern are so framed that taxes and government
expenditure automatically change with the change in national
income.
o Personal income taxes, corporate income taxes and transfer payments

(unemployment compensation, welfare benefits) are prominent
automatic stabilizers.
o As we know, during recession incomes are reduced; with progressive

tax structure, there will be a decline in the proportion of income that
is taxed. This would result in lower tax payments as well as some tax
refunds. Simultaneously, government expenditures increase due to
increased transfer payments like unemployment benefits. These two
together provide proportionately more disposable income available
for consumption spending to households.
o On the contrary, when an economy expands, employment increases,

with progressive system of taxes people have to pay higher taxes as
their income rises. This leaves them with lower disposable income and
thus causes a decline in their consumption and therefore aggregate
demand. With higher income taxes, firms are left with lower surplus
causing a decline in their consumption and investments and thus in
the aggregate demand.

o The built-in stabilizers automatically remove spending from the
economy to reduce demand-pull inflationary pressures and further
expansionary stimulation.
o In brief, automatic stabilizers work through limiting the increase in

disposable income during an expansionary phase and limiting the
decrease in disposable income during the contraction phase of the
business cycle.
INSTRUMENTS OF FISCAL POLICY
1. Government Expenditure
➢ Government Expenditure directly affects the National Income.
➢ It includes governments’ expenditure towards consumption, investment, and

transfer payments. Government expenditures include:
o current expenditures to meet the day to day running of the
government,
o capital expenditures which are in the form of investments made by
the government in capital equipment and infrastructure, and
o transfer payments
➢ During a recession, it may initiate a fresh wave of public works, such as

construction of roads, irrigation facilities, sanitary works, ports, electrification
of new areas etc. Government expenditure involves employment of labour as
well as purchase of multitude of goods and services. These expenditures directly
generate incomes to labour and suppliers of materials and services.
➢ Apart from the direct effect, there is also indirect effect in the form of working
of multiplier. The incomes generated are spent on purchase of consumer goods.
The extent of spending by people depends on their marginal propensity to
consume (MPC).
➢ The concepts of public spending in recession are:

o Pump Priming: - The Government infuses money in the economy to
stimulate economic activity. However, it does not replace private
investment.
o Compensatory spending: Compensatory spending is said to be resorted
to when the government spending is carried out with the obvious
intention to compensate for the deficiency in private investment.

➢ Public expenditure is also used as a policy instrument to reduce the severity of
inflation and to bring down the prices, in case of very high economic activity.
This is done by reducing government expenditure when there is a fear of
inflationary rise in prices. Reduced incomes on account of decreased public
spending helps to eliminate excess aggregate demand.
➢ Government Spending Multiplier
o Spending multiplier (also known as Keynesian or fiscal policy multiplier)
represents the multiple by which GDP increases or decreases in response
to an increase and decrease in government expenditures and investment,
holding the real money supply constant.
o Quantitatively, the government spending multiplier is the same as the
investment multiplier.
o It is the reciprocal of the marginal propensity to save (MPS).
o Higher the MPS, lower the multiplier, and lower the MPS, higher the
multiplier.
2. Taxes
➢ Taxes determine the size of disposable income in the hands of the public, which
in turn determines aggregate demand and possible inflationary and deflationary
gaps.
➢ During recession and depression, the tax policy is framed to encourage private
consumption and investment. A general reduction in income taxes leaves higher
disposable incomes with people inducing higher consumption. Low corporate
taxes increase the prospects of profits for business and promote further
investment.
➢ During inflation, new taxes can be levied, and the rates of existing taxes are
raised to reduce disposable incomes and to wipe off the surplus purchasing
power.
➢ Balanced Budget multiplier - The government budget is said to be in balance

when ∆G = ∆T. The balanced budget multiplier is always equal to 1. The
balanced budget multiplier is obtained by adding up the government spending
multiplier (fiscal multiplier) and the tax multiplier.
3. Public Debt

➢ Public debt refers to Government borrowing from the public. If such borrowing
is within the country, then it is known as internal debt. If the source of the
borrowing is outside the country, then it is known as external debt.
➢ Public debt takes two forms namely:
o Market loans – In the case of market loans, the government issues

treasury bills and government securities of varying denominations and
duration, which are traded in debt markets. For financing capital
projects, long-term capital bonds are floated and for meeting short-
term government expenditure, treasury bills are issued.
o Small savings – The small savings represent public borrowings, which
are not negotiable and are not bought and sold in the market.
Borrowing from the public through the sale of bonds and securities
curtails the aggregate demand in the economy. Repayments of debt
by governments increase the availability of money in the economy and
increase aggregate demand.
4. Budget
➢ The budget is simply a statement of revenues earned from taxes and other
sources and expenditures made by a nation’s government in a year.
➢ A government’s budget can either be balanced, surplus or deficit. A balanced

budget results when expenditures in a year equal its revenues for that year.
Such a budget will have no net effect on aggregate demand since the leakages
from the system in the form of taxes collected are equal to the injections in the
form of expenditures made. A budget surplus that occurs when the government
collects more than what it spends, though sounds like a highly attractive one,
has in fact a negative net effect on aggregate demand since leakages exceed
injections. A budget deficit wherein the government expenditure in a year is
greater than the tax revenue it collects has a positive net effect on aggregate
demand since total injections exceed leakages from the government sector.
TYPES OF FISCAL POLICY
1. Expansionary Fiscal Policy
➢ A recession sets in with a period of declining real income (output), as measured

by real GDP simultaneously with a situation of rising unemployment.

➢ A recessionary gap, also known as a contractionary gap, is said to exist if the
existing levels of aggregate production is less than what would be produced with
full employment of resources. Due to decline in real GDP, the aggregate demand
falls and therefore, lesser quantity of goods and services will be produced. To
combat such a slump in overall economic activity, the government can resort to
expansionary fiscal policies.
➢ In an expansionary fiscal policy, the Government may increase Government

expenditure, or reduce taxes. Increase in Government expenditure stimulates
economic activity, boosts employment leading to increase in income of the
people. Reduction in taxes leaves people with higher disposable income. Both
these actions would result in increase in consumption and consequently,
demand.
➢ The impact of Expansionary Fiscal Policy may be of two kinds:

o Direct effect on the market and economic activity
o Effect on Monetary Policy
➢ The following figure illustrates the operation of expansionary fiscal policy in a

market:
AD1 represents the demand curve. Everything else remaining constant, if the
demand increases, the demand curve shifts rightward and the quantity increases
from Y1 to Y2.
In case where the supply increases, it boosts employment and increases income
of the people.

➢ Fiscal Multiplier
o Any increase in autonomous aggregate expenditures (including
government expenditures) has a multiplier effect on aggregate
demand. As such, the government needs to incur only a lesser amount
of expenditure to cause aggregate demand to increase by the amount
necessary to achieve the natural level of real GDP. Such multiplier is
known as “Fiscal Multiplier”. Fiscal Multiplier is the response of gross
domestic product to an exogenous change in government
expenditures.
o A pertinent question here is; from where will the government find
resources to increase its expenditure? We know that if government
resorts to increase in taxes, it is self- defeating as increased taxes will
reduce the disposable incomes and therefore aggregate demand. So,
besides taxes, there can be two other sources for Government
expenditure:
1. Government Borrowing: Government may choose to borrow from

the financial market. In such case, the borrowing available to the
private firms would reduce, resulting in increase in interest rates.
2. Increasing money supply: To avoid rise in interest rates as
explained above, the Government may resort to increasing the
supply of money in the economy, through the Monetary Policy.
Hence, an expansionary monetary policy would be successful only
if there is an accommodative monetary policy.
2. Contractionary Fiscal Policy
➢ When aggregate demand rises beyond what the economy can potentially
produce by fully employing given resources, it gives rise to inflationary pressures
in the economy. The aggregate demand may rise due to large increase in
consumption demand by households or investment expenditure by
entrepreneurs, or government expenditure. In these circumstances inflationary
gap occurs which tends to bring about rise in prices.
➢ Contractionary fiscal policy refers to the deliberate policy of government

applied to curtail aggregate demand and consequently the level of economic
activity. This can be achieved either by:
o Decrease in Government spending: the total amount of money
available in the economy is reduced which in turn trim down the
aggregate demand.

o Increase in personal income taxes/business taxes: An increase in
personal income taxes reduces disposable incomes leading to fall in
consumption spending and aggregate demand.
o Combination: of decrease in government spending and increase in
personal income taxes and/or business taxes
➢ The increase or decrease in Aggregate Demand caused by an Expansionary Fiscal

Policy or a Contractionary Fiscal Policy should be adequately supported by
accommodative infrastructure in the economy.
3. Other effects of Fiscal Policy
➢ Fiscal Policy may be instrumental in reducing inequalities of income and wealth.

The following measures may be used to equality and justice as part of the Fiscal
Policy:
o Direct and Indirect Taxes: A progressive direct tax system ensures that
those who have greater ability to pay contribute more towards
defraying the expenses of government and that the tax burden is
distributed fairly among the population. Under Indirect taxes, the
commodities which are primarily consumed by the richer income
group, such as luxuries, are taxed heavily while the necessaries may
be taxed lightly.
o Government Expenditure: This is done through spending programs
targeted on welfare measures for the disadvantaged, like poverty
alleviation programs, free or subsidized medical care, infrastructure
provision on a selective basis, and other social security programs such
as pensions, sickness allowance, unemployment relief etc.
LIMITATIONS OF FISCAL POLICY

Some significant limitations in respect of choice and implementation of fiscal
policy are given below:
➢ Different types of lags involved in fiscal-policy action:

o Recognition lag: The economy is a complex phenomenon and the state
of the macro economic variables is usually not easily comprehensible.
o Decision lag: Once the need for intervention is recognized, the
government has to evaluate the possible alternative policies. Delays
are likely to occur to decide on the most appropriate policy.

o Implementation lag: There are possible delays in bringing in
legislation and implementing them. It is highly possible that an
expansionary policy is initiated when the economy is already on a path
of recovery and vice versa.
o Impact lag: impact lag occurs when the outcomes of a policy are not
visible for some time.
➢ There may be administrative problems. Public works cannot be adjusted easily

along with movements of the trade cycle because many huge projects such as
highways and dams have long gestation period. Besides, some urgent public
projects cannot be postponed for reasons of expenditure cut to correct
fluctuations caused by business cycles. Further, expenditure like social security
may not be immediately reduced.
➢ Certain fiscal measures may cause disincentives. For example, increase in

profits tax may adversely affect the incentives of firms to invest and an increase
in social security benefits may adversely affect incentives to work and save.
➢ The production of goods and services, especially in underdeveloped countries

may not catch up simultaneously to meet the increased demand. This will result
in prices spiraling beyond control.
➢ In case the Government borrowing increases as part of an expansionary fiscal

policy, it may lead to increase in interest rates. This may lead to reduction in
borrowing by private firms, further decreasing their investment expenditure and
their ability to meet an increased demand in an expansionary fiscal policy. This
may defeat the very purpose of an expansionary fiscal policy. This problem is
known as Crowding Out. Nevertheless, during deep recessions, crowding-out is
less likely to happen as private sector investment is already minimal and
therefore there is only insignificant private spending to crowd out. Moreover,
during a recession phase the government would be able to borrow from the
market without increasing interest rates.

Fiscal Policy Responses of Government of India to COVID 19
A stimulus During May,

March 26, 2020 package of an Business-support
2020
A stimulus package additional 150 package
valued at Many new
billion rupees
approximately 0.8 measures
(about 0.1
percent of GDP (forming about
percent of
announced by 2.7 percent of - Financial sector
GDP)
Finance minister. GDP), were measures for micro,
announced by
announced small, and medium-
Prime minister
sized enterprises
Allocated to - Waiving-off EMI and
- Cash transfers to - Support for poor other financial
lower-income health households,
infrastructure, obligations for certain
households & especially period of pandemic
Transfers in kind including for migrants and
such as food items, testing farmers (about - Liquidity injection
cooking gas etc facilities for 1.5 percent of for companies and a
COVID-19, PPE GDP) reduction in up-front
- Insurance coverage kits, isolation & tax deductions.
for the healthcare ICU beds and - Support for the
workers ventilators. agricultural sector - Postponement of
(about 0.7 tax-filing and other
- Wage support to compliance deadlines.
low-wage workers percent of GDP)
- Providing work - Interest rate on
opportunities to overdue filings
low-wage reduced to half of
labourers (about what is payable.
0.2 percent of - Contribution to PF
GDP) on complying with
specified conditions
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Chapter 3 – Money Market
Unit I: The Concept of Money Demand: Important
Theories
INTRODUCTION
1. Structure of the Unit
Money
Demand
Theories of
Functions Demand for
Money
of Money money
Demand
Post
Neo
Classical Keynesian Keynesian
Classical
Approach theory Development
approach
s
Theory of Demand
Inventory Freidman’s for money as
approach theory behavior towards
risk
2. Barter system and troubles attached
Long before a medium of exchange, money, existed, people transacted in goods

in a barter system where goods were exchanged for other goods and services.
Often barter system did not exist as an independent system. At different times,
different goods were made the medium, for example livestock, agricultural
produce, salt etc.
After a while, the system started failing due to the following reasons:

o Different sellers valued their goods differently, and hence demanded
different things in return. There was no way to assign an official value to
goods.
o There was difficulty in demand and supply to match to make an exchange.
It is known as “double coincidence of wants”.
o Many goods faced lack of divisibility.
The above reasons and more lead to invention of money. Money performed the
various functions (enumerated below) to overcome the limitations of barter
system.
FUNCTIONS AND CHARACTERISTICS OF MONEY
3. Functions of Money
➢ Serves as a convenient medium of exchange – It eliminates the need for double

coincidence of wants and makes exchange of goods and services easier.
➢ Money acts as unit of measurement of value –We determine the value of

different goods based on their prices, based on money.
Values of goods or services are expressed as a price – the number of rupees to

be exchanged for receiving such goods. The monetary units for India are Rupees,
USA – Dollars, Japan – Yen, Britain – Pounds. All these are known as monetary
units.
Instead of expressing various goods and services in terms of one another, all
goods and services are expressed in terms of monetary units.
Point to note: Purchasing power is inversely related to the general price level.
E.g. – If 3 pencils can be purchased for INR 15, Price = INR 5 each.
However, if only 2 pencils can be purchased with the same INR 15, Price = INR
7.5 each.
Purchasing power reduced (3 pencils to 2 pencils). Price level increased – INR 5

to INR 7.5.
Point to note: Money derives its value because of its purchasing power.
“Currency” does not have any intrinsic value. Only when it is money, it has some

value attached to it. The government has given it the status of medium of
exchange and called it “Legal tender”.
➢ Money serves as a unit of deferred payment – Like any other asset, money is
a store of value. Promises to pay value on a future date (deferred payment) can
be made because money holds value. However, as the purchasing power of
money reduces with time generally, money may not be a permanent store of
value. So, for money to be a permanent store of value, its purchasing power
should remain constant, or gradually rise over time.
➢ Money commands perfect reversibility – Two characteristics of money are

liquidity and reversibility.
Liquidity is availability of liquid assets, i.e. any asset that can be readily be
converted into money. Consequently, money itself is the most liquid asset.
Reversibility means the value in payment of money is the same as value in

receipt.
Question:
Define money.
Answer:
Money refers to liquid assets, which are commonly used and accepted as means
of payment or medium of exchange.
4. Characteristics of money –
➢ Generally acceptable
➢ Effortlessly recognizable
➢ Easily transported
➢ Possessing uniformity
➢ Durable/long lasting
➢ Divisible without losing value

DEMAND FOR MONEY
➢ Money has a derived demand because people’s desire to hold money is not for
consuming it, but for its purchasing power and for its liquidity.
➢ Demand for money is the decision about how much of one’s wealth should be
held as money instead of holding it as any other asset and that depends on total
income, price of various goods etc.
Note:
➢ If the prices of good are more expensive, one has to hold more cash in hand to
satisfy day- to-day needs. Hence, the quantity of cash demanded is directly
proportional to the prevailing price level.
➢ Opportunity cost of money is the interest a person foregoes that could have
been earned if invested in other assets. Higher the interest rate, higher is the
opportunity cost of money. And if opportunity cost of money is very high, then
the willingness to hold it will be less, hence reducing demand for money.
THEORIES OF DEMAND FOR MONEY
1. Classical Approach: The Quantity Theory of Money (QTM)
➢ This theory was put forth by Irving Fisher.
Example 1:
Following depicts the movement of money from one person to another
INR 100 INR 100 INR 100
Person A Person B Person C Person D
2 Pens of INR 50 each Food Vegetables
In the above transactions, the same money has travelled from Person A to Person D.
The same money was used for purchasing three times, once for buying 2 pens, once
for food and once for vegetables.
➢ All the currency that is in existence in the economy and in circulation refers to
is knowns as Money and is represented by “M”.
The number of times Money is exchanged for goods and services is known as
Velocity of circulation denoted by “V”.
Total circulation of in terms of value = MV
➢ In Example 1 above the total final goods and services actually sold = Two pens
* 50 INR + Food * 100 INR + Vegetables *100
The number of transactions of goods and services sold * their prices = T*P
Where “T” refers to the number of transactions

“P” refers to the average price level.
➢ Fisher equation is MV = PT
That is, buy side = sell side

PT represents the total sale in the economy, which meets total demand for
goods and services. To make such demand for goods and services, people in turn
demand money. Hence, MV = PT = Demand for money.
➢ So MV = PT = Demand for money.
Further,
P = MV/T → The average price level is dependent on the demand divided by the
total transactions.
➢ Fisher further considered credit money also to determine the demand for
money. The currency and the velocity of credit money is are denoted by M’ and
V’.
Therefore, MV + M’V’ = PT.
➢ Assumptions made by Fisher:

1. Full employment in the economy. Since there is full employment, the total
number of goods and services produced cannot change even if there is
increase in demand. So, the total final goods and services produced/the total
transactions in the economy “T” is a constant in the short run.
2. “V” is the velocity of money in circulation and is a constant.

➢ Given that V and T are constant, any change in M would directly affect P. If M
increases, the money in circulation in the economy increases, people have more
money in hand to spend and the demand for goods and services, consequently,
increases. However, as there is full employment in the economy (assumption),
the supply does not increase. Demand increasing without increase in supply
leads to increase in the price levels.
➢ The quantity theory establishes a relationship between the quantity of money

and general price level. It explains the effect on general price level of changes
in money demand.
Example 2:
If
M = Rs. 1000
V=4
T = 2000
P = Rs. 2
Fisher equation is MV = PT → 1000*4 = 2*2000
If M rises to 1500, P also would increase as shown below:
MV = PT
1500*4 = P*2000
P = Rs. 3
2. Neo Classical Approach: The Cambridge Approach
➢ Cambridge economists, Alfred Marshall, John Maynard Keynes, AC Pigou, and

Robertson gave a different approach to the quantity theory. It is also known as
the cash balance approach.
➢ In the Cambridge approach, the demand for money is on account of two things
–
o Enabling the split of purchase and sale to different points in time. Both
purchase and sale need not be simultaneous because there is no need for
double coincidence of wants. Because of this characteristic, money has
utility and its demand increases Fisher also explained demand of money
to be on account of transactions of sales and purchases happening at
different times.

o Being a hedge against uncertainty. This refers to money being a temporary
store of value. Holding of money answers uncertainties of the future by
money acting as a store of value.
➢ The Cambridge equation is stated as
Md = k PY
Where
Md refers to - Demand for money
P refers to - Average price level of goods and services
Y refers to - Real national output
PY refers to - Nominal Income, i.e. real output at current prices
k refers to - Proportion of income that people want to hold as cash.
Thus, according to the Cambridge theory, the money demand is completely

dependent on the Nominal income. That is the chief difference between
classical theory and the Neo-classical theory.
However, both the theories commonly explain money being a means of

transactions/exchange. Both are models for transaction demand for money.
3. Keynesian Theory of Demand for Money
➢ This theory is also known as the “Liquidity Preference Theory”.

➢ According to Keynes, people hold money for three motives
o Transactions motive,
o Precautionary motive, and
o Speculative motive.
1.3.1. Transactions motive –
➢ This refers to the requirement of cash for all our day-to-day transactions.
➢ Since there may be difference in timings of receipt transactions and payment

transactions, hold money becomes essential.
➢ Transaction motive is further divided into

o Income motive (Individuals demand money due to difference in timing of
payment and receipt)

o Business/Trade motive (Businesses demand money due to difference in
timing of payment and receipt)
➢ In this motive, Keynes only considered demand for money being to bridge the
gap between payments and receipts. Keynes, however, did not consider the
interest rates (Opportunity cost of money).
➢ Transactions demand for money depends directly on income. The equation for
Transactions Demand is given below:
Lr = kY
Where
Lr → Transactions demand for money
K → ratio of earnings kept for trnasactions
Y → Earnings/Income
1.3.2. Precautionary motive –
➢ It is very common for individuals and businesses to hold money for

contingencies. This is known as the precautionary motive to demand money.
The quantum of money demanded depends on various factors like size of income
(income elastic), characteristics of the individual (optimism/pessimism,
farsightedness) etc.
1.3.3. Speculative Motive –
➢ “Speculation” means expectation.
Example 3:
The current price of bonds is INR 100, with interest rate 10%. At the end of
1 year, interest received is INR 10, and the price of the bond at the end of
1 year is INR 105.
For a person who bought the bond at INR 100 and sold it at the end of the
year,
Total benefit:
Interest = 10
Capital appreciation/gain = 105-100 = 5.
Total benefit = 10+5 = 15
Effective interest rate = 15/100 = 15%

Example 4:
Find the current price of the bond if total benefit is INR 15 and effective
interest rate is 12%
(Total benefit/ Current price) = Effective interest rate

Current Price = Total benefit / Effective interest rate
Current Price = 15/12% = INR 125
Example 5:
Find the current price of the bond if total benefit is INR 15 and effective
interest rate is 20%
(Total benefit/ Current price) = Effective interest rate

Current Price = Total benefit / Effective interest rate
Current Price = 15/20% = INR 75
➢ Note in Example 3, 4 and 5 the relationship between the price of the bond and
the effective interest rates. When the effective interest rate reduced, the value
of the bond increased, and when the effective interest rate increased, the value
of bond reduced.
➢ Investors generally have in mind the “normal” interest rate that should be. It is
called as the “critical rate”.
➢ If the effective interest rate prevailing is higher than the critical rate,
speculators generally expect it to reduce and return to normal. If the effective
interest rate reduces in the future, the price of the bond would increase. Hence,
to reap the benefit of capital appreciation, investors might reduce the demand
for holding money and invest the sane in bonds.
➢ However, if the interest rate in the future is expected to increase, the bond
price in the future will reduce and result in a loss for a person holding a bond.
Speculators would rather hold money than invest in bonds as –
o They are still foregoing some amount of interest; however, such interest
may be negligible.
o They will avoid the total capital loss that they might incur if the bond is
purchased and the price goes down in the future.
o If the interest rates rise in the future and the bond prices reduce, the
money today will be continuing to be held so that bonds could be bought
in the future when the prices are low.

Summary of speculative motive:
1. If current rates > normal rates – Hold only bonds – At this point choose to hold
only interest-bearing assets and no demand for cash/money held in hand.
2. If current rates < normal rates – Hold only cash (Here, there is demand for
money)
3. If current rates = normal rates – Indifferent
At this level, there is no capital loss or gain as no change in value of bond is
expected. So, no net benefit from holding a bond is expected.
➢ The following graph depicts the speculative demand for money for an individual
–
o Arc is the critical rate. When actual interest rate is above that, there is
no demand for money. Entire money is held as investments in bonds.
o When actual interest rate is below the critical rate, there is no investment
in bonds. Entire money is demanded to be held in hand.
o Note that the graph depicts the effective interest rates and the
speculative demand only for an individual only where the critical rate is
clearly determinable.
➢ Aggregate Speculative Demand – Since different persons in the economy may

have different expectation of the “normal rate”, it creates not a single point
but a range of normal rates or “critical rates”. Consider for example 3% to 15%.
Above 15%, there will not be any demand for money, as interest rate is higher
than the critical rate. So, the curve will be on the y axis.
Between these two boundaries, as interest rates decrease, demand for money
increases (as the opportunity cost is has reduced)

When the interest rate is as low as 3% (r0 in the diagram) or below 3%, the total
wealth is held as money in hand, and nothing is invested in bonds
The below diagram depicts the Aggregate Speculative Demand:
Note: The increase in the Money demand is much higher than the reduction in
the interest rates.
4. POST KEYNESIAN DEVELOPMENTS
1.4.1. Inventory Approach (Baumol-Tobin)
➢ Propounded by two economists Baumol and Tobin, this theory assumes that
there are two ways of holding one’s wealth – Money (Cash) or other interest-
bearing financial assets (Keynes called them bonds).
➢ Not all wealth will be held as cash as there is opportunity cost of cash. There is
interest that is lost which would have been otherwise earned.
➢ Not all wealth will be held as bonds as people generally desire liquidity for day
to day transactions and for contingencies.
➢ Further, when wealth is held in assets, their conversion into cash and vice versa
involves some fixed cost like bank charges, brokerage etc. So, the number of
times bonds are to be converted to cash or vice versa is selected such that the
benefit (interest) net of this fixed cost remains positive and are maximized.

➢ According to this theory, people wish to hold an optimum combination of bonds
and cash to minimize their opportunity cost.
➢ According to Baumol, income is received once in a given period, but expenditure

is spread across the period. So, the excess of cash holding beyond what is
required for the transactions is held in interest bearing assets. Higher the
income, higher will be the money held in hand (As transactions of goods and
services tend to be high), and higher is the inventory (stock) of cash.
➢ Such holding of cash inventory involves two elements –

o Carrying cost – Opportunity cost which is the interest forgone. This is a
cost incurred by holding inventory.
o Net cost of transfer between bonds and cash – This is cost avoided when
inventory of cash is held (benefit).
➢ So, increase in brokerage and other conversion costs makes it costlier to keep
switching between bonds and cash, and hence would increase the benefit of
inventory holding and thus would result in increase in demand for money.
1.4.2. Friedman’s Theory
➢ The Friedman’s theory explains two types of demand for money –

o Demand for money as it serves as medium of exchange (similar to QTM)
o Demand for money as it is considered as an asset – It is more than just a
mere means of exchange. It is a store of value/store of purchasing power.
➢ This theory is also called a Restatement of the quantity theory.
➢ Friedman submitted that money is like any other capital asset; it has long-term
use. So, the theory of demand for money is also a general theory of demand for
capital assets.
➢ The factors affecting the demand for any capital asset –

o Permanent income –Permanent income is the present value of the total
income that is expected to be earned by a person over many years.
o Relative return on assets – The whole wealth is divided into various

assets. Amount to be invested into one asset depends is compared with
the return on various assets. The amount to be invested into each asset
depends on the risk of each asset, the total returns the investor wants
and the return of other assets.

➢ Determinants of demand for money:
o Wealth – Demand for money is directly proportional with the total wealth.
o Price level – Demand for money us directly proportional with price levels.
o Opportunity cost of money (interest rate on bonds etc) – Demand for
money is inversely proportional to opportunity cost.
o Inflation – Inflation reduces the value of money, hence increasing the
opportunity cost of money and reducing its demand.
o
1.4.3. Demand for Money as Behavior Towards Risk
➢ Risk refers to the possibility of loss/ possibility of threat or it may also be

expressed as deviation from expectation.
In this model, we are referring to risk involved in investing money in interest
bearing assets/bonds and the possibility of change in prices of bonds and shares
➢ Return refers to the benefit received out of investing money. Example, Bonds
pay interest, shares pay dividends. Return is the reward for taking risk. Higher
the risk, higher is the return.
➢ Money does not have any risk and hence does not have any return either.
➢ Summary of the theory of demand for money as behavior towards risk given by
Tobin:
o A person would make a combination of assets to maximize the

benefit/return and reduce the risk. Such people are called “risk averse”.
o One would want to hold money in hand because one desires liquidity and
cash is riskless.
o Uncertainty about future changes in bond prices and the risk involved in
buying bonds affect the demand for money.
o The demand for money depends on the interest rates. If the interest rate
on the risky assets is increased, that is an incentive to take higher risk.
This would lead to people taking higher risk and placing more of their
wealth in risky assets and reducing the amount of wealth held as money
in hand.
o Just as Keynes concluded, Tobin’s theory also implies that demand for
money as a store of wealth depends negatively on the interest rate.

Unit II: The Concept of Money Supply
INTRODUCTION
Money
Supply
Sources Determin Effect of

Measurement Money
of ants of Government
of Money Multiplie
Money Money Expenditure on
Supply r
Supply Supply Money Supply
Monetar Monetar
Commer
y y Liquidity
Central cial
Measure Measure Measure
Bank Banking
s since s after s
System
1977 1998
2. Meaning of Money Supply
➢ Money Supply refers to the total amount of money/ stock of money in an

economy at a particular point in time.
➢ The stock of money means the stock available to the public as a means of
payments and store of value. For example, after demonetization in November
2016, new 2000-rupee notes were printed but were kept unavailable for public
use for some time. During this time, currency was in existence, but it was not
available to the public for use, and so will not be included in the total stock of
money. It also implies that the stock of money available to the public is always
lesser than the total stock of money in existence in the economy.
➢ When supply refers to currency available for public use, “Public” means all
households, firms, institutions etc., except the producers of money. Therefore,
except the Government and the banking system, everyone else is included in
the word “public”.
➢ Since Government and banks are excluded from the meaning of public, any
currency held by them will not be called as money, so also, any interbank
deposits (banks holding with RBI, or the Government holding RBI’s money) will
not be included in money supply.

3. Rationale for Measuring Money Supply
➢ As discussed in Fisher’s concept of money demand, the amount of money in the

economy directly affects the price levels in the economy. Government makes
monetary policy through which it controls the quantity of money in circulation
in the economy, consequently regulating the price level, inflation and
consequently GDP growth.
SOURCES OF MONEY SUPPLY

➢ There are two broad sources of money supply in the economy –
o Central bank
o Commercial banking system
1. Central Bank
➢ Central bank is the bank that serves the Government and the rest of the
commercial banking system, issues currency, and makes policies relating to
money and banking in the economy. In India, Reserve Bank of India (RBI) is the
Central Bank.
➢ In all countries, Central Banks are empowered to issue currency. So Central bank
is the primary source of money supply in any economy.
➢ The Government issues currency and undertakes to be liable for its value.
Hence, such liability is backed by real resources like gold and foreign reserves.
In reality, the amount of reserves may not be equal to the amount of currency
issued. Only a minimum percentage of the currency may be required to be held
in real resources. This is known as the Minimum reserve system.
➢ The currency issued by the Central Bank is called “Fiat money” or “High
Powered money”.
2. Commercial Banking system
➢ Commercial banks create “credit money”.

Example 1:
INR 1000 INR 900 INR 900 in C Deposits
Deposit Lending Cheque the cheque Bank 2 Receives
money INR 900
A Bank 1 B C Bank 2
INR 810
Lending
Goods D
INR 810
Deposit
Bank 3
INR 729
Lending
E
A has INR 1000. He deposits it with Bank 1.
Bank 1 lends INR 900 to B after maintaining 10% of the deposits money of
INR 100 as a reserve for settlement obligations and complying with the RBI
requirement. This is known as the Cash Reserve Ratio (CRR)/Statutory
Liquidity Ratio (SLR)
B purchases goods and services and pays to C in check.
C presents this cheque to his banker (Bank 2) and Bank 2 receives the money
from B and holds it on behalf on C.
Bank 2 lends 900*90% = 810 to D after withholding 10% as SLR/CRR.
D deposits 810 in Bank 3.
Bank 3 again lends to E – 810*90% = 729 (After complying with the SLR/CRR
guidelines)
In the above set of transactions, A owns INR 1000 as a deposit in the Bank; B
owned INR 900 which was used to purchase goods from C; C receives INR 900
which deposited into the bank is held by the bank on behalf of C. D, after
borrowing money from Bank, deposits it with Bank 3, and owns INR 810 as
the deposit.
Though only INR 1000 of currency is issued by the Government, the same
currency is being held and owned by different people as assets at the same
time. The banking system has created credit money of INR 900, INR 810, and
INR 729.

The additional money created because of bank lending is known as Credit
money.
So, for increase of 1000 in Fiat money,

Increase in total money = 1000 + 1000*90% + 1000*90%*90% + 1000*90%*90%*90%
and so on.
= 1000 [1+0.9+0.92+0.93 + ……]
= 1000 [1/1-0.9] … (Geometric progression)
= 1000 [1/0.1]
So, the increase in high powered money is multiplied by 1/Required reserve.

This is known as the Credit multiplier.
1
𝐶𝑟𝑒𝑑𝑖𝑡 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑎𝑡𝑖𝑜
Question:
Find the total Credit money created by the banks if Initial Deposit is INR 1000
for required reserve ratios 0.2, 0.5 and 0.10.
Answer:
Initial deposit Required reserve ratio Credit multiplier Total credit
1000*50 =
1000 0.02 1/0.02 = 50 50,000
1000 0.05 1/0.05 = 20 20,000
1000 0.10 1/0.10 = 10 10,000
MEASUREMENT OF MONEY SUPPLY
➢ Because of complexity of sources of money like credit money, measurement of

money becomes a difficult task.
1. Monetary Measures Since 1977
Since 1977, RBI has been publishing four different measures of money supply.

➢ M1 = Currency notes and coins + Net Demand deposits with banks + other
deposits with RBI.
o Currency: It includes both paper currency (notes) and coins

o Demand Deposits –
▪ Interbank deposits – Not to be included (as it is between two
producers of money) That is, only demand deposits “net” of
interbank deposits. [Short question on why only “NET”]
▪ Demand Deposits by public –Those deposits made with a bank
which can be withdrawn on demand –
• Current account – An account generally maintained by
businesses
• Savings account – Maintained by individuals – A portion of it
may be withdrawn on demand.
▪ Other deposits with RBI – by persons other than Govt./Banks like
• Financial institutions which are not banks
• Foreign banks
• Foreign Govt.
• IMF
• World Bank etc.
➢ M2 = M1 + Savings deposits with post office savings banks
➢ M3 = M1 + Net Time deposits with banks
Time deposits cannot be withdrawn on demand and may be withdrawn only

after a specified period.
➢ M4 = M3 + Total (Demand + Time) deposits with Post office savings

organization
Note:
The above measures are in the order of liquidity, M1 being the most liquid.
2. Monetary Measures After 1998
After 1998, RBI started publishing a set of four new monetary aggregates –
➢ Reserve Money = Currency in circulation + Bankers’ deposits with RBI +

Other deposits with RBI
o Bankers’ deposit with RBI – Means the reserves that bankers create (CRR)
may be deposited with RBI.

o Reserve money does not include the deposits made with commercial
banks. That is, the “credit money” created by the banking system out of
deposits made with them is not included here.
Therefore, Reserve money is only High-powered money, also called
“Central Bank money” or “Base money”.
o Reserve Money may also be depicted as
Reserve Money = 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
o Reserve money determines the level of liquidity and price level in the
economy and is therefore crucial for the Government to analyze and
stabilize liquidity, growth and price levels.
Question:
Compute Reserve Money if
Currency = 15428.4
Bankers’ deposit with RBI = 4596.18
Other Deposits = 183.30
Answer:
Reserve money = Currency + Banker’s deposit with RBI + Other deposits with
RBI = 15428.40 + 4596.18 + 183.30 = 20,207.88
➢ NM1 = Currency + Demand deposits with banks + Other RBI deposits
➢ NM2 = NM 1 + Short term time deposits of residents
➢ NM3 = NM2 + Long term time deposits of residents + Call Funding from
financial institutions
Call funding refers to the money loaned by banks that must be repaid on
demand
3. Liquidity Measures

➢ L1 = NM3 + Total (Demand + Time) deposits with Post office savings
organization
➢ L2 = L1
+ 1. Term deposit with lending (Institutions which only accept and lend
money, no other banking function) /refinancing organization (which
give money to the banks so that they can in turn lend to people –
Example NABARD, NHB etc.)
+ 2. Term borrowing by lending/ refinancing organization
+3. Certificate if deposits issued by lending/ refinancing organization
➢ L3 = L2 + Public deposits of NBFCs
Question:
Compute M3 if
Currency with Public 12,637.10
Demand Deposits with banks 14,106.30
Time deposits with banks 101,489.50

Other deposits with Reserve
bank 210.90
Answer:
M3 = M1 + Net Time deposits with banks
= Currency + Demand deposits of Banks + Other deposits with RBI +
Net time deposits with banks
= 128,443.8
DETERMINANTS OF MONEY SUPPLY

There are three broad views explaining the determinants of Money Supply:
➢ Determined by the independent element – The decision by the Central Bank

about the amount of money in the economy solely determines the supply of
money.

➢ Determined by people’s desire to hold currency – Based on economic
activity, interest rates, the demand for money changes and affects the supply
of money.
➢ Money Multiplier approach (Explained in detail in Para 5) – The current

practice is to explain the determinants of money supply based on “money
multiplier approach”. It holds that total supply of nominal money in the
economy is determined by joint behavior of
o Central Bank
o Commercial Banks
o Public
CONCEPT OF MONEY MULTIPLIER

➢ As per the Money Multiplier approach, Money supply is determined as follows
M = m X MB
Where M – Money supply
m – Money multiplier
MB – Monetary base
➢ An increase in the money base (High powered money) increases supply by a

multiple. Increase in supply of money is not just on account of increase in fiat
money, but also on account of a multiplier. This multiplier is determined by
the commercial banks and the public.
1. Money Multiplier Approach to Supply of Money
➢ This theory is propounded by Milton Freidman and Anna Schwartz.
➢ According to the Money Multiplier approach Three factors that determine

money supply:
o Behavior of Central Bank

o Behavior of Commercial banks
o Behavior of General public
1. Behavior of Central Bank –

o Central bank supplies high powered money.

2. Behavior of Commercial Banks
o Commercial banks create credit money through operation of credit
multiplier and credit money increases the total supply of money in the
economy. The credit multiplier is dependent on CRR – i.e. the reserve to
deposit ratio.
o If the required reserve ratio increases, more reserves would be needed

and banks must contract their loans, causing decline in further deposits
and consequently, a decline in money supply.
o Generally, banks keep with themselves a percentage higher than the

statutorily required percentage of deposits in the form of cash for the
following reasons:
▪ When banks hold money in cash, it has an opportunity cost. The
interest that could have been earned by investing the cash
elsewhere is given up. So, if interest rates decrease, opportunity
cost goes down and deposits held as reserve increases and the
reserves to deposits ratio also increases. Banking system’s excess
reserves ratio (“e”) is negatively related to the market interest
rate.
▪ If banks anticipate that the deposits made with them may be
withdrawn shortly, and settlement may have to be made, the
deposits outflow may increase, and the deposits held as reserve
also increases.
o If the central bank injects money into the banking system and these are
held as excess reserves by the banking system, there will be no effect on
the credit multiplier and no effect on money supply.
o Behavior of commercial banks affects the economy in many ways. For

example, if there is a financial crisis, and there is fear of loss in the
minds of the banks, banks may hesitate from giving loans to small and
medium scale industry considering them risky. However, for such loans,
banks may charge higher rates of interest as they assign high risk to
them. So, the banks charge a risk premium from their customers. The
Government may decrease the lending rate of Reserve Bank to
encourage borrowing and lending in the economy, and banks may be
able to borrow at a lower rate of interest (“Easy monetary policy”). This
gap in bank’s borrowing rate and lending rate may increase the money in
the hands of the banks. Such increase in reserves may lead to
deceleration in monetary growth.
3. Behavior of the Public

o Public influences bank credit through decisions on the ratio of currency
to the money supply designated as the “currency ratio”.
o “Currency ratio” refers to the money people desire to hold in cash out of
the total money.
o Currency ratio = Cash/Total money. If this ratio increases, the amount
of money going into banks as deposits decreases, which consequently
reduces the amount of credit money that the banks can create.
o So, increase in currency ratio decreases the money multiplier and hence
the supply of money. Currency ratio and Supply of Money are negatively
related.
o Another example of behavior of public affecting the supply is the time
deposit-demand deposit ratio. An increase in time deposit-demand
deposit ratio means greater availability of free reserves with banks and
consequent enlargement of volume of lending by banks and increase in
the credit multiplier, which increases the Supply of Money.
➢ To summarize, money multiplier depends on
o Required reserve ratio (r)
o Excess reserve ratio (e)
o Currency ratio (c)
All the above three are inversely related to m. These three are known as
“Proximate determinants” of money supply as they closely affect the supply
of money.
➢ If behaviors of commercial banks and public remain constant, the money

multiplier will be 1, and the nominal supply in the economy will vary directly
with the supply of the high-powered money issued by the Central bank.
Note: In Credit multiplier, only r and we were considered, while money

multiplier considers currency ratio (c) also.
Money multiplier approach to money supply propounded by Milton

Friedman and Anna Schwartz
The Behaviour of
The Behaviour of The Behaviour of
Commercial
the Central Bank the Public
Banks
H - Stock of high- Reserves

r = Deposits
Currency
c = Deposits
powered money

Whether money multiplier can be ‘0’?
• Money multiplier can be zero,

• when the banks prefer to hold the newly injected reserves as excess reserves
with no risk attached to it and the interest rates are too low.
EFFECT OF GOVERNMENT EXPENDITURE ON MONEY SUPPLY
➢ If Government expenditure increases, it may borrow from RBI to meet the

expenditure (Known as Ways and Means advances – WMA or overdraft – OD).
Such expenditure may be to be paid as salaries to employees or purchase of
goods and services for Government Functions. This would result in increase in
money in the hands of the recipients, who might deposit some portion of it in
the commercial banking system. Commercial banks create credit money
through such deposits and consequently, the supply of Money in the economy
increases.
➢ So, the Government expenditure is directly related with money supply.
CONCLUSION
This Unit covered the following concepts:

1. Rationale of measuring money
2. Sources of money supply
3. Credit multiplier
4. Measurement
5. Monetary aggregates
6. Liquidity aggregates
7. Determinants of money supply
8. Money multiplier
9. Money multiplier approach to money supply
10. Relation between interest rates, cash reserve ratio, excess ratio, currency
ratios etc. with the money multiplier and the supply of money.

Unit III: Monetary Policy
INTRODUCTION
Monetary Policy
Monetary Policy The organisational

Framework structure
Implementation
Strategy Phase Phase
Operating
Procedures
Objective Analytics
Operating and Monetary Policy

Intermediate Targets Instruments
Direct Indirect
Instruments Instruments
1. Repos
2. Open market
1. Cash Reserve operations
Ratio
3. Standing
2. Liquidity facilities
Ratios
4. Market based
3. Others discount window.
2. Meaning of Monetary Policy
➢ Monetary policy is
o a programme of action undertaken by the monetary authorities,
normally the central bank,

o to control and regulate the demand for and supply of money with the
public and the flow of credit
o with a view to achieving predetermined macroeconomic goals.
MONETARY POLICY FRAMEWORK
1. Components of Monetary Policy Framework
➢ The Monetary Policy has three basic components:

o the objectives of monetary policy,
o the analytics of monetary policy which focus on the transmission
mechanisms, and
o the operating procedure.
2. The Objectives of Monetary Policy
➢ Monetary Policies may incorporate multiple objectives, all of which are

equally desirable, such as rapid economic growth, debt management,
moderate long-term interest rates, exchange rate stability and external
balance of payments equilibrium.
➢ Following are the most commonly pursued objectives of Monetary Policy:
o Price Stability: As explained by Fisher, price directly affects the

supply of money. In the pre-Keynesian era, it was the most common
and fundamental objective of a Monetary Policy. Ensuring price
stability reposes public confidence and promotes business activity.
o Full Employment: Keynes explained unemployment to be the cause

for the Great Depression. Government can regulate the Government
expenditure or the interest rates to stimulate economic activity and
create more employment in the economy while increasing the
National Income.
o Economic growth: Economic growth is represented by increase in Real

Output in the Economy. The Government may regulate the supply of
money through Monetary Policy which may indirectly affect the real
output and demand for money.
➢ The need for simultaneous achievement of several objectives brings in the

possibility of conflict among the different monetary policy objectives. For

example, there is often a conflict between the objectives of holding down
both inflation and unemployment; a policy targeted at controlling inflation
is very likely to generate unemployment. The monetary policymakers have
to exercise appropriate trade-offs to balance the conflicting objectives.
3. Analytics of Monetary Policy
➢ Mentioned below are mainly four different mechanisms through which

monetary policy influences the price level and the national income. These
are the channels through which the effects of monetary policy spreads
through the real economy. This is known as the Monetary Transmission
Mechanism:
o the interest rate channel,

o the exchange rate channel,
o the quantum channel (e.g., relating to money supply and credit), and
o the asset price channel i.e. via equity and real estate prices.
➢ Interest Rate channel: According to the traditional Keynesian interest rate

channel, a contractionary monetary policy‐induced increase in interest rates
increases the cost of capital and the real cost of borrowing for firms with
the result that they cut back on their investment expenditures. Similarly,
households facing higher real borrowing costs, cut back on their purchases
of homes, automobiles, and all types of durable goods. A decline in
aggregate demand results in a fall in aggregate output and employment.
Conversely, an expansionary monetary policy induced decrease in interest
rates will have the opposite effect through decreases in cost of capital for
firms and cost of borrowing for households.
➢ Exchange Rate channel: Interest rates indirectly impact the exchange rates.
Higher interest rates would mean higher return to the foreign investors
investing in the domestic market, and thus foreign investments would
increase, and would result in appreciation of domestic currency due to its
high demand. When the domestic currency appreciates, foreign goods
become cheaper than the domestically produced goods. This may result in
decrease in demand for domestically produced goods.
➢ Bank Lending Channel/ the quantum channel: If the total money in the
economy reduces, lesser money is available for circulation by banks and for
borrowing by firms for further investment expenditure. This would result in
reducing output and consequently reducing employment. Similar is the
effect if there is an increase in the required reserve ratio by the Government
through the Policy. This is an example of how the effect of the monetary
policy spreads to the real economy through the Bank Lending Channel.

➢ Asset Price channel: When interest rates increase the demand for debt
instruments paying interests also increases, and the demand for equity
instruments (which are riskier and pay return, which is not fixed) reduces.
This results in decrease in the prices of equity instruments. As the value of
equity reduces, the entrepreneurs owning equity would reduce consumption
in their firms, which would result in reduction of output and ad increase in
unemployment. This is also known as the Balance Sheet Channel.
4. Operating Procedures and Instruments
➢ The day-to-day implementation of monetary policy by central banks through

various instruments is referred to as ‘operating procedures. The operating
framework relates to all aspects of implementation of monetary policy. It
primarily involves three major aspects, namely,
o Choosing the operating target – The operating target refers to the

variable (for e.g. inflation) that monetary policy can influence with
its actions.
o Choosing the intermediate target – The intermediate target (e.g.

economic stability) is a variable which the central bank can hope to
influence to a reasonable degree through the operating target.
o Choosing the policy instruments – The monetary policy instruments

are the various tools that a central bank can use to influence money
market and credit conditions and pursue its monetary policy
objectives
5. Monetary Policy Instruments

➢ Consist of two types of instruments:
o Direct Instruments – There exists direct relationship between the
instrument and the Objective.
o Indirect Instruments – These instruments act through the market to
affect demand.
➢ Direct Instruments
o Cash Reserve Ratio – Cash Reserve Ratio (CRR) refers to the fraction
of the total net demand and time liabilities (NDTL) of a scheduled
commercial bank in India, which it should maintain as cash deposit
with the Reserve Bank.
The Reserve Bank does not pay any interest on the CRR balances.
However, failure of a bank to meet its required reserve requirements

would attract penalty in the form of penal interest charged by the
RBI.
If there is economic slowdown, the RBI may reduce the CRR, which
increases the balances of money with the bank, which may be further
lent to firms to increase production.
o Statutory Liquidity Ratio – The Statutory Liquidity Ratio (SLR) is a

prudential measure. As per the Banking Regulations Act 1949, all
scheduled commercial banks in India are required to maintain a
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:
• Treasury-bills of the Government of India.
• Dated securities including those issued by the
Government of India from time to time under the market
borrowings programme and the Market Stabilization
Scheme (MSS).
• State Development Loans (SDLs) issued by State
Governments under their market borrowings
programme.
• Other instruments as notified by the RBI. These include
mainly the securities issued by PSEs.
While CRR has to be maintained by banks as cash with the RBI, the
SLR requires holding of assets in one of the above three categories
by the bank itself. The banks, which fail to meet its SLR obligations,
are liable to be imposed penalty.
Changes in the SLR chiefly influence the availability of resources in

the banking system for lending. A rise in the SLR which is resorted to
during periods of high liquidity, tends to lock up a rising fraction of
a bank’s assets in the form of eligible instruments, and this reduces
the credit creation capacity of banks. A reduction in the SLR during
periods of economic downturn has the opposite effect.
o Others:
▪ Directed credit which takes the form of prescribed targets for
allocation of credit to preferred sectors (for e.g. Credit to
priority sectors)
▪ Administered interest rates wherein the deposit and lending
rates are prescribed by the central bank.

➢ Indirect Instruments
o Liquidity Adjustment Facility – A central bank is a ‘bankers’ bank.’

It provides liquidity to banks when the latter face shortage of
liquidity. This facility is provided by the Central Bank through its
discount window. The scheduled commercial banks can borrow from
the discount window against the collateral of securities like
commercial bills, government securities, treasury bills etc.
This type of support earlier took the form of refinance of loans given
by commercial banks to various sectors. By varying the terms and
conditions of refinance, the RBI could encourage /discourage lending
to particular sectors.
The Liquidity Adjustment Facility (LAF) is a facility extended by the

Reserve Bank of India to the scheduled commercial banks (excluding
RRBs) and primary dealers to avail of liquidity in case of requirement
(or park excess funds with the RBI in case of excess liquidity).
Currently, the RBI provides financial accommodation to the

commercial banks through repos/reverse repos under the Liquidity
Adjustment Facility (LAF)
▪ Repos –
Repo is a money market instrument, which enables collateralized

short term borrowing and lending through sale/purchase operations
in debt instruments. The Repo transaction in India has two elements:
in the first, the seller sells securities and receives cash while the
purchaser buys securities and parts with cash. In the second, the
original holder repurchases the securities. The user pays to the
counter party the amount originally received, plus the return on the

money for the number of days for which the money was used, which
is mutually agreed. The rate charged by RBI for this transaction is
called the ‘repo rate’. Repo operations thus inject liquidity into the
system.
▪ Reverse Repos –
Reverse repo operation takes place when RBI borrows money

from banks by giving them securities. The securities transacted
here can be either government securities or corporate
securities or any other securities which the RBI permits for
transaction. 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:
• Repo on sovereign securities
• Repo on corporate debt securities, and
• Other Repos
▪ A change in the policy rate (repo rate) gets transmitted through

the money market to the entire the financial system and alters
all other short-term interest rates in the economy, thereby
influencing aggregate demand – a key determinant of the level
of inflation and economic growth.
▪ If the RBI wants to make it more expensive for banks to borrow

money, it increases the repo rate. Similarly, if it wants to make
it cheaper for banks to borrow money, it reduces the repo rate.
In other words, an increase in the repo rate will lead to

liquidity tightening and vice-versa, other things remaining
constant.
▪ The repo rate and the reverse repo rate are changed only
through the announcements made during the Monetary Policy
Statements of the RBI. In addition to the existing overnight LAF
(repo and reverse repo) and MSF, from October 2013, the
Reserve Bank has introduced ‘Term Repo’ (repos of duration
more than a day) under the Liquidity Adjustment Facility (LAF)
for 14 days and 7 days tenors.
o Marginal Standing Facility (MSF) – 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
( a fixed per cent of their net demand and time liabilities deposits
(NDTL) liable to change every year ) at a penal rate of interest. The
MSF rate being a penal rate automatically gets adjusted to a fixed per
cent above the repo rate.
o Market Stabilization Scheme – was introduced in 2004 following a

MoU between the Reserve Bank of India (RBI) and the Government of
India (GoI) with the primary aim of aiding the sterilization operations
of the RBI. (Sterilization is the process by which the monetary
authority sterilizes the effects of significant foreign capital inflows on
domestic liquidity by off-loading parts of the stock of government
securities held by it). Under this scheme, the Government of India
borrows from the RBI (such borrowing being additional to its normal
borrowing requirements) and issues treasury-bills/dated securities for
absorbing excess liquidity from the market arising from large capital
inflows.
▪ Bank Rate – Bank Rate refers to the standard rate at which the
Reserve Bank is prepared to buy or re-discount bills of
exchange or other commercial paper.
Discounting/rediscounting of bills of exchange by the Reserve
Bank has been discontinued on introduction of Liquidity
Adjustment Facility (LAF). As a result, the bank rate has
become dormant as an instrument of monetary management.
The bank rate has been aligned to the Marginal Standing
Facility (MSF) rate and, therefore, as and when the MSF rate
changes alongside policy repo rate changes, the bank rate also
changes automatically.
o Open Market Operations – Open Market Operations (OMO) is a general

term used for 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 on a durable basis. When the RBI feels there is excess
liquidity in the market, it resorts to sale of securities thereby sucking
out the rupee liquidity. Similarly, when the liquidity conditions are
tight, the RBI will buy securities from the market, thereby releasing
liquidity into the market.
ORGANISATIONAL STRUCTURE
➢ The Expert Committee under Urijit Patel to revise the monetary policy
framework, in its report in January 2014 suggested that RBI abandon the
‘multiple indicator’ approach and make inflation targeting the primary
objective of its monetary policy.
➢ The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016,
for giving a statutory backing to
o The Monetary Policy Framework Agreement – an agreement reached
between the Government of India and the Reserve Bank of India (RBI)
on the maximum tolerable inflation rate that the RBI should target to
achieve price stability.
o For setting up a Monetary Policy Committee (MPC).
The Monetary Policy Framework Agreement (Monetary Policy in

India)
➢ The inflation target is to be set by the Government of India, in consultation

with the Reserve Bank, once in every five years. Accordingly,
o The Central Government has notified 4 per cent Consumer Price Index
(CPI) inflation as the target for the period from August 5, 2016 to
March 31, 2021 with the upper tolerance limit of 6 per cent and the
lower tolerance limit of 2 per cent.
o The RBI is mandated to publish a Monetary Policy Report every six
months, explaining the sources of inflation and the forecasts of
inflation for the coming period of six to eighteen months.
➢ CPI is the index of general price levels in the economy, year on year. An
increase in the CPI would direct towards inflation in the economy.
𝑪𝑷𝑰 𝑵𝒖𝒎𝒃𝒆𝒓 = (𝑵𝒆𝒘 𝑷𝒓𝒊𝒄𝒆 𝑳𝒆𝒗𝒆𝒍)/(𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆 𝑳𝒆𝒗𝒆𝒍_CPI Number = New

Price level / Old Price level

The Monetary Policy Committee (MPC)
1.5.1. Whom does it comprise?
➢ Reserve Bank of India Governor (Chairman)

➢ Reserve Bank of India Deputy Governor
➢ Official nominated by RBI
➢ 3 Central Government Representatives
1.5.2. Why is it formed?
➢ To formulate Monetary Policy

➢ Decide Policy Rate
➢ Target Inflation
The new system is intended to incorporate:

• Diversity of views,
• Specialized experience,
• Independence of opinion,
• Representativeness, and
• Accountability.
1.5.3. Functioning of MPC
The MPC functions with the assistance of the following departments:
➢ Monetary Policy Department (MPD) assists the MPC in formulating the

monetary policy. The views of key stakeholders in the economy and
analytical work of the Reserve Bank contribute to the process for arriving at
the decision on the policy repo rate.
➢ The Financial Markets Operations Department (FMOD) operationalizes the

monetary policy, mainly through day-to-day liquidity management
operations.

Question :
What will be the nature of the monetary policy undertaken by RBI in the
following?
Answer:
Situation Nature of Monetary Policy

a) Increases repo rate by 50 basis
Contractionary monetary policy
points -
b) Reduces the cash reserve ratio Expansionary monetary policy
c) Increases the supply of currency
Expansionary monetary policy
and coins
d) Terminates marginal standing
facility
e) Increases the interest rates
chargeable by commercial banks
f) Sells securities in the open
market
Absorbs the liquidity in the
g) Initiates reverse repo operation
system
Influence the availability of
h) Changes in the SLR resources in the banking system
for lending

Chapter – 4: International Trade
Unit I: Theories of International Trade
INTRODUCTION
Theories of
International Trade
Arguments in Arguments Important

favor against Theories
1. Mercantilist's view of
International
2. Theory of Absolute
Advantage
3. The Theory of
Comparative Advantage
4. Heckscher-Ohlin Theory
of Trade
5. New Trade Theory
➢ International trade is the exchange of goods and services as well as resources

between countries.
➢ It involves transactions between residents of different countries.
➢ As distinguished from domestic trade or internal trade, which involves exchange
of goods and services within the domestic territory of a country using domestic
currency, international trade involves transactions in multiple currencies.
➢ Compared to internal trade, international trade has greater complexity as it
involves 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 IN SUPPORT OF INTERNATIONAL TRADE
➢ Competition from foreign goods compels manufacturers, especially in

developing countries, to enhance efficiency and profitability by adoption of cost
reducing technology and business practices. Efficient deployment of productive
resources to their best uses is a direct economic advantage of foreign trade.
➢ Trade provides access to new markets and new materials and enables sourcing
of inputs and components internationally at competitive prices. International
trade enables consumers to have access to wider variety of goods and services
that would not otherwise be available.
➢ Exports stimulate economic growth by creating jobs, which could potentially

reduce poverty and augmenting factor incomes and in so doing raising standards
of livelihood and overall demand for goods and services.
➢ Countries can gainfully dispose of their surplus output and, thus, prevent undue
fall in domestic prices caused by overproduction. Trade also allows nations to
maintain stability in prices and supply of goods during periods of natural
calamities like famine, flood, epidemic etc.
ARGUMENTS AGAINST TRADE OPENNESS

➢ Possible negative labour market outcomes in terms of labour-saving
technological change that depress demand for unskilled workers, loss of
labourers’ bargaining power, downward pressure on wages of semi-skilled and
unskilled workers and forced work under unfair circumstances and unhealthy
occupational environments.
➢ International trade is often not equally beneficial to all nations. Economic

exploitation is a likely outcome when underprivileged countries become
vulnerable to the growing political power of corporations operating globally.
Financially stronger transnational companies can easily outperform the
domestic entities.
➢ International trade is often criticized for its excessive stress on exports and
profit-driven exhaustion of natural resources due to unsustainable production
and consumption. Substantial environmental damage and exhaustion of natural

resources in a shorter span of time could have serious negative consequences
on the society.
➢ Risky dependence of underdeveloped countries on foreign nations impairs

economic autonomy and endangers their political sovereignty.
IMPORTANT THEORIES OF INTERNATIONAL TRADE
1. Mercantilist’s View of International Trade
➢ This view was propagated in Europe in the 1500s and was based on the premise
that national wealth and power are best served by increasing exports and
collecting precious metals in return.
➢ Mercantilists also believed that the more gold and silver a country accumulates,
the richer it becomes. Mercantilism advocated maximizing exports in order to
bring in more “specie” (precious metals) and minimizing imports through the
state imposing very high tariffs on foreign goods.
➢ This view argues that trade is a ‘zero-sum game’, with winners who win does so
only at the expense of losers and one country’s gain is equal to another country’s
loss, so that the net change in wealth or benefits among the participants is zero.
2. The Theory of Absolute Advantage
➢ Adam Smith was the first to put across the possibility that international trade is
not a zero-sum game.
➢ The absolute cost advantage theory points out that a country will specialize in
the production and export of a commodity in which it has an absolute cost
advantage. Each nation can produce one good with less expenditure of human
labour or more cheaply than the other. As a result, each nation has an absolute
advantage in the production of one good.
➢ The absolute advantage can be explained with the following example:

Example 1:
Commodity Country A Country B
Wheat (Units/Hour) 6 1
Cloth (Units/Hour) 4 5
➢ One hour of labour time produces 6 units and 1 unit of wheat respectively in
country A and country B. On the other hand, one hour of labour time produces
4 units of cloth in country A and 5 in country B. Country A is more efficient than
country B, or has an absolute advantage over country B in production of wheat.
Similarly, country B is more efficient than country A, or has an absolute
advantage over country A in the production of cloth.
➢ If country A exchanges six units of wheat (6W) for six units of country B’s cloth
(6C), then country A gains 2C or saves half an hour or 30 minutes of labour time
(since the country A can only exchange 6W for 4C domestically). Similarly, the
6W that country B receives from country A is equivalent to, or would require six
hours of labour time to produce in country B.
➢ Country B gains 24C, or saves nearly five hours of work.
➢ This example shows trade is advantageous, although gains may not be

distributed equally.
➢ By specializing and trading freely, global output is maximized and more of both
goods are available to the consumers in both the countries. If they specialise
but do not trade freely, country A’s consumers would have no cotton, and
country B’s consumers would have no wheat. That is not desirable situation .
3. The Theory of Comparative Advantage
➢ Ricardo attempted to answer the question of what happens when a country has
higher productivity in both commodities, compared to another country. He
formalized the concept of ‘comparative advantage’ to espouse the argument
that even when one country is technologically superior in both goods, it could
still be advantageous for them to trade.
➢ The theory of comparative advantage can be explained with the following

example:

Example 2:
Commodity Country A Country B
Wheat (Units/Hour) 6 1
Cloth (Units/Hour) 4 2
➢ Country B has now absolute disadvantage in the production of both wheat and
cloth. However, since B’s labour is only half as productive in cloth but six times
less productive in wheat compared to country A, country B has a comparative
advantage in cloth. On the other hand, country A has an absolute advantage in both
wheat and cloth with respect to the country B, but since its absolute advantage is
greater in wheat (6:1) than in cloth (4:2), country A has a comparative advantage
in production and exporting wheat.
➢ Country B’s absolute disadvantage is smaller in cloth, so its comparative advantage

lies in cloth production.
➢ Assume that country A could exchange 6W for 6C with country B. Then, country A
would gain 2C (or save half an hour of labour time) since the country A could only
exchange 6W for 4C domestically. We can observe from the table above that the
6W that the country B receives from the country A would require six hours of labour
time to produce in country B. With trade, country B can instead use these six hours
to produce 12C and give up only 6C for 6W from the country A. Thus, the country
B would gain 6C or save three hours of labour time and country A would gain 2C.
➢ Country A would gain if it could exchange 6W for more than 4C from country B;
because 6W for 4 C is what it can exchange domestically. The more C it gets, the
greater would be the gain from trade. Conversely, in country B, 6W = 12C. Anything
less than 12C that country B must give up to obtain 6W from country A represents
a gain from trade for country B.
➢ Thus, the range for mutually advantageous trade is 4C to 12C. The spread between
12C and 4C (i.e., 8C) represents the total gains from trade available to be shared
by the two nations.
➢ Ricardo based his law of comparative advantage on the ‘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. This is quite unrealistic because
labour is not the only factor of production.
➢ In 1936, Haberler resolved this issue when he 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.
Example 3:
Compute the opportunity cost for country A for producing Wheat.
In continuation of Example 2 above,

For Country A:
1 W takes 1/6 Hours

1C takes ¼ Hours
Opportunity cost of W is the amount of C to be given up, to produce 1 unit of
W.
¼ hours produce 1 C. 1/6 Hours would produce 2/3 C ---> [6/4]
Therefore, 2/3 C would have to be given up [1/6 hours of production] for

producing 1 unit of W.
➢ According to the opportunity cost theory, the cost of a commodity is the amount
of a second commodity that must be given up, to release just enough resources
to produce one extra unit of the first commodity. The opportunity cost of
producing one unit of good X in terms of good Y may be computed as the amount
of labour required to produce one unit of good X divided by the amount of labour
required to produce one unit of good Y.
Opportunity Cost of Producing X
= Labour required for 1 Unit of X/ Labour required for 1 Unit of Y
➢ The opportunity cost of wheat (in terms of the amount of cloth that must be
given up) is lower in country A than in country B, and country A would have a
comparative (cost) advantage over country B in wheat.
➢ In summary, international differences in relative factor-productivity are the

cause of comparative advantage and a country exports goods that it produces
relatively efficiently.
4. The Heckscher-Ohlin Theory of Trade

➢ The Heckscher-Ohlin theory of trade, (named after two Swedish economists, Eli
Heckscher and his student Bertil Ohlin) is also referred to as Factor-Endowment
Theory of Trade or Modern Theory of Trade.
➢ ‘Factor endowment’ refers to the overall availability of usable resources

including both natural and man-made means of production. Nevertheless, in the
exposition of the modern theory, only the two most important factors—labour
and capital— are taken into account.
➢ This theory attempts to answer the question of why some countries have
comparative advantage in the production of one commodity, and the answer is
explained to lie in Factor Endowment.
Example 4:
Understanding Factor endowment:
Industry 1 - Agriculture Industry 2 - Aircraft Manufacturing
Labour Capital Labour Capital
While industry 1 is labor intensive, Industry 2 is Capital intensive. Further, the

price of labor in Industry 1 would be lesser as compared to Industry 2. Hence,
if Units belonging to Industry 1 are set up in countries with abundant
population, such countries will have comparative advantage in production of
goods in Industry 1.
➢ Different goods have different production functions, that is, factors of

production are combined in different proportions to produce different
commodities. While some goods are produced by employing a relatively larger
proportion of labour and relatively small proportion of capital, other goods are
produced by employing a relatively small proportion of labour and relatively
large proportion of capital. Thus, each region is suitable for the production of
those goods for whose production it has relatively plentiful supply of the
requisite factors.

➢ Difference in factor endowments is the main cause of international trade as well
as inter-regional trade. According to Ohlin, 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 and this is the case of international trade as well.
➢ If a country is a capital abundant one, it will produce and export capital-

intensive goods relatively more cheaply than another country.
➢ The Heckscher-Ohlin theory of foreign trade can be stated in the form of two
theorems:
o Heckscher-Ohlin Trade Theorem – establishes that a country tends to

specialize in the export of a commodity whose production requires
intensive use of its abundant resources and imports a commodity whose
production requires intensive use of its scarce resources.
o Factor-Price Equalization Theorem – Countries abundant in labor produce
those goods, which are in a labor-intensive technology minimizing their
cost of production. Goods produced at such lower costs are exported to
non-labor-intensive countries, thereby reducing their costs to consume
such goods. The Factor-Price Equalization Theorem states that
international trade tends to equalize the factor prices between the
trading nations.
➢ The following table provides a comparison between the Comparative Cost

theory and the Modern theory:
Theory of Comparative Costs Modern Theory

Explains the causes of differences in
Explains that difference between comparative costs as differences in
countries is due to comparative costs factor endowments
Based on Labor theory of Value Based on money cost
Attributes the differences in Attributes the differences in
comparative advantage to differences comparative advantage to the
in productive efficiency of workers differences in factor endowments.
Widened the scope to include labour
Considered labour as the sole factor of and capital as important factors of
production production
Normative; tries to demonstrate the Positive; concentrates on the basis of
gains from international trade trade
5. New Trade Theory

➢ New Trade Theory (NTT) is an economic theory that was developed in the 1970s
as a way to understand international trade patterns. NTT came about to help us
understand why developed and big countries trade partners are when they are
trading similar goods and services. These countries constitute more than 50% of
world trade.
➢ According to New Trade Theory, two key concepts give advantages to countries
that import goods to compete with products from the home country:
o Economies of Scale: As a firm produces more of a product its cost per unit
keeps going down. So, if the firm serves domestic as well as foreign market
instead of just one, it can reap the benefit of large scale of production
consequently the profits are likely to be higher.
o The value of the product or service is enhanced as the number of
individuals using it increases. This is also referred to as the ‘bandwagon
effect’.
➢ Those countries with the advantages will dominate the market, and the market
takes the form of monopolistic competition. Monopolistic competition tells us
that the firms are producing a similar product that isn't exactly the same, but
awfully close.
Question:
Given the number of labor hours to produce one unit of cloth and grain in
two countries, which country should produce grain?
Products Country A Country B
Cloth 40 80
Grain 80 40
Answer:
For Country A:
Opportunity cost of 1 Unit of Grain = 80/40 = 2 Units of Cloth
For Country B:
Opportunity cost of 1 Unit of Grain = 40/80 = 0.5 Units of Cloth
Hence, country B has lesser opportunity cost for production of Grain and
should produce Grain.

Question:
Given the number of labor hours to produce one unit of wheat and rice in
two countries, exchange happens at 1:1, what will be the gain of country
X?
Country Wheat Rice
Country X 10 20
Country Y 20 10
Answer:
For Country X
Opportunity cost of wheat = 10/20 = 0.5 units of rice.
For Country Y
Opportunity cost of wheat = 20/10 = 2 units of rice.
Since the opportunity cost of wheat is lesser for Country X, X should produce
wheat and Y should produce Rice.
X to produce 1 unit of wheat and exchange for 1 unit of rice (Exchange ratio is
given as 1:1). X would have taken 20 hours to produce 1 unit of rice, but due
to the exchange, X spends only 10 hours (to produce wheat) to get 1 unit of
rice. Hence the gain for X is 10 hours.

Unit II: The Instruments of Trade Policy
INTRODUCTION
Instruments of
Trade Policy
Export-
Non Tariff
Tariffs Related
Measures
Measures
➢ Trade policy encompasses all instruments that governments may use to promote
or restrict imports and exports. Trade policy also includes the approach taken
by countries in trade negotiations.
➢ The challenges involved in International Trade make it obvious that

governments do not conform to free trade despite the potential efficiency and
welfare outcomes it will promote; rather, they employ different devices for
restricting the free flow of goods and services across their borders.
➢ The instruments of trade policy that countries typically use to restrict imports
and/ or to encourage exports can be broadly classified into price- related
measures such as tariffs and non-price measures or non-tariff measures (NTMs),
and Export related measures.
TARIFFS
➢ Tariffs, also known as customs duties, are basically taxes or duties imposed on
goods and services which are imported or exported. It is defined as a financial
charge in the form of a tax, imposed at the border on goods going from one
customs territory to another.
➢ Tariffs are aimed at altering the relative prices of goods and services imported,
so as to contract the domestic demand and thus regulate the volume of their
imports. Tariffs leave the world market price of the goods unaffected; while
raising their prices in the domestic market.

➢ It is obvious that tariffs on imports are more widespread. This is based in the
Mercantilist’s view of international trade, which generally encourages exports
and discourages imports. Import duties being pervasive than export duties,
tariffs are often identified with import duties and in this unit, the term ‘tariff’
would refer to import duties.
1. Broad Forms of Import Tariffs
There are two broad forms of import tariffs:
➢ Specific Tariffs: A specific tariff is an import duty that assigns a fixed monetary
tax per physical unit of the good imported. It is calculated on the basis of a unit
of measure, such as weight, volume, etc., of the imported good. Thus, a specific
tariff of INR 1000 may be charged on each imported bicycle.
The disadvantage of specific tariff as an instrument for protection of domestic

producers is that its protective value varies inversely with the price of the
import. For example: if the price of the imported cycle is INR 5,000, then the
rate of tariff is 20%; if due to inflation, the price of bicycle rises to INR 10,000,
the specific tariff is only 10% of the value of the import.
➢ Ad Valorem Tariffs: An ad valorem tariff is levied as a constant percentage of

the monetary value of one unit of the imported good. A 20% ad valorem tariff
on any bicycle generates an INR 1000 payment on each imported bicycle priced
at INR 5,000 in the world market; and if the price rises to INR 10,000, it
generates a payment of INR 2,000.
2. Other variations in tariffs
➢ Mixed Tariffs: Mixed tariffs are expressed either on the basis of the value of
the imported goods (an ad valorem rate) or on the basis of a unit of measure of
the imported goods (a specific duty) depending on which generates the most
income. For example, duty on cotton: 5% ad valorem 0r INR 3000 per ton,
whichever is higher.
➢ Compound Tariff or a Compound Duty: is a combination of an ad valorem and

a specific tariff. For example: duty on cheese at 5% ad valorem plus 100 per
kilogram.
➢ Technical/Other Tariff: the duties are payable by its components or related

items. For example: INR 3000 on each solar panel plus INR 50 per kg on the
battery.

➢ Tariff Rate Quotas: It is a combination of two policy instruments, Quota and
Tariffs. Quota refers to reserving a portion, which can be imported at a lower
rate of tariff or zero tariff. If imports are made until the prescribed quantity, it
is known as “In Quota”. The imports made beyond the prescribed quantity is
known as “Out Quota”.
➢ Most-Favored Nation Tariffs: MFN tariffs are what countries promise to impose
on imports from other members of the WTO.
➢ Variable Tariff: A duty typically fixed to bring the price of an imported

commodity up to the domestic support price for the commodity.
➢ Preferential Tariff: Nearly all countries are part of at least one preferential
trade agreement, under which they promise to give another country's products
lower tariffs than their MFN rate. These agreements are reciprocal. A lower
tariff is charged from goods imported from a country, which is given preferential
treatment.
- Examples are preferential duties in the EU region under which a good coming
into one EU country to another is charged zero tariffs.
- Another example is North American Free Trade Agreement (NAFTA) among
Canada, Mexico and the USA where the preferential tariff rate is zero on
essentially all products.
Countries, especially the affluent ones also grant ‘unilateral preferential
treatment’ to select list of products from specified developing countries. The
Generalized System of Preferences (GSP) is one such system which is currently
prevailing wherein different products from different countries are given
preferential duty-free entry.
➢ Bound Tariff: A bound tariff is a tariff which a WTO member binds itself with a
legal commitment not to raise it above a certain level. By binding a tariff, often
during negotiations, the members agree to limit their right to set tariff levels
beyond a certain level.
The bound rates are specific to individual products and represent the maximum
level of import duty that can be levied on a product imported by that member.
A member is always free to impose a tariff that is lower than the bound level.
Once bound, a tariff rate becomes permanent and a member can only increase
its level after negotiating with its trading partners and compensating them for
possible losses of trade.

➢ Applied Tariffs: An 'applied tariff' is the duty that is actually charged on imports
on a most-favoured nation (MFN) basis. A WTO member can have an applied
tariff for a product that differs from the bound tariff for that product as long as
the applied level is not higher than the bound level.
➢ Escalated Tariff: the system wherein the nominal tariff rates on imports of
manufactured goods are higher than the nominal tariff rates on intermediate
inputs and raw materials. For example, a 4% tariff on iron ore and 12% tariff on
steel pipes. This type of tariff is discriminatory as it protects manufacturing
industries in importing countries and dampens the attempts of developing
manufacturing industries of exporting countries. Developing countries are thus
forced to continue to be suppliers of raw materials without much value addition.
➢ Prohibitive tariff: A prohibitive tariff is one that is set so high that no imports
will enter. Example: 1000% import duty.
➢ Import subsidies: In some countries, import subsidies also exist. An import

subsidy is simply a payment per unit or as a percent of value for the importation
of a good.
➢ Tariffs as Response: Sometimes countries engage in 'unfair' foreign-trade

practices which are trade distorting in nature and adverse to the interests of
the domestic firms. The affected importing countries, upon confirmation of the
distortion, respond quickly by measures in the form of tariff responses to offset
the distortion. These policies are often referred to as "trigger-price"
mechanisms.
➢ Anti-dumping Duties: Dumping occurs when manufacturers sell goods in a

foreign country below the sales prices in their domestic market or below their
full average cost of the product. Dumping is an international price
discrimination, favoring buyers of exports, but in fact, the exporters
deliberately forego money in order to harm the domestic producers of the
importing country.
Anti-dumping measures, which are tariffs to offset the effects of dumping may
be initiated as a safeguard instrument by imposition of additional import duties
so as to offset the foreign firm's unfair price advantage. This is justified only if
the domestic industry is seriously injured by import competition, and protection
is in the national interest.
For example: In January 2017, India imposed anti- dumping duties on colour-
coated or pre-painted flat steel products imported into the country from China

and European nations for a period not exceeding six months and for jute and
jute products from Bangladesh and Nepal.
➢ Countervailing Duties: Countervailing duties are tariffs that aim to offset the
artificially low prices charged by exporters who enjoy export subsidies and tax
concessions offered by the governments in their home country. Government
subsidy allows the foreign firm to be an exporter of the product and the subsidy
generates a distortion from the free-trade allocation of resources. In such cases,
CVD is charged in an importing country to negate the advantage that exporters
get from subsidies to ensure fair and market-oriented pricing of imported
products and thereby protecting domestic industries and firms.
3. Effects of Tariffs
➢ Tariff barriers create obstacles to trade. The prospect of market access of the
exporting country is worsened when an importing country imposes a tariff.
➢ By making imported goods more expensive, tariffs discourage domestic

consumers from consuming imported foreign goods. Domestic consumers now
pay a higher price for the good and also because compared to free trade
quantity, they now consume lesser quantity of the good.
➢ Tariffs encourage consumption and production of the domestically produced

import substitutes and thus protect domestic industries.
➢ Tariffs create trade distortions by disregarding comparative advantage and

prevent countries from enjoying gains from trade arising from comparative
advantage. Thus, tariffs discourage efficient production in the rest of the world
and encourage inefficient production in the home country.
NON-TARIFF MEASURES (NTMs)
➢ Tariffs constitute the visible barriers to trade and have the effect of increasing
the prices of imported merchandise. By contrast, the non- tariff measures
constitute the hidden or 'invisible' measures that interfere with free trade.
➢ Non-tariff measures (NTMs) are policy measures, other than ordinary customs
tariffs, that can potentially have an economic effect on international trade in
goods, changing quantities traded, or prices or both.
➢ Non-tariff measures may be categorized as

o Technical Measures – These measures are intended for ensuring
product quality, food safety, environmental protection, national
security and protection of animal and plant health.
o Non-technical Measures – These include different types of trade
protective measures, which are put into operation to neutralize the
possible adverse effects of imports in the market of the importing
country.
1. Technical Measures
➢ Sanitary and Phytosanitary (SPS) Measures: SPS measures are applied to

protect human, animal or plant life from risks arising from additives, pests,
contaminants, toxins or disease-causing organisms and to protect biodiversity.
For example, prohibition of import of poultry from countries affected by avian
flu, meat and poultry processing standards to reduce pathogens, residue limits
for pesticides in foods etc.
➢ Technical Barriers to Trade (TBT): cover both food and non-food traded
products refer to mandatory ‘Standards and Technical Regulations’ that define
the specific characteristics such as its size, shape, design, labelling / marking /
packaging, functionality or performance and production methods.
The specific procedures used to check whether a product is really conforming

to these requirements (conformity assessment procedures e.g. testing,
inspection and certification) are also covered in TBT. These can also be used
effectively as obstacles to imports or to discriminate against imports and
protect domestic products.
Altering products and production processes to comply with the diverse

requirements in export markets may be either impossible for the exporting
country or would obviously raise costs hurting the competitiveness of the
exporting country. Some examples of TBT are food laws, quality standards,
industrial standards, organic certification, eco-labeling, marketing and label
requirements.
2. Non-technical Measures
➢ Import Quotas:
o An import quota is a direct restriction which specifies that only a
certain physical amount of the good will be allowed into the country
during a given time period.
o Import quotas are typically set below the free trade level of imports
and are usually enforced by issuing licenses. This is referred to as a

binding quota; a non-binding quota is a quota that is set at or above
the free trade level of imports, thus having little effect on trade.
o Import quotas are mainly of two types: absolute quotas and tariff-rate
quotas. Absolute quotas or quotas of a permanent nature limit the
quantity of imports to a specified level during a specified period of
time. For example: 1000 tonnes of fish import of which can take place
any time of the year from any country. Example: A quota of 1000
tonnes of fish that can be imported any time of the year, but where
750 tonnes must originate in country A and 250 tonnes in country B.
o If a quota is set below free trade level, the amount of imports will be
reduced. A reduction in imports will lower the supply of the good in
the domestic market and raise the domestic price. Consumers of the
product in the importing country will be worse-off because the
increase in the domestic price of both imported goods and the
domestic substitutes reduces consumer surplus in the market. The
price increase also induces an increase in output of existing firms (and
perhaps the addition of new firms), an increase in employment, and
an increase in profit.
o The license holders are able to buy imports and resell them at a higher
price in the domestic market and they will be able to earn a ‘rent’ on
their operations over and above the profit they would have made in a
free market.
➢ Price Control Measures: These are also known as 'para-tariff' measures and
include measures, other than tariff measures, that increase the cost of
imports in a similar manner, i.e. by a fixed percentage or by a fixed amount.
Example: A minimum import price established for Sulphur.
➢ Non-automatic Licensing and Prohibitions: These measures are normally

aimed at limiting the quantity of goods that can be imported. These
measures may take the form of non-automatic licensing, or through
complete prohibitions. For example, textiles may be allowed only on a
discretionary license by the importing country. India prohibits import/export
of arms and related material from/to Iraq.
➢ Financial Measures: It includes measures such as advance payment

requirements and foreign exchange controls denying the use of foreign
exchange for certain types of imports or for goods imported from certain
countries. For example, an importer may be required to pay a certain
percentage of the value of goods imported three months before the arrival
of goods or foreign exchange may not be permitted for import of newsprint.

➢ Measures affecting competition: aimed at granting exclusive or special
preferences or privileges to one or a few limited groups of economic
operators. For example, a statutory marketing board may be granted
exclusive rights to import wheat: or a canalizing agency (like State Trading
Corporation) may be given monopoly right to distribute palm oil.
➢ Government Procurement Policies: involve mandates that the whole of a

specified percentage of government purchases should be from domestic
firms. In accepting public tenders, a government may give preference to the
local tenders rather than foreign tenders.
➢ Trade-Related Investment Measures:

o minimum levels of locally made components
o restricting the level of imported components
o Limiting the purchase or use of imported products to an amount
related to the quantity or value of local products that it exports. (A
firm may import only up to 75 % of its export earnings of the previous
year)
➢ Distribution Restriction: limitations imposed on the distribution of goods in

the importing country involving additional license or certification
requirements. For example, a restriction that imported fruits may be sold
only through outlets having refrigeration facilities.
➢ Restriction on Post-sales Services: Such services may be reserved to local

service companies of the importing country.
➢ Administrative Procedures: costly and time-consuming administrative

procedures, which are mandatory for import of foreign goods, increase
transaction costs and discourage imports.
➢ Rules of Origin: Important procedural obstacles occur in the home countries

for making available certifications regarding origin of goods, especially when
different components of the product originate in different countries.
➢ Safeguard Measures: are initiated by countries to restrict imports of a

product temporarily if its domestic industry is injured or threatened with
serious injury caused by a surge in imports.
➢ Embargos: An embargo is a total ban imposed by government on import or

export of some or all commodities to particular country or regions for a
specified period. This may be done due to political reasons or for other
reasons such as health, religious sentiments.

3. Export-Related Measures
➢ Ban on exports: during periods of shortages, export of agricultural

products such as onion, wheat etc., may be prohibited to make them
available for domestic consumption.
➢ Export taxes: may be either specific or ad valorem. Since an export tax

reduces exports and increases domestic supply, it also reduces domestic
prices and leads to higher domestic consumption.
➢ Export subsidies and Incentives: export subsidies, duty drawback, duty-

free access to imported intermediates etc.
➢ Voluntary Export Restraints: Voluntary Export Restraints (VERs) refer to a

type of informal quota administered by an exporting country voluntarily
restraining the quantity of goods that can be exported out of that country
during a specified period.
Question:
Country D is importing goods X from A, B and C.
(i) Which of the three exporters engage in anticompetitive act in the
international market while pricing its export of good X to country D?
(ii) What would be the effect of such pricing on the domestic producers
of good X. Advise remedy available for country D?
Goods X Country A Country B Country C
Average Cost 30.5 29.4 30.9
Price per Unit for Domestic Sales 31.2 31.1 30.9
Price charged in country 31.9 30.6 30.6
Answer:
(i) Dumping by Country B and Country C. B because it sells at a lower price
than that in domestic market. Country C because it is selling at a price
which is less than the average cost of production.
(ii) Country D may prove damage to domestic industries and charge anti-
dumping duties on goods imported from Country B and Country C so as
to raise the price and make it at par which similar goods produced by
domestic firms.

Question:
(i) What are the implications on trade will be if India pays an export
subsidy of INR 400 on every pair of cotton trousers exported by it to
Germany.
(ii) Suppose Germany charged an equivalent countervailing duty on
every pair of cotton trousers imported from India. Do you think world
welfare will be affected?
Answer:
(i) Unfair and artificially created price advantage to trousers exporters of
India. German trousers industry lose competitiveness and market share
as trousers from India are lower priced- Loss of world welfare. German
industry can ask for protection by introducing countervailing duties.
(ii) An equivalent countervailing duty will push the prices of Indian trousers
and afford protection to domestic trousers industry. World welfare will
be the same as before India introduced export subsidy.
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Unit III: Trade Negotiations
INTRODUCTION
Trade
Negotiations
Regional
World Trade
Trade
GATT Organisatio
Agreeme
n
nts
Major
Guiding
Structure issues
Principles
faced
➢ The Previous Unit elaborated about what the instruments of trade policy are
and how international trade involves many factors that the Government
considers. International Trade is a wide and complex interaction between
different nations because different countries have different goals (some might
desire free trade to ensure efficiency, while some may want to protect domestic
industries and retain autonomy).
➢ This Unit explains how these interactions happen, different kinds of agreements
that countries enter into to promote/restrict imports and exports.
REGIONAL TRADE AGREEMENTS

➢ Unilateral Trade Agreements – The importer country gives benefits to the
exporter countries for some goods, unilateral benefit, without any direct
advantage in return. GSP (Generalized system of preferences) is an example.
➢ Trading Blocs – A block of countries that may agree to have more favorable
tariffs among themselves and may agree to impose common external tariff to
non-members. Examples are EFTA and Arab League.

➢ Free trade area – This is also a trading block, but no tariffs exist for trade
among the members. Members may agree to retain independence in tariffs with
non-members. Example is NAFTA.
➢ Customs Union – A block of countries with no tariffs among members and

common tariffs for non-members.
➢ Common market – Similar to Customs Union, such a block also allows free flow
of other factors of production like Capital, labor etc. Examples are European
Union (EU) and ASEAN (Association of South Eastern Asian Nations)
➢ Economic and Monetary Union – Further extension of common market –

Implement the same currency, same macro-economic policies – EU.
➢ Bilateral agreements – Agreements between two countries, or two blocks. For

example, association of blocks like ASEAN or EU, India with ASEAN, EU with
South Africa.
GATT – GENERAL AGREEMENT ON TARIFFS AND TRADE
1. Introduction to GATT
➢ GATT, an agreement initially made between 23 countries to liberalize trade,

provided rules for trade between those countries from 1948 to 1994.
➢ Member countries had many rounds of negotiations to set up rules of trade,

reduce tariffs on exchange of goods between member countries, and establish
rules for dispute resolution, dumping etc.
➢ However, over the years, GATT lost relevance due to the following reasons –
o It did not have any institutional existence. It was only an agreement, and
the rules it gave were provisional.
o GATT did not have an institutional structure, and dispute resolution was
difficult.
o GATT provided rules only for trade in goods, not in services.
o When trade in goods became complex, most of the world-merchandise
became out of scope and the agreement became obsolete.
o GATT had many ambiguities that could be exploited.

2. Uruguay Round
➢ The Uruguay round of GATT began in 1986 and concluded in 1993. 123 countries
participated in this round of negotiations and various agreements were signed
in 1994, plugging loopholes in GATT.
➢ Agreements entered into in the Uruguay round:

o Establishing the World Trade Organisation (WTO) – To provide an
institutional framework.
o GATT 1994 – GATT continued to exist as an umbrella treaty though as an
institution WTO replaced GATT.
➢ Overview of WTO Agreements which are known as the WTO Rules:
o Agreement on Agriculture – To improve agricultural trade, many different

agreements are made by Governments of different countries for
supporting each other with market access, domestic support and export
subsidies.
o Agreement on application of Sanitary and Phytosanitary measures – The

WTO regulates application of these measures to ensure that countries
don’t take undue advantage of these rules to simply prohibit or restrict
trade in some goods or make unjustifiable discrimination.
o Agreement on technical barriers to trade: To stop countries from

exploiting these measures and stop formation of unnecessary trade
barriers.
o Agreement on application of Rules of Origin – Rules on how to arrive at

the origin of goods, dispute settlement procedures. A Rules of Origin
committee was also created.
o Agreement on Anti-dumping measures – This gives the definition of

dumping, and regulations governing identification of dumping if any
resorted to by countries, rules for calculating dumping margins,
conducting dumping investigations.
o Customs Valuation Agreement: For harmonization of valuation between

different countries to arrive at the amount of value of goods exchanged
on which tariff should be applied (Ad valorem tariff)

o Subsidies and Countervailing Duties (CVD) – Clarify definitions of subsidy
and give procedures for adopting CVD.
o General Agreement in Trade in Services (GATS) – Giving definitions of what

would constitute services and service sector, what kind of restrictions may
be placed, and how there should not be discrimination in trade with
different countries.
o Agreement on Trade related Investment Measures (TRIMS) – Governs

investment measures in relation to cross border investments.
o Agreement on Trade related aspects of Intellectual Property Rights

(TRIPS) – This agreement provides various rules for trade in IPRs like
trademarks, copyrights, patents, MFN status, rules for trade restrictions
etc.
o Rules for settlement of disputes – Rules for prohibiting unilateral

measures, establishing dispute settlement panels, appellate body, setting
time frames for dispute resolution etc.
o Agreement for Government Procurement – Requires National treatment

and non-discriminatory treatment in the area of government procurement
to ensure fair and transparent procurement procedures.
➢ The above agreements are renegotiated from time to time by the member
countries.
➢ The round of discussion that is currently going on in WTO is called the Doha
round. It commenced in November 2001 and has not been concluded yet. Each
round has many rounds of discussions with various focus points and the most
controversial one right now is agricultural trade.
2. WORLD TRADE ORGANISATION

1. Introduction to WTO
➢ WTO is a forum for trade negotiations. It oversees agreements between

countries, and assists developing countries in trade policy issues.
➢ The WTO was set up with the following objectives and functions:
o to set and enforce rules for international trade
o to provide a forum for negotiating and monitoring further trade
liberalization

o to resolve trade disputes
o to increase the transparency of decision-making processes
o to cooperate with other major international economic institutions
involved in global economic management, and
o to help developing countries benefit fully from the global trading system.
2. Structure of WTO
Supports Secretariat of WTO Headed by

WTO Director General
(Geneva)
Level 1 Ministerial Conference
Dispute Settlement
Body
Level 2 General Council
Trade Policy Review
Body
Councils:
1. Goods Council
Level 3 2. Services Council
3. Intellectual
Property Council
➢ The WTO is supported by Secretariat of WTO, situated in Geneva and headed by

the Director General
➢ WTO has three-tier system of decision making
o Level 1 is Ministerial Conference – Takes decisions on all matters under
any of the multilateral trade agreements.
o Level 2 is General Council – Also meets as the Dispute Settlement Body
and Trade Policy Review Body
o Level 3 Councils – Which oversee implementation of WTO agreements
▪ Goods Council
▪ Services Council
▪ Intellectual Property Council
3. Guiding Principles of WTO
The WTO encourages free trade among countries. World trade has evolved over
many years, from trade in only goods, to services and other factors of
production and intellectual property. The WTO encourages countries gradually

liberalizing trade while also suiting their domestic conditions. This is the motto
with which the WTO works, and all other guiding principles mentioned below
are aligned to this motto.
➢ Trade without discrimination: WTO states that any privilege extended to one
member should be extended to all and no discrimination should be done
between member countries in relation to international trade. Few exceptions
are permitted to this principle, like free trade agreements between only few
countries with special privileges, or prohibition of trade from few countries for
political reasons (Embargo) or for health reasons, which the WTO may permit.
➢ The National Treatment Principle: Further to import/export without

discrimination among member countries, this principle further states that no
discrimination should be made of the imported/ exported goods as compared
with the domestically produced goods. Once imported, the goods should be
treated at par with domestic products. No restrictions, marketing, advertising
or geographic, may be placed that do not apply to domestic products.
➢ Predictability: It is imperative for a country’s environment (political and

economic) to be stable, and not be very volatile to encourage business in the
country. So also, in treatment of imports or exports, the more stable the policies
are, easier it is for countries to import and export. Therefore, the WTO
promotes practices like setting bound tariffs, discourages quotas (which
restricts the quantities that can be imported, generally known as the “Principle
of general prohibition of quantitative restrictions”).
➢ Greater competitiveness: To encourage competitiveness, WTO discourages

unfair practices, like dumping and Export subsidies.
➢ Dispute settlement: WTO finds a mechanism for countries to play fairly in

exchange transactions and in case of any disputes, be the authority to resolve
disputes.
➢ Others: WTO works to ensure better market access over the years, give
privileges to developing countries, protection of health and environment
(Technical measures permitted by the Govt.), and make information disclosure
necessary for ensuring transparency.
4. Major Issues faced at WTO

➢ Concluding agreements between countries is a time-consuming process.
Every agreement requires consent from majority of member nations, and that
creates rigidity in the system. Evidently, the first round of WTO took about 7

years to conclude and the Doha round, which began in end of 2001 is still
continuing. For this reason, countries prefer entering into Bilateral agreements
or Regional Trade Agreements.
➢ Trade in many goods is yet to develop including agriculture, textiles, and

apparels.
➢ Dissatisfaction of developing countries due to following reasons –
o Developing countries generally depend on agriculture and there has not

been much expansion of trade in this area. Similar is the case in textiles
and services.
o Generally, the WTO encourages restrictions through tariffs and

discourages non-tariff measures as non-tariff measures affect demand and
the quantity of goods exchanged directly. Also, non-tariff measures are
less apparent and visible, while tariff measures are straighter forward,
visible and do not impact quantity of goods as much.
o However, developed countries generally place prohibitive tariffs, enhance

their export subsidies, also apply non-tariff measures like safeguards
against some goods etc. and the developing countries cannot these
measures. This has distorted the international trade over the years.
o Complexities in the current agreements, which are difficult for the

developing countries to implement.
o Developing countries who export textiles, clothing, fish and fish products
etc. face exceptionally high tariffs.
o In the form of Tariff escalation, higher duties are charged on import of

finished products and lower on raw material by many developed countries.
This increases the gap between developing and developed countries
because it discourages the production facilities set up in developing
countries generating employment and fueling growth.
o North-South Divide has not yet resolved in WTO.
5. 25 years of the WTO acheivements and concerns

The WTO has helped transform international economic relations to a great extent
over the past 25 years of its existence.

Since 1995, the dollar value of world trade has increased nearly four-fold, while the
real volume of world trade has expanded by 2.7 times. This is commendable as it
outstrips the two-fold increase in world GDP over that period. The average tariffs
have almost halved, from 10.5% to 6.4% during this period.
At present, trade within these value chains accounts for almost 70% of total
merchandise trade. The rise of global value chains has been a significant factor in
enabling rapid catch-up growth in developing economies.
Over the past 25 years, there has been the fastest poverty reduction in history: in
1995, over one in three people living around the world fell below the World Bank's
$1.90 threshold for extreme poverty. Today the extreme poverty rate is less than
10%, the lowest ever.
However, in recent years, apprehensions have been raised in respect of the WTO
and its ability to maintain and extend a system of liberal world trade. The major
issues are:
a. The progress of multilateral negotiations on trade liberalization is very slow and
the requirement of consensus among all members acts as a constraint and
creates rigidity in the system. As a result, countries find regionalism as a
plausible alternative. Moreover, contemporary trade barriers are much more
complex and difficult to negotiate in a multilateral forum. Logically, these
issues are much easier if discussed on bilateral or regional level.
b. The complex network of regional agreements introduces uncertainties and
murkiness in the global trade system.
c. While multilateral efforts have effectively reduced tariffs on industrial goods,
the achievement in liberalizing trade in agriculture, textiles, and apparel, and
in many other areas of international commerce has been negligible.
d. The negotiations, such as the Doha Development Round, have run into
problems, and their definitive success is doubtful.
e. Most countries, particularly developing countries are dissatisfied with the WTO
because, in practice, most of the promises of the Uruguay Round agreement to
expand global trade has not materialized.
f. The developing countries have raised a number of concerns and a few are
presented here:
• The developing countries contend that the real expansion of trade in the
three key areas of agriculture, textiles and services has been dismal.
• Protectionism and lack of willingness among developed countries to provide
market access on a multilateral basis has driven many developing countries
to seek regional alternatives.

• The developing countries have raised a number of issues in the Doha Agenda
in respect of the difficulties that they face in implementing the present
agreements.
• The North-South divide apparent in the WTO ministerial meets has fuelled
the apprehension of developing countries about the prospect of trade
expansion under the WTO regime.
• Developing countries complain that they face exceptionally high tariffs on
selected products in many markets and this obstructs their vital exports.
Examples are tariff peaks on textiles, clothing, and fish and fish products.
• Another major issue concerns ‘tariff escalation’ where an importing country
protects its processing or manufacturing industry by setting lower duties on
imports of raw materials and components, and higher duties on finished
products.
• There is also possible erosion of preferences i.e. the special tariff
concessions granted by developed countries on imports from certain
developing countries have become less meaningful because of the
narrowing of differences between the normal and preferential rates.
• The least-developed countries find themselves disproportionately
disadvantaged and vulnerable with regard to adjustments due to lack of
human as well as physical capital, poor infrastructure, inadequate
institutions, political instabilities etc.
• The rising uncertainty about market conditions is causing businesses to
postpone investment, weighing on growth and the future potential of our
economies. Many areas of trade such as e-commerce are still outside the
WTO.
• There are mounting trade tensions as some members do not adhere to the
WTO’s established procedures. The unilateral tariffs threatened by the U.S.
and China are examples. Countries are using the permissible clause of
‘national security’ as a justification for tariffs.
• There is an ongoing stalemate in the appointment of members of the
Appellate Body of WTO’s dispute settlement mechanism. The appellate
body is nearly paralyzed because it does not have the three panellists
required to sign rulings.
Details of India’s disputes at WTO (as on 16.03.2020)
India currently has 15 disputes with other members of WTO (4 as Complainant
and 11 as respondent)
Disputes where India is a Complaining party (4 cases)
DS436 (Countervailing duty by United States on Indian steel products) Respondent-
The United States
DS-503 (Measures by US concerning non-immigrant visas) Respondent- The United
States

DS-510 (Sub-Federal Renewable energy programmes of US) Respondent- The United
States
DS-547 (Certain measures by US on Steel and Aluminium products) Respondent- The
United States
WTO disputes where India is a Responding Party (11 cases)
DS-430: (Prohibition by India on Import of poultry and poultry products)
Complainant – The United States
DS-456 (India’s Measures Relating to Solar Cells and Solar Modules under National
Solar Mission dispute) Complainant – The United States
DS-518 (India’s safeguard measures on import of iron and steel products)
Complainant – Japan
DS-541 (India’s Export Promotion Schemes)-Complainant-United States
DS579, DS580 and DS581 (India-Measures Concerning Sugar and Sugarcane)-
Complainants- Brazil, Australia and Guatemala, respectively
DS582 and DS584, DS588 (India-Tariff Treatment on Certain Good in the Information
and Communications Technology Sector)- Complainants- EU, Japan and Taiwan,
respectively
DS-585 (Additional duties on certain products from US) - Complainant– The United
States

Unit IV: Exchange rates and its Economic effects
1. Structure
Exchange
Rates
Exchange Rate Changes in Impact of forex

Regimes Exchange fluctuations on
Rates domestic economy
Fixed Floating
Exchange Others
Exchange
Rate Rate
Ragime Regime Hard Soft Floatin
Peg Peg g
Dollarizat Currency
ion Baord
2. Introduction to Exchange Rates
➢ Foreign Exchange refers to money, which is foreign. Anything other than

domestic currency is foreign currency and is known as foreign exchange.
➢ Exchange rate: Rate at which something can be exchanged.
➢ Foreign Exchange rate: Rate at which foreign currencies can be exchanged, i.e.,
the rate at which one currency can be exchanged with another. Following are
all examples of exchange rates where the rate at which rupees can be
exchanged with various currencies is given:
1 $ = Rs. 65.
1 Euro = Rs. 80
1 British Pound = 1.5 $
➢ Direct Quote and Indirect Quote:

o Direct Quote:
When we express value of foreign currency in terms of domestic currency,
it forms a Direct Quote.
Example: If domestic currency is Rupee, then,www.IndigoLearn.com

1 $ = Rs. 65 or 1 Euro = Rs.
80 – are direct quotes. 9640 11111 0

o Indirect Quote:
When we express value of Domestic currency in terms of foreign
currency, it forms an Indirect Quote.
Example: If domestic currency is Rupee, then 1 Re = 0.015 $ is an Indirect

quote.
Note:
1. Whether a given quote is direct or indirect depends on which currency is the

domestic currency.
Example:
For the given quote 1 $ = Rs. 65
If domestic currency is Rupee, then it is a direct quote.

If domestic currency is Dollar, then it is dollar expressed in terms of foreign
currency and is an Indirect quote.
2. If direct quote is given, indirect quote can be found as shown below:
Direct quote: 1$ = INR 65

Indirect quote: INR 1 = $ 1/65 = 0.015 --> INR 1 = 0.015 $
➢ The currency whose value is being expressed will be called the “base
currency”. For example, if 1$ = Rs. 65 then dollar is the base currency, because
it is the value of the dollar that is being expressed here.
If it is a direct quote, then foreign currency will be the base currency.

If it is an indirect quote, then domestic currency will be the base currency.
The currency other than the base currency will be called the “counter
currency”.
➢ Cross Rates: The exchange rate arrived at between two currencies by using
exchange rates with common currencies, is known as a Cross Rate.
Example: If the domestic currency is Rupee and a quote for Pound is to be found,
given 1 $ = Rs 65 and 1 pound = USD 1.5.
To arrive at 1 Pound in terms of rupees:

1 $ = 65 Rs
1.5 $ = 65*1.5 = Rs. 97.5 = 1 Pound.
1.5$ = 1 Pound
1.5$ = Rs. 97.5
Therefore, 1 Pound = Rs. 97.5 ----> Cross Rate.
➢ Buying rate and Selling rate:
o Buying rate: The rate at which the banker purchases foreign currency is
known as the buying rate.
Example: X, resident in India, sold/exported goods to USA and the buyer
makes payment of USD 100. X sells the USD received to the bank and the
bank purchases USD by paying to X INR. If the rate quoted by the banker
is $1 = Rs 65, then X would pay $100 to the banker and received INR 6500
(65*100).
The banker has purchased foreign currency from X, and the rate quoted
by the bank for such transaction is the Buying rate.
o Selling Rate: The rate at which the banker sells foreign currency is
known as the selling rate.
Example: Y has purchased/ imported goods from USA. The seller requests
payment of $100 (USD and not INR). So, Y purchases USD from the banker.
The rate quoted by the banker is $1 = Rs. 67.
$1 = Rs. 67
$100 = 67*100 = Rs. 6700.
Y pays to the bank INR 6700 and takes $100 to pay to the supplier.
The banker has sold foreign currency to Y, and the rate quoted by the
bank for such transaction is the Selling rate.
Note:
Generally, the banker sells at a higher rate and buys at a lower rate. In the
examples above, purchase of foreign currency is made at 65 and bank sold
foreign currency at 67, thus making a profit of INR 2. Banks earn this commission

for buying and selling forex. If the buying rate and selling rate are the same,
then it will be called “unique” or “unified” rate.
EXCHANGE RATE REGIMES

➢ Exchange Rate Regime refers to the method of determining the value of the
domestic currency in terms of foreign currency, i.e., the method to determine
the foreign exchange rates.
➢ Exchange rate regimes:
o Floating exchange rate regime
o Fixed exchange rate regime
o Others
▪ Hard Peg
▪ Soft Peg
▪ Floating
1. Floating Exchange Rate Regime
➢ It is also known as flexible exchange rate regime. Under this regime, the rate is
completely market determined.
➢ Price for foreign currency, similar to that of goods, is determined by the demand
and supply in the market. If the demand is high, the price increases, and if
demand reduces, the price decreases.
Example: If the demand for dollar is high, the price may increase from INR 65
to INR 68. If the supply is higher than demand, the price will fall.
➢ The above is market determination of price. The prices fluctuate with

fluctuations in demand. The Government or the Central Bank do not involve in
manipulating the prices.
➢ However, the Government may interfere in very rare cases, not to establish a
particular price level but to moderate, if any sudden, unwarranted
decrease/increase in prices takes place. The Government may regulate the
price by affecting the demand for the currency by buying or selling the currency.
In few countries like USA, New Zealand and Sweden, there is no Government
intervention in the market and price of the currency is completely market
determined.
➢ Advantages of Floating Rate Regime:

o The Government can choose to have its own monetary policy without any
dependence on the monetary policy of another currency against which
the currency is pegged as in fixed regime.

o No obligation to maintain forex reserves as the Central Bank need not
interfere in the market.
o However, the country may have uncertainties regarding international
trade and exchange rate risks in a floating rate regime.
2. Fixed Exchange Rate Regime
➢ The Government or the Central Bank decides price of its currency expressed in
terms of various foreign currencies or expressed in terms of Gold. Central Bank
does not allow the rate to fluctuate. In such a case, the Central Bank is said to
have established a “peg” for its currency.
➢ The Government or the Central Bank regulate the price after establishing a peg
through market intervention. The Government or Central Bank may buy and
create demand if demand is less and price is going low and sell and increasing
the supply if the demand is already high and the price is on the rise.
➢ Advantages of Fixed Rate Regime:

o Avoids currency fluctuations and eliminates exchange rate risks.
o When the value of money remains constant, inflation remains in control
o More stability in the economy encourages trade and foreign investment.
o If the rate is pegged against another currency, which is stronger, its
monetary policies also will be based on that other currency and thus the
credibility of such monetary policy is also enhanced.
o Further, the Central bank should have adequate forex reserves to
intervene in the market whenever it is necessary to maintain the rate
fixed.
3. Other Exchange Rate Regimes
➢ In reality, floating rate and fixed rate regimes are extreme regimes, and are not
adopted by many countries. Countries find many intermediate exchange rate
regimes, broadly classified into three categories:
o Hard Peg
▪ Dollarization
▪ Currency Board
o Soft Peg
o Floating
➢ Hard Peg
o Dollarization – The country uses the legal tender of another country for
doing its commercial transactions. That other currency acts as the legal

tender in the country and the home country does not have a separate
legal tender. For example, Zimbabwe ran a dollarization test for 18
months using US Dollars and then USD was completely adopted as its legal
tender. The monetary policies for the country would be decided by the
country whose currency is adopted.
Dollarization does not necessarily mean using dollar as legal currency, it

can be any foreign currency, example Euro.
It is generally adopted by countries whose currencies are volatile and

unstable, facing high inflation (the value of the currency reduces). A
more stable currency is adopted, so that the demand cycle in the
economy is not affected as a result of increase or decrease in prices.
7.3% countries out of the 189 countries of WTO (Based on the annual
report released by it in 2016) adopt this regime.
o Currency Board – Management of the currency and monetary policy is

taken away from the Central Bank and given to separate Board that is
formed known as the Currency Board. The country retains its own
currency, but the Board maintains a fixed exchange rate with a foreign
currency. So, the value of the domestic currency directly pegged against
that other currency. An example is Honk Kong Dollar pegged against USD.
About 5.7% of the WTO members adopt this regime.
Example 1
If India fixes the value of its currency based on US Dollars, and the rate is fixed
at 1$ = INR 60.
If in the international market, 1 Pound = 1.5 $,

Then the value of Pound expressed in terms of Rupees will be
1 Pound = 1.5*60 = INR 90
If in the international market, the price of 1 Pound expressed in terms of Dollars

changes to 1 Pound = 2 $, then the rate of Pound in terms of INR also changes
as follows:
1 Pound = INR 2*60 = INR 120.
Note: As value of USD decreased (In terms of Pounds), value of Rupee also
automatically decreased. Similarly, every time there is a change in the value of
dollar, value of rupee automatically changes.

➢ Soft Peg
o Conventional fixed Peg – The currency is pegged against another

currency, but it is not completely fixed against that currency. The
Government maintains the currency value at a fixed level, with a
tolerance level of +/- 1% (Fluctuation margin).
23% of the WTO members adopt this regime. Examples are China, Bhutan,
Kuwait, and Malaysia.
o Pegged Exchange Rates within horizontal bands – Similar to

Conventional fixed peg, but the fluctuation margin is beyond +/- 1%.
0.5% countries of the WTO members adopt this regime.
o Crawling Peg – The rate of the home currency is fixed against another
currency and generally adjusted from time to time. If there is inflation
in the country and the value of domestic currency is on the decline, then
the exchange rate is periodically adjusted for inflation.
o Crawling Bands – The rate is first fixed by pegging against another

currency, then a band is created (upper and lower limit of fluctuation).
However, if the value of domestic currency has changed significantly
from the fixed price, the Government revises the band.
➢ Floating Rate Regime
o Managed Floating with no preannounced path for exchange rate – The

Central Bank sometimes intervenes in the Market in case of sudden
fluctuations. Example – India
o Free Floating – is a regime followed by countries like USA, New Zealand,

Japan (Explained in Para 2.1)

CHANGES IN EXCHANGE RATES
1. Basics of Exchange Rates
➢ Nominal and Real Exchange Rates

Nominal Exchange Rate (NER) refers to the value of one currency expressed in
terms of another currency.
Real Exchange Rate (RER) refers to the value of exchange of goods/services as
expressed in terms of value of goods/services in another country.
RER = NER X Domestic Price Index / Foreign Price Index
Therefore, if RER is higher than NER, it implies that domestic prices are higher
than Foreign Prices, and Vice versa.
➢ Real Effective Exchange Rate (REER)
REER means the weighted average of the RER of one currency expressed in terms
of many currencies.
Example 2
The RER of Pound expressed in terms of $, INR and Yen are given below, along
with the % of trade that each of these countries account for in UK. Find REER.
Currency RER % of Trade Weighted average
$ 1.2 70% 0.84
INR 0.75 25% 0.19
Yen 1 5% 0.05
REER 1.0775
In the above example, REER is more than 1, which implies that the domestic prices in
UK are higher than prices in foreign countries, and the Pound is over-valued.
➢ Overview of Forex Market
o Following table explains the various players in a foreign exchange

market:

Central Banks Commercial Banks and Dealers
Hedging Speculation Arbitrage
To buy/sell when Pre-existing risk. No pre-existing risk but No pre-existing
there is volatility Already there is a has an expectation of risk. An arbitrager
in the exchange forex forex prices makes riskless
rate payable/receivable, increasing/reducing. profit. Generally,
and The takes on risk by this is possible
forward/futures are purchasing/selling due to mismatch
bought/sold to forex in anticipation of in cross
hedge the existing profit. currencies.
risk
Risk Taking.
Risk avoidance.
o There are broadly two types of transactions in the foreign exchange

market
▪ Spot transactions – The settlement of such transactions takes
generally two days. The exchange rates used for such transactions
are known as Spt exchange rates.
▪ Future transactions – The delivery of currencies bought/sold in
such transactions takes place on a future date, however the rate
of exchange is agreed upon just like a spot rate. Such an exchange
rate is known as Forward rate. If forward rate is higher than the
spot rate, there occurs a forward premium. If the forward rate is
lower than the spot rate, there occurs a forward discount.
➢ Determination of Nominal Exchange Rate
o Exchange rate refers to the price of one currency expressed in terms of

another currency. Similar to prices of goods, the prices of currencies are
also based on demand and supply. The intersection of demand and supply
will be the equilibrium price and that will be the price of the foreign
currency expressed in terms of home currency.
o The question is why is forex demanded or supplied? – That becomes the
determinants of exchange rate –
o Reasons for demand for forex (Determinants of exchange rates)
▪ 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
2. Changes in Exchange Rates
➢ Changes in exchange rates means appreciation or depreciation of currency.
Example 3
If the Rupee Dollar exchange rate in January is $1 = INR 65, and in April it is $1
= INR 70. It indicates that a greater amount of INR has to be paid in April to get
the same $1. The value of INR has gone down; INR has depreciated in value.
Further, the same 1$ would fetch INR 70 instead of INR 65, meaning that the
value of USD has gone up. USD has appreciated in value.
➢ If value of one currency depreciates, value of the other currency appreciates,

and vice versa.
➢ If demand for Foreign Currency increases, price also increases. If Price of

Foreign Currency increases, Home Currency depreciates.
➢ If demand for Foreign Currency decreases, price also decreases. If Price of

Foreign Currency decreases, Home Currency appreciates.
➢ Devaluation and Depreciation, Revaluation and Appreciation

o Depreciation and appreciation are due to market forces (Demand and
Supply)
o Devaluation is relevant in case of a fixed rate regime, where market
forces do not affect the value, but when the Government decides that
the currency should be devalued, a new fixed rate is set. For example,
the rate of 1$ = 60 INR is shifted to 1$ = 70 INR. Rupee is devalued.
o Revaluation is also discrete movement in exchange rate in case of a fixed
rate regime. However, it refers to upward movement of the currency.
IMPACT OF FOREX FLUCTUATIONS ON DOMESTIC ECONOMY

Impact of Forex Fluctuations on the domestic economy is enumerated below –

o Exchange rates directly impact international trade volume of a country.
The import prices and export prices which affected by the exchange rates,
determine international trade. If domestic currency appreciates,
exporters realizing forex will exchange it for lesser domestic currency.
Exports become less lucrative and imports become more attractive, and
that affects the volume traded.
o Change in exchange rates affects domestic production also. For example,

when rupee depreciates, imports become costlier. So, demand for
domestically produced goods increases. Further, exports become
attractive, that further increases the production activity in the country.
This will lead to expansion of economic activity and output, also
increasing competitiveness of domestic industries globally, and promotes
trade balance as higher exports are generally better for the economy.
o Also, if exports are significant in an economy which is labor intensive,

then it would mean increase in employment and increase in wages.
Appreciation of domestic currency will have the opposite impact and
shrink the economy and the growth in National Income.
o However, currency depreciation may have contractionary effect also.

Developing countries’ manufacturing inputs like oil are majorly imported.
If import prices increase due to depreciation of home currency, then cost
of production increases. Output produced and supplied may decrease. It
may also result in inflation due to increase in cost (Cost-push inflation).
o Depreciation in currency would increase debt burden on those who have

borrowed through external commercial borrowings. In addition, if
Government borrowing from foreign market is high, it will affect the
Government’s exchequer. However, the Government revenue may
increase due to increase in value of imports and hence the amount of
taxes on them.
o Exchange rates affect foreign investments too. Investors will be cautious

in investing in countries with high exchange rate fluctuation.

Unit V: International Capital Movements
INTRODUCTION
➢ This unit deals with movement of capital across boundaries.
➢ Types of Foreign Capital Flows:

o Foreign Aid or assistance – Aid from Governments who pool their funds in
international organizations like World Bank, Inter Government grants
(with mandates or without any mandates).
o Borrowings – Inter Government loans, External commercial borrowings,
credit facilities etc.
o Deposits from NRIs
o Investments – Foreign Portfolio investments and Foreign Direct
Investments.
➢ This Unit specifically deals with the fourth category of Capital Flow,
Investments.
1. Structure of the Unit:
FDI
Advantages and
Reasons Scenario in
FDI and FPI Disadvantages
for FDI India
of FDI
FDI ODI
2. FOREIGN DIRECT INVESTMENT AND FOREIGN PORTFOLIO INVESTMENT
1. Foreign Direct Investment (FDI)
➢ According International Monetary Fund (IMF), FDI means

o All investments involving long term relationship

o And reflecting a lasting interest and control of a resident entity in one
economy
o In an enterprise resident in an economy other than that of the direct
investor.
➢ According to OECD, generally, if there is a foreign ownership in an asset or an

entity of 10% or more, it is said to be FDI. FDI may be in real assets like factories,
assets, land, inventories, and production facilities, equity shares of public or
private entities.
➢ The foreign investor making FDI should have ownership and control over the
asset and management decisions regarding the asset.
➢ The country from which the investment in being made is called the home
currency and the investee country is known as the host country.
➢ Modes of FDI:
o Opening a subsidiary or associate company in a foreign country,
o Equity injection into an overseas company,
o Acquiring a controlling interest in an existing foreign company,
o Mergers and acquisitions
o Joint venture with a foreign company,
o Green field investment – A green field investment is a type of foreign
direct investment (FDI) where a parent company builds its operations in a
foreign country from the ground up. In addition to the construction of new
production facilities, these projects can also include the building of new
distribution hubs, offices and living quarters.
➢ Based on nature, FDI may be classified as Horizontal, Vertical and

Conglomerate
o Horizontal – Investment into business of similar nature. Example:

Marketing of clothes and textiles business investing in an entity in the
same line of business in another country.
o Vertical – Investment into business upward or downward in the value

chain. Example: Marketing of clothes business acquiring shares in a foreign
company where the business may be production of yarn.

Example 1
Value chain of the cloth industry
Production of cotton
Production of thread
Manufacture of
cloth/textiles
Manufacture of
garments
Marketing of
garments
If company A acquires shares in another foreign company engaged in

manufacture of textiles, it will be horizontal FDI. If A acquires another foreign
company engaged in production of yarn or manufacture of garments then it will
be vertical FDI.
o Conglomerate type – Foreign investment in businesses which are

unrelated.
o Two-way direct foreign investments – Which are reciprocal investments

between countries that occur when some industries are more advanced in
one nation one nation while other industries are more efficient in other
nations.
2. Foreign Portfolio Investment (FPI)
➢ FPI refers to investment in financial assets. Financial assets are non-physical

assets like Bank deposits, bonds, shares, debentures, stocks etc.
➢ These investments generally do not involve setting up production units, or

generation of employment or income generation or manufacture of goods or
provision of services. In an FPI, no control is exercised over the asset, and it
does not involve management control or managing the affairs of the company
or ownership interest.
➢ In FPI, the purpose of the investor is to earn return on investment, protect

capital, and capital appreciation.

3. The differences between FDI and FPI:
FDI FPI
Creation of Physical assets Deals only in Financial assets
Long Term interest Short Term interest
Ownership and management interest,
management of the enterprise No control or management interest
Less liquid, difficult to withdraw More liquid, easy to withdraw
Speculative - If investor speculates and
sees a better opportunity in some other
Not speculative financial asset, they'll easily liquidate
Direct impact on employment, labor, No direct impact on employment, labor,
wages wages
REASONS FOR FDI

➢ Market seeking FDI –
o Excess capital available in the country invested into other countries for
efficient use of capital, greater profits, with desire to capture markets
across different countries.
➢ Resource or asset seeking FDI –

o Technological growth – Investing in various countries to reap economies of
scale, reach greater markets by using better technology.
o Vertical integration into another country to ensure there is uninterrupted
supply of raw material at stable prices for the manufacturing facility in
the home country.
o Availability of cheaper labor in a foreign country for labor-intensive
industries.
o Better physical infrastructure
➢ Efficiency Seeking FDI –

o Internationalization of production – Production can take place wherever
it is more efficient through setting up of subsidiaries.
o A firm with better technology can use resources of a foreign country more
efficiently.
➢ Policy Framework –
o Stable political environment, stable taxes, and lesser environmental
regulations attract FDI.

o If a country has tariff walls, blanket ban on import of products etc.,
foreign countries would resort to investing in the form of FDI and setting
up production units in those countries instead of exporting to the country,
to get behind the tariff wall.
➢ Business Facilitation –
o Necessity to retain control of technology, production, production facilities
and management over an enterprise.
o For lucrative investment incentives in the host country
➢ However, the following factors pose challenges for FDI in a host country –
o Infrastructure lags
o High rates of inflation
o Bureaucracy and corruption
o Cumbersome legal and administrative processes
o Industrial Disputes
o Double taxation
ADVANTAGES OF FDI (From the Perspective of Host Country)

➢ Entry of foreign enterprises generates competitiveness in host country resulting
in better use of resources for cost reduction, innovation and wider choice for
customers. Further, it weakens the market power of monopolies in the host
country.
➢ FDI results in better use of the capacity within the country. Inflow of
technological know-how and better management skills increases production in
the country and directly impacts employment.
➢ Indirect employment opportunities also get created due to backward and

forward linkages.
➢ Domestically, there may not be enough capital for large-scale production.

Foreign investment would increase capital and help firms scale up production
and reap benefits of economies of scale.
POTENTIAL PROBLEMS ASSOCIATED WITH FDI

➢ FDI comes with high-powered technology and encourages capital-intensive
methods. For a host country, which is labor intensive, this may not prove to be
advantageous.
➢ Accentuates the already existing income disparity in the host country, as FDI is
generally concentrated in regions, which are more developed, hence developing
them even further leaving behind the underdeveloped regions in the country.
➢ Often, foreign companies investing in a host country make such investment by

borrowing in the host country itself. This leads to crowding out, and lesser funds
being available for borrowing by domestic firms. It further increases interest
rates in the country.
➢ Generally, FDI betters the Balance of Payments position. However, when the
foreign firms repatriate profits to the home country and this will lead to
unfavorable balance of payments.
➢ Foreign firms are generally profit oriented and may produce elitist products
instead of necessaries affecting welfare adversely.
➢ Foreign firms generally have lower costs due to large-scale production and
better technology. The foreign firms may increase wages of workers, which the
domestic corporations may not afford.
➢ Adverse impact on terms of trade (Price of exports/price of imports) – If FDI is

used for export goods, supply of such goods increases, and price of exports may
reduce.
➢ Exploitation of natural resources, environmental deterioration.
➢ Large foreign corporations influence decision-making in the country, may resort

to corruption, evasion of contribution towards Corporate Social Responsibility
and ultimately potential loss of control by the host country over its domestic
policies.
SCENARIO IN INDIA
1. FDI
➢ Post-independence, India encouraged exports and focused on developing

domestic industry while discouraging imports.

➢ FERA, enacted in 1973, permitted only 40% foreign holding of equity.
➢ In 1982-83, there was liberalization of imports of capital goods and technology

and reduction in tariffs.
➢ In 1991, the economy was liberalized, and the following are some of the reforms
introduced –
o Automatic approval of FDI was introduced in many sectors. Currently,
numerous sectors fall under the automatic approval route like agriculture
and mining civil aviation.
o 100% FDI was permitted in many sectors
o Permitting use of foreign trademarks and brand names
o Signing of Multilateral Investment Guarantee Agency (MIGA) protocol –
MIGA is an international agency providing political risk insurance and
credit enhancement guarantees to investors. India is a member of MIGA,
and this is a step to ensure that foreign investments in India are protected.
o Setting up of SEZ and giving infrastructure facilities and other benefits
including tax benefits.
o FEMA was enacted with many regulations including the % of FDI permitted,
the instruments in which FDI is permitted (equity shares, fully convertible
preference shares, fully convertible debentures), the way FDI can be
brought in or dividends may be repatriated (Only through authorized
dealers).
➢ In 2016, there were radical changes in policies to make India an open economy
and encourage FDI –
o Increase in sectoral caps
o Easing of FDI in defense, e-commerce, pharma (Make in India project)
➢ Currently, FDI is permitted under the automatic route (No approval of

Government or RBI) and also under the approval route (approval of Government
or RBI)
➢ Following sectors are prohibited from receiving FDI –

o Lottery business including Government / private lottery, online lotteries,
etc.
o Gambling and betting including casinos etc.
o Chit funds
o Nidhi company
o Trading in Transferable Development Rights (TDRs)
o Real Estate Business or Construction of Farmhouses

o Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or
of tobacco substitutes
o Activities/sectors do not open to private sector investment e.g. atomic
energy and railway operations (other than permitted activities)
2. Overseas Direct Investment By Indian Companies (ODI)
➢ Regulations on the amount of ODI permitted have been eased with lesser
administrative procedures and relaxed external borrowing limits.
➢ Reasons for ODI –
o Seeking resources, market access, better technology.
o Tax benefits – Investments in tax havens like Mauritius, Singapore, Virgin
Islands etc.
➢ Many firms especially providing manpower services and software development
services like TCS, Infosys, Wipro etc. with large client bases abroad have set up
offices there to operate closer to their clients.

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Table of Content

Chapter 1 - Determination of National Income ............................................ 2

Economics for Finance www.IndigoLearn.com 1

1.1. Structure of the Unit

Concepts of Methods of Usefullness and System of

1.2. System of National Accounts

➢ National accounts refer to the accounts of the various Macro-economic activities

Economics for Finance www.IndigoLearn.com 2

➢ In Production phase, firms employ factors of production for production of goods

➢ In the expenditure or disposition phase, the income received by factors of

Economics for Finance www.IndigoLearn.com 3

2.1. Gross Domestic Product

➢ GROSS refers to the value being gross of depreciation. Depreciation represents

➢ DOMESTIC refers to the goods or services

Economics for Finance www.IndigoLearn.com 4

Market Price / Value of cotton = INR 50

Hence, the value of the thread may be expressed as

INR 70 = INR 50 (value of cotton which is a raw material)

INR 20 is the value added by the process of manufacturing of cloth.

Economics for Finance www.IndigoLearn.com 5

GDP = ∑ Value Added

➢ Value of only Economic goods should be considered for computation of GDP

Hence, GDP is the market value of “Economic” Goods and Services.

Note: According to the production boundary defined in the System of Nation

Year 0 / Today Year 2

At the end of Year 1:

Economics for Finance www.IndigoLearn.com 6

At the end of Year 2:

1. It is the value of goods produced that is included in GDP, irrespective of

3. Value of sale of goods produced in earlier period is not included in GDP of

4. Expenditure incurred for the purpose of production only is included in valuing

5. Sale of secondhand goods is not included in computing GDP as they were

➢ Real GDP and Nominal GDP

GDP is generally at Market Prices

In case of a chocolate manufacturer,

Contribution to GDP by the Manufacturer = 10,000 Units X INR 50 = INR 500,000

Economics for Finance www.IndigoLearn.com 8

3. The increase in contribution to GDP of the chocolate manufacturer in the year

2.2. Net Domestic Product (NDP)

NDP = GDP - Depreciation

2.3. Gross National Product (GNP)

Economics for Finance www.IndigoLearn.com 9

➢ Earnings of Indian Corporations / Indian residents Overseas net of earnings of

➢ NFIA will be positive if earnings of Indian residents overseas exceed the

➢ NFIA will be negative if earnings of foreign residents in India exceed the

GNP = GDP + earnings of Indian Corporations / Indian residents Overseas –

GNPMP = GDP MP + Net Factor Income from abroad (NFIA)

2.4. Net National Product (at Market Prices)

Economics for Finance www.IndigoLearn.com 10

NNPMP = NDP +NFIA

2.5. GDP at Factor Cost

Rent Wages Interest Profit Product Production

In the example of the chocolate manufacturer referred in Example 3, the value

Taking the example further, to manufacture the chocolate, the manufacturer

As the manufacturer wanted to sell the chocolates, the Government wanted a

EconomicsThe total price

Further to Example 4, the Government gives a subsidy to the chocolate

Market Price = Factor Cost + Indirect Taxes – Subsidy

GDPFC = GDP at market prices + Subsidy – Indirect taxes

2.6. Net Domestic Product at Factor Cost (NDPFC)

NDPFC = GDPFC – Depreciation

Economics for Finance www.IndigoLearn.com 12

NNPFC = NNPMP + Subsidy – Indirect taxes