DETERMINATION OF NATIONAL INCOME

Unit I: National Income Accounting

1.1 Introduction

The performance of an economy depends on the output of goods and services

produced by it. Just as there are accounting conventions which measure the
performance of business, there are conventions for measuring and analyzing the
economic performance of a nation.
National Income Accounting, pioneered by the Nobel prize-winning
economists Simon Kuznets and Richard Stone, is one of the measures for
analyzing the economic performances of a nation.
National Income is defined as the net value of all economic goods and
services produced within the domestic territory of a country in an
accounting year plus the net factor income from abroad. According to
the Central Statistical Organization (CSO) ‘National income is the sum total
of factor incomes generated by the normal residents of a country in the
form of wages, rent, interest and profit in an accounting year’.

1.2 Usefulness and Significance of National Income estimates

a. National income accounts provide a comprehensive, conceptual and

accounting framework for analyzing and evaluating the short-run
performance of an economy. The level of national income indicates the
level of economic activity and economic development as well as
aggregate demand for goods and services of a country.
 b. The distribution pattern of national income determines the pattern of
demand for goods and services and enables businesses to forecast the
future demand for their products.

c. Economic welfare depends to a considerable degree on the magnitude

and distribution of national income, size of per capita income and the
growth of these over time.

d. International comparisons in respect of incomes and living standards assist

in determining eligibility for loans, and or other funds or conditions on which
such loans, and / or funds are made available. The national income data
are also useful to determine the share of nation’s contributions to various
international bodies.

e. Combined with financial and monetary data, national income data

provides a guide to make policies for growth and inflation.

f. National income or a relevant component of it, is an indispensable

variable considered in economic forecasting and to make projections
about the future development trends of the economy.

g. National income estimates throw light on income distribution and the possible
inequality in the distribution among different categories of income earners. It is
also possible to make comparisons of structural statistics, such as ratios of
investment, taxes, or government expenditures to GDP

1.3 Different Concepts of National Income

National income accounts have three sides:
1 . a product side,
2 . an expenditure side and
3 . an income side.
The product side measures production based on concept of value added. The
expenditure side looks at the final sales of goods and services, whereas the
income side measures the distribution of the proceeds from sales to different
factors of production. Accordingly, national income is a measure of the total
flow of ‘earnings of the factor-owners’ which they receive through the
production of goods and services. Thus, national income is the sum total of all
the incomes accruing over a specified period to the residents of a country
and consists of wages, salaries, profits, rent and interest.
 On the product side there are two widely reported measures of overall
production namely, Gross Domestic Product (GDP) and Gross National Product
(GNP).

1.3.1 Gross Domestic Product (GDP MP)

Gross domestic product (GDP) is a measure of the market value of all final
economic goods and services, gross of depreciation, produced within the
domestic territory of a country during a given time period. It is the sum
total of ‘value added’ by all producing units in the domestic territory and
includes value added by current production by foreign residents or
foreign-owned firms. The term ‘gross’ implied that GDP is measured ‘gross’
of depreciation. ‘Domestic’ means domestic territory or resident
production units. It refers to ‘the geographic confines’ of a country. For
example, if a Chinese citizen works temporarily in India, her production is part of
the Indian GDP. If an Indian citizen owns a factory in another country, for e.g.,
Germany, the production at her factory is not part of India’s GDP. However,
GDP excludes transfer payments, financial transactions and non-reported
output generated through illegal transactions such as narcotics and
gambling.
Gross Domestic Product (GDP) is in fact Gross Domestic Product at market prices
(GDP MP) because the value of goods and services is determined by the
common measuring unit of money or it is evaluated at market prices. Money
enables us to measure and find the aggregate of different types of products
expressed in different units of measurement by converting them in terms of
Rupees.

GDPMP = Value of Output in the Domestic Territory – Value of Intermediate

Consumption
GDP MP = ∑ Value Added

While learning about national income, there are a few important points which
one needs to bear in mind.

a. The value of only final goods and services or only the value added by
the production process would be included in GDP. By ‘value added’
 we mean the difference between value of output and purchase of
intermediate goods. Value added represents the contribution of labor
and capital to the production process.

b. Intermediate consumption consists of the value of the goods and

services consumed as inputs by a process of production, excluding fixed
assets whose consumption is recorded as consumption of fixed capital.
Intermediate goods used to produce other goods rather than being sold
to final purchasers are not counted as it would involve double counting.
For example, the value of flour used in making bread would not be
counted as it will be included while bread is counted. This is because
flour is an intermediate good in bread making process.

c. Gross Domestic Product (GDP) is a measure of production activity. GDP

covers all production activities recognized by SNA called the
‘production boundary’. The production boundary covers production of
almost all goods and services classified in the National Industrial
Classification (NIC). Production of agriculture, forestry and fishing which
are used for own consumption of producers is also included in the
production boundary.

d. Economic activities, as distinguished from non-economic activities,

include all human activities which create goods and services that are
exchanged in a market and valued at market price.

e. National income is a ‘flow’ measure of output per time period – for

example, per year – and includes only those goods and services
produced in the current period i.e., produced during the time interval
under consideration. The value of market transactions such as
exchange of goods which already exist or previously produced, do not
enter into the calculation of national income. Therefore, the value of
assets such as stocks and bonds which are exchanged during the
pertinent period are not included in national income as these do not
directly involve current production of goods and services. However, the
value of services that accompany the sale and purchase (e.g., fees
paid to real estate agents and lawyers) represent current production
and therefore, is included in national income.

f. An important point to remember is that two types of goods used in the

production process are counted in GDP namely, capital goods (business
 plant and equipment purchases) and inventory investment – the net
change in inventories of final goods awaiting sale or of materials used in
the production which may be positive or negative. Additions to
inventory stocks of final goods and materials belong to GDP because
they are currently produced output.

1.3.2 Nominal GDP vs Real GDP: GDP at Current and Constant prices

When GDP is estimated on the basis of current year’s market prices, it is called
nominal GDP or GDP at current prices., for example, GDP of year 2020-21 may
be measured using prices of 2020- 21. Nominal GDP changes from year to year
for two reasons
1. The amount of goods and services produced changes
2. The market price changes.
Changes in GDP due to changes in prices fail to correctly explain the performance
of the economy in producing goods and services.
The same physical output will correspond to a different GDP level if the
average level of market prices changes. That is, if prices rise, GDP measured
at market prices will also rise without any changes in the actual volume of
output. To correct this i.e., to eliminate the effect of prices, in addition to
computing GDP in terms of current market prices, termed ‘nominal GDP’ or
‘GDP at current prices’, the national income accountants also calculate
‘real GDP’ or ‘GDP at constant prices’ which is the value of domestic
product in terms of constant prices of a chosen base year. Real GDP
changes only when production changes.

In other words, it is calculated using the prices of the selected’ base year. For
example, if 2011-12 is selected as a base year, real GDP for 2020-21 will be
calculated by taking the quantities of all goods and services produced in
2020-21 and multiplying them by their 2011-12 prices. Thus, GDP at constant
prices or real GDP refers to the total money value of final goods and services
produced within the domestic territory of a country during an accounting
year, estimated using base year prices. Real GDP is an inflation adjusted
measure and is not affected by changes in prices; it changes only when
there is a change in amount of output produced in the economy. It is a
better measure of economic wellbeing as it shows the true picture of the
change in the production of an economy.
The calculation of real GDP gives us a useful measure of inflation known as
GDP deflator. The GDP deflator is the ratio of nominal GDP in a given year to
real GDP of that year.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
GDP deflator = *100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

The GDP deflator can be used to deflate or take inflation out of GDP. It is a
price index used to convert nominal GDP to real GDP.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
Real GDP= ∗ 100
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟
The deflator measures the change in prices that has occurred between the
base year and the current year. In other words, it measures the current level
of prices relative to the level of prices in the base year. For example, in 2019 if
the nominal GDP is 6000 billion and real GDP is 3500 billion, then GDP deflator
is 171.43. Since nominal GDP and real GDP must be the same in the base
year, the deflator for the base year is always 100.
Using the GDP deflator, the inflation rate between two consecutive years
can be computed using the following procedure:

𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 𝑦𝑒𝑎𝑟 2−𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 𝑦𝑒𝑎𝑟 1

Inflation rate in year 2= *100
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 𝑦𝑒𝑎𝑟 1

For example, if the GDP deflator in 2020 increased to 240 from 171 in 2019,
240−171
inflation rate in year2= *100=40.35%
171

Let’s solve

Q 1: Find out the GDP deflator. Interpret it.

Year Nominal GDP Real GDP GDP deflator

2014 500 500
2015 800 650
2016 1150 800
2017 1300 950
2018 1550 1190
2019 1700 1240
Interpretation: We used 2014 prices to compute GDP of subsequent years.
Real GDP has risen over the years from 500 billion in 2014 to 1240 billion in
2019. This indicates that the increase is attributable to an increase in
quantities produced because the prices are held constant at base year. A
deflator above 100 is an indication of price levels being higher as compared
to the base year. From years 2015 through 2019, we find that price levels are
higher than that of the base year, the highest being in the year 2016.

 If GDP deflator is greater than 100, the nominal GDP is greater than
real GDP.
 If the GDP deflator next year is less than the GDP deflator this year,
then the price level has fallen,
 If it is greater, price level has increased.

Q 2: The nominal and real GDP respectively of a country in a particular year

are rupees 3000 crores and rupees 4700 crores respectively. Calculate GDP
deflator and comment on the level of prices of the year in comparison with
the base year. [Ans: GDP deflator=63. 83.. The price level has fallen since
GDP deflator is less than 100]

Q 3: Find nominal GDP if real GDP =450 and price index = 120. [ans:540]

Q 4: Suppose nominal GDP of a country in year 2010 is given at 600 crores

and price index given is of base year 2010 as100. Now let the nominal GDP
increase to 1200 cr in year 2018 and price index rises to 110, find out real
GDP.[ans:1090.9 cr]
 1.3.3 Gross National Product (GNP)

Gross National Product (GNP) is a measure of the

market value of all final economic goods and services,
gross of depreciation, produced within the domestic
territory of a country by normal residents during an
accounting year including net factor incomes from
abroad. It is the total income earned by a nation’s
permanent residents called nationals. It differs from
GDP by including income that our citizens earn abroad
and excluding income that foreigners earn here. In the
example given in 1.3.1 above, the Chinese citizen’s
production is part of the Indian GDP, but it is not part of
Indian GNP. (It is part of China’s GNP).

GNP is evaluated at market price and therefore it is in fact GNP at MP

GNP MP = GDP MP +Factor income earned by the domestic

factors of production employed in the rest of the world - Factor income
earned by the factors of production of the rest of the world employed in
the domestic territory
GNP MP = GDP MP + Net Factor Income from Abroad

GDP MP = GNP MP - Net Factor Income from Abroad

NFIA is the difference between the aggregate amount that a country’s

citizens and companies earn abroad, and the aggregate amount that foreign
citizens and overseas companies earn in that country.
 NFIA =Net compensation of employees + Net income from property and
entrepreneurship + net retained earnings

If Net Factor Income from Abroad is positive, then GNP MP would be greater
than GDP MP.

The two concepts GDP and GNP differ in their treatment of

international transactions.
 The term ‘national’ refers to normal residents of a
country who may be within or outside the domestic
territory of a country and is a broader concept
compared to the term ‘domestic’. For example, GNP
includes earnings of Indian corporations overseas and
Indian residents working overseas; but GDP does not
include these. In other words, GDP excludes net factor
income from abroad.

 Conversely, GDP includes earnings from current

production in India that accrue to foreign residents or
foreign-owned firms; GNP excludes those items. For
instance, profits earned in India by X Company, a
foreign-owned firm, would be included in GDP but not
in GNP. Similarly, profits earned by Company Y, an
Indian company in UK would be excluded from GDP, but
included in GNP.

1.3.4 Net Domestic Product at Market Prices (NDP MP)

Net domestic product at market prices (NDP MP) is a measure of the market
value of all final economic goods and services, produced within the domestic
territory of a country by its normal residents and non-residents during an
accounting year less depreciation. The portion of the capital stock used in the
process of production or depreciation must be subtracted from final sales
because depreciation represents capital consumption and therefore a cost
of production.

NDP MP = GDP MP – Depreciation

NDP MP = NNP MP - Net Factor Income from Abroad
 1.3.5 Net National Product at Market Prices (NNPMP)

Net National Product at Market Price (NNP MP) is a measure of the market
value of all final economic goods and services, produced by normal residents
within the domestic territory of a country including Net Factor Income from
Abroad during an accounting year excluding depreciation.

NNP MP = GNP MP - Depreciation

NNP MP = NDP MP + Net Factor Income from Abroad
NNP MP = GDP MP + Net Factor Income from Abroad - Depreciation

1.3.6 Net Domestic Product at Factor Cost (NDP FC)

Net Domestic Product at Factor Cost (NDP FC) is defined as the total factor
incomes earned by the factors of production. In other words, it is sum of
domestic factor incomes or domestic income net of depreciation.

NDP FC = NDP MP – Net Indirect Taxes

= Compensation of employees + Operating Surplus (rent
+ interest + profit) + Mixed Income of Self - employed
 NDPfc/FID(factor income earned in
domestic territory)/domestic factor income

income from NDP accruing to private income from NDP accruing to

sector(private sector income/IPS) government/public sector(IGS)

income of government from

business & savings of non departmetal enterprises(for
property(e.g.Railways,post e.g.Indian Oil)
office Etc)

1.3.7 Net National Product at Factor Cost (NNP FC) or National Income

National Income is defined as the factor income accruing to the normal

residents of the country during a year. It is the sum of domestic factor income
and net factor income from abroad. In other words, national income is the
value of factor income generated within the country plus factor income from
abroad in an accounting year.
NNPfc=National income=NDPfc/FID (factor income earned in domestic
territory) +NFIA
If NFIA is positive, the national income will be greater than factor income.

1.3.8 Per Capita Income

The GDP per capita is a measure of a country’s economic output per person.
It is obtained by dividing the country’s gross domestic product, adjusted by
inflation by the total population. It serves as an indicator of the standard of
living of a country.

1.3.9 Personal Income

While national income is income earned by factors of production, personal

income is the income received by the household sector including Non-Profit
institutions Serving Households. Thus, national income is a measure of income
earned and personal income is a measure of actual current income receipts
of persons from all sources which may or may not be earned from productive
activities during a given period of time. In other words, it is the income
‘actually paid out’ to the household sector, but not necessarily earned.
Examples of this include transfer payments such as social security benefits,
unemployment compensation, welfare payments etc. Individuals also
contribute income which they do not actually received; for example,
undistributed corporate profits and the contribution of employers to social
security. Households receive interest payments from the firms and
governments; they also make interest payments to the firms and governments.
As such, the net interest paid by the households to firms and government is
also deducted from national income. Personal income forms the basis for
consumption expenditures and is derived from national income as follows:

PI =[ NI -Income of government or public sector (IGS)]+ income

received but not earned(e.g. Transfer payments such as social security
benefits, unemployment compensation,welfare payments etc.) –
income earned but not received
(undistributed corporate profits/corporate savings/retained
earnings/undistributed reserves and surplus,
contribution of employers to social security schemes
,indirect business taxes,
direct corporate income taxes)
 PI=private income -income earned but not received

An important point to remember is that national income is not the sum of

personal incomes because personal income includes transfer payments (e.g.,
Pension) which are excluded from national income. Also, not all national
income accrues to individuals as their personal income.

1.3.10 Disposable Personal Income (DI)

Disposal personal income is a measure of amount of the money in the hands

of the individuals that is available for their consumption or savings. Disposable
personal income is derived from personal income by subtracting the direct
taxes paid by individuals and other compulsory payments made to the
government.

DI = PI – Personal Income Taxes-non tax payments

Apart from the above aggregates, a few other aggregates are reported in. They
reflect the amount of goods and services the domestic economy has at its disposal.
They are:
a. Net national disposable income- It is defined as the maximum the country can
afford to spend on consumption of goods and services during an accounting
year without having to finance its expenditure by disposing of its assets or
increasing its liabilities.
NNDI=NNPfc+NIT+ net current transfers from the rest of the world
GNDI=NNDI+depreciation

THREE GOLDEN RULES TO REMEMBER

1:National=domestic+NFIA

2:Gross=net+depreciation

3:Market=factor cost+net indirect taxes

=factor cost+indirect taxes-subsidies
Q 5:From the following data, calculate NNPFC, NNPMP, GNPMP and GDPMP.
Items ` in Crores
Operating surplus 2000
Rent 550
Profit 800
Net indirect tax 450
Consumption of fixed capital 400
Net factor income from abroad -50
Compensation of employees 1000
Q 6:From the following data, estimate National Income and Personal Income.
Items Rs in Crores
Net national product at market price 1,891
Income from property and entrepreneurship accruing
to government administrative departments 45
Indirect taxes 175
Subsidies 30
Saving of non-departmental enterprises 10
Interest on National debt 15
Current transfers from government 35
Current transfers from rest of the world 20
Saving of private corporate sector 25
Corporate profit tax 25
Solution
 Q 7:Calculate the aggregate value of depreciation when the
GDP at market price of a country in a particular year was 1,100 Crores.
Net Factor Income from Abroad 100 Crores.
The value of Indirect taxes – Subsidies was 150 Crores and
National Income was 850 Crores.

Q 8: On basis of following information, calculate NNP at market price and Disposable

personal income
Items ` in Crores
NDP at factor cost 14900
Income from domestic product accruing to government 150
Interest on National debt 170
Transfer payment by government 60
Net private donation from abroad 30
Net factor income from abroad 80
Indirect taxes 335
Direct taxes 100
Subsidies 262
Taxes on corporate profits 222

Undistributed profits of corporations 105

Solution
 1.4 MEASUREMENT OF NATIONAL INCOME IN INDIA
National Accounts Statistics (NAS) in India are compiled by National Accounts
Division in the Central Statistics Office, Ministry of Statistics and Programme
Implementation (MOSPI). Annual as well as quarterly estimates are published.
This publication is the key source-material for all macroeconomic data of the
country. As per the mandate of the Fiscal Responsibility and Budget
Management Act 2003, the Ministry of Finance uses the GDP numbers (at
current prices) to determine the fiscal targets.
The Ministry of Statistics and Programme Implementation has released the new
series of national accounts, revising the base year from 2004-05 to 2011-12.
In the revision of National Accounts statistics done by Central Statistical
Organization (CSO) in January 2015, it was decided that sector-wise estimates of
Gross Value Added (GVA) will now be given at basic prices instead of at factor cost.
In simple terms, for any commodity the ‘basic price’ is the amount receivable by
the producer from the purchaser for a unit of a product minus any tax on the
product plus any subsidy on the product.

The Circular Flow of Income

Circular flow of income refers to the continuous circulation of production, income

generational and expenditure involving different sectors of the economy. There are three
different interlinked phases in a circular flow of income, namely: production, distribution and
disposition as can be seen from the following figure.

Figure 1.1.1

Circular Flow of Income

Production of
Goods and
Services

Distribution as
Dispositon
factor incomes
Consumption /
(Rent, Wages,
Investment
Interest, Profit)

a. In the production phase, firms produce goods and services with the help of factor
services.

b. In the income or distribution phase, the flow of factor incomes in the form of rent,
wages, interest and profits from firms to the households occurs.

c. In the expenditure or disposition phase, the income received by different factors of

production is spent on consumption goods and services and investment goods. This
 expenditure leads to further production of goods and services and sustains the circular
flow.

Corresponding to the three phases, there are three methods of measuring national income.
They are: Value Added Method (alternatively known as Product Method; Income Method
and Expenditure Method).

1.4.1 Value Added Method or Product Method

Product Method or Value-Added Method is also called Industrial Origin Method or Net
Output Method. National income by value added method is the sum total of net value
added at factor cost across all producing units of the economy. The value-added method
measures the contribution of each producing enterprise in the domestic territory of the
country in an accounting year and entails consolidation of production of each industry
fewer intermediate purchases from all other industries. This method of measurement shows
the unduplicated contribution by each industry to the total output. This method involves the
following steps:

Step1. Identifying the producing enterprises and classifying them into different sectors
according to their activities.

All the producing enterprises are broadly classified into three main sectors namely:

a. Primary sector
b. Secondary sector, and
c. Tertiary sector or service sector

These sectors are further divided into sub-sectors and each sub-sector is further divided into
commodity group or service-group.

Step 2. Estimating the gross value added (GVA MP) by each producing enterprise

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

consumption /value of intermediaries
= (Sales + change in stock) – intermediate consumption
=(sales+change in stock)-(domestic consumption+imports)

Step 3. Estimation of National Income

For each individual unit, Net value added is found out.

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

Adding the net value-added by all the units in one sub-sector, we get the net value-added
by the sub-sector. By adding new value-added or net products of all the sub-sectors of a
sector, we get the value-added or net product of that sector. For the economy as a whole,
we add the net products contributed for each sector to get Net Domestic Product. We
subtract new indirect taxes and add net factor income from abroad to get national income.

Net value added (NVA MP)

– Net Indirect taxes = Net Domestic Product
(NVA FC)
Net Domestic Product (NVA FC) + (NFIA) = National Income (NNP FC)

The values of the following items are also included:

a. Own account production of fixed assets by government, enterprises and households.

b. Production for self-consumption, and
c. Imputed rent of owner-occupied houses.

1.4.2 Income Method

Production is carried out by the combined effort of all factors of production. The factors are
paid factor incomes for the services rendered. In other words, whatever is produced by a
producing unit is distributed among the factors of production for their services.

Under Factor Income Method, also called Factor Payment Method or Distributed Share
Method, national income is calculated by summation of factor incomes paid out by all
production units within the domestic territory of a country as wages and salaries, rent, interest
and profit. By definition, it includes factor payments to both residents and non-residents.

Only incomes earned by owners of primary factors of production are included in national
income. Transfer incomes are excluded from national income. Thus, while wages of
laborer’s will be included, pensions of retired works will be excluded from national income.
Labor income includes, apart from wages and salaries, bonus, commission, employers’
contribution to provident fund and compensations in kind. Non-labor income includes
dividends, undistributed profits of corporations before taxes, interest, rent, royalties and
profits of unincorporated enterprises and of government enterprises.

However, normally, it is difficult to separate labor income from capital income because in
many instances people provide both labor and capital services. Such is the case with self-
employed people like lawyers, engineers, traders, proprietors etc. In economies where
subsistence production and small commodity production is dominant, most of the incomes
of people would be of mixed type. In sectors such as agriculture, trade, transport etc. in
underdeveloped countries (including India), it is difficult to differentiate between the labor
element and the capital element of incomes of the people. In order to overcome this
difficulty a new category of incomes, called ‘mixed income’ is introduced which includes
all those incomes which are difficult to separate.
 INCOME
METHOD(NDPfc)

Rent,royalty , interest & Mixed income

profits(together known
Compensation of employees as operating surplus)
1:wages and salaries in where profits=corporate
cash taxes+dividend+retained
(a)basic pay earnings/ndistributed
(b)dearness allowance reserves &
surplus/corporate
(c):house rent allowance savings
(d):overtime allowance
(e):cost of travel
(f):city compensatory
allowance
(g):bonus and
commissions
(h):sick leave allowance
2:wages & salaries in kind
like free housing,uniform,
medical facilities etc
3:Employer's contribution
to social security schemes
like provident fund,life
insurance etc
To summarise:
Income Method gives as NDPfc
National income(NNPfc)=NDPfc+NFIA

1.4.2 Expenditure Method

In the expenditure approach, also called Income Disposal Approach, national income is the
aggregate final expenditure in an economy during an accounting year. In the expenditure
approach to measuring GDP, we add up the value of the goods and services purchased
by each type of final user mentioned below.

a. Final Consumption Expenditure

1.Private Final Consumption Expenditure (PFCE)

To measure this, the volume of final sales of goods and services to consumer households and
nonprofit institutions serving households acquired for consumption (not for use in production)
are multiplied by market prices and then summation is done.1. It also includes the value of
primary products which are produced for own consumption by the households, payments
for domestic services which one household renders to another, the net expenditure on
foreign assets or net foreign investment.

2:Government Final Consumption Expenditure

Since the collective services provided by the governments such as defence, education,
healthcare etc. are not sold in the market, the only way they can be valued in money terms
is by adding up the money spent by the government in the production of these services.
This total expenditure is treated as consumption expenditure of the government.
Government expenditure on pensions, scholarships, unemployment allowance etc. should
be excluded because these are transfer payments.

3:Gross Domestic Capital formation

Gross domestic capital formation includes final expenditure on machinery and equipment
and own account production of machinery and equipment, expenditure on construction,
expenditure on changes in inventories, and expenditure on the acquisition of valuables such
as jewellery and works of art.

4:Net Exports-Net exports are the difference between exports and imports of a country
during the accounting year. It can be positive or negative
.
 Expenditure method(GDPmp)=sum total of final
expenditures

PFCE(private GFCE(govern Gross domestic capital Net exports(Exports-

final ment final formation(assets)/Gross Imports)
consumption consumption investment [CA INTER
expenditure)= expenditure) DEC’22 ]
personal
consumption
expenditure
+expenditure
of non profit
institutions Inventory Produced fixed
Gross domestic fixed capital
serving investment=closing assets/net acquisition
formation
households stock-opening of valuables
stock

Residential construction Public investment

Business fixed investment

National Income(NNPfc)=GDPmp-depreciation+NFIA-NIT

1.4 The System of Regional Accounts in India

Regional accounts provide an integrated database on the innumerable transactions taking

place in the regional economy and help decision making at the regional level. At present,
practically all the stages and union territories of India compute state income estimates and
district level estimates. State Income or Net Stage Domestic Product (NSDP) is a measure in
monetary terms of the volume of all goods and services produced in the state within a given
period of time (generally a year) accounted without duplication. Per Capita State Income
is obtained by diving the NSDP (State Income) by the midyear projected population of the
state.

The state level estimates are prepared by the State Income Units of the respective State
Directorates of Economics and Statistics (DESs). The Central statistical Organization assists
the States in the preparation of these estimates by rendering advice on conceptual and
methodological problems. In the preparation of state income estimates, certain activities
such as railways, communications, banking and insurance and central government
administration, that cut across state boundaries, and thus their economic contribution
cannot be assigned to any one state directly are known as the ‘Supra-regional sectors’ of
the economy. The estimates for these supra regional activities are compiled for the
economy as a whole and allocated to the states on the basis of relevant indicators.

GDP and Welfare

Can the GDP of a country be taken as index of welfare of people in that country? There are
many reasons to dispute the validity of GDP as a perfect measure of well being.In fact, GDP
measures our ability to obtain many requirements to make our life better, yet leave out many
important aspects which ensure quality of life for all. GDP measures exclude the following which
are critical for the overall well being of the citizens:
 Income distribution, and, therefore GDP per capita is a completely inadequate measure of
welfare. Countries may have significant different income distributions and consequently
different levels of overall well-being for the same level of per capita income.
 Quality improvements in systems and processes due to technological as well as managerial
innovations which reflect true growth in output from year to year
 Productions hidden from government authorities, either because those engaged in it are
evading taxes or because it is illegal. For example drugs gambling etc
 The disutility of loss of leisure time. We know that , other things remaining the same, our
country’s GDP rises if the total hours of work increase.
 Economic bads for example crime,pollution , traffic congestion etc which makes us worse
off.
 Many things that contribute to our economy welfare such as leisure time, fairness, gender
equality, security of community feeling etc.
 Both positive and negative externalities which are external effects that do not form part of
the market transactions .
 The volunteer works and services rendered without remuneration undertaken in the
economy, even though such work can contribute to social well being as much as paid
work.

1.4 Limitations and Challenges of National Income Computation

a. Quality improvements in systems and processes due to technological as well as managerial

innovations which reflect true growth in output from year to year.

b. Production hidden from government authorities, either because those engaged in it

are evading taxes or because it is illegal (drugs, gambling etc.).

c. Nonmarket production (with a few exceptions) and non-economic contributors to

well-being for example: health of a country’s citizens, education levels, political
factors that may significantly affect well-being levels.

d. The disutility of loss of leisure time. We know that, other things remaining the same, a
country’s GSP rises if the total hours of work increase.

e. Economic ‘bads’ for example: crime, pollution, traffic congestion etc. which make us
worse off.

f. The volunteer work and services rendered without remuneration undertaken in the
economy, even though such work can contribute to social well-being as much as
paid work.
 g. Many things that contribute to our economic welfare such as, leisure time, fairness,
gender equality, security of community feeling etc.

There are many conceptual difficulties related to measurement which are difficult to resolve,
such as:

a. Lack of an agreed definition of national income

b. Accurate distinction between final goods and intermediate goods,
c. Issue of transfer payments,
d. Services of durable goods,
e. Difficulty of incorporating distribution of income
f. Valuation of new good at constant prices and
g. Valuation of government services

Other challenges relate to:

a. Inadequacy of data and lack of reliability of available data.

b. Presence of non-monetized sector
c. Production of self-consumption
d. absence of recording of income due to illiteracy and ignorance
e. lack of proper occupation classification, and
f. accurate estimation of consumption of fixed capital
Q 9:Calculate National Income by Value Added Method with the help of
following data-
Particulars ` (in Crores)
Sales 700
Opening stock 500
Intermediate Consumption 350
Closing Stock 400
Net Factor Income from Abroad 30
Depreciation 150
Excise Tax 110
Subsidies 50
 Q 10:Calculate the Operating Surplus with the help of following data-
Particulars ` in Crores
Sales 4000

Compensation of employees 800

Intermediate consumption 600

Rent 400

Interest 300

Net indirect tax 500

Consumption of Fixed Capital 200

Mixed Income 400

Q 11.Calculate national income by value added method.

Value of output in primary sector 2000
Intermediate consumption of primary sector 200
Value of output of secondary sector 2800
Intermediate consumption of secondary 800
sector
Value of output of tertiary sector 1600
Intermediate consumption of tertiary sector 600
Net factor income from abroad -30
Net indirect taxes 300
Depreciation 470

Q 12:Calculate Net Value Added by Factor Cost from the following data
Items ` in Crores
Purchase of materials 85
Sales 450
Depreciation 30
Opening stock 40
Closing stock 30
Excise tax 45
Intermediate consumption 200
Subsidies 15
Q 13:Calculate NI with the help of Expenditure method and income method with
the help of following data:
Items ` in Crores
Compensation of employees 1,20 0

NFIA 20
Net indirect taxes 120
Profit 800
Private final consumption expenditure 2,000

Net domestic capital formation 770

Consumption of fixed capital 130
Rent 400
Interest 620
Mixed income of self-employed 700
Net export 30
Govt. final consumption expenditure 1100
Operating surplus 1820
Employer’s contribution to social security scheme 300
Solution
Q 14:From the following data calculate (a) Gross Domestic Product at Factor Cost, and
(b) Gross Domestic Product at Market price

Items ` in Crores
61,500
Gross national product at factor cost
Net exports (-) 50

Compensation of employees 3000

Rent 800
Interest 900
Profit 1,300
Net indirect taxes 300
Net domestic capital formation 800
Gross domestic capital formation 900
Factor income to abroad 80
Q 15:Calculate NNPFC. By expenditure method with the help of following information-
Items ` in Crores
Private final consumption expenditure 10
Net Import 20
Public final consumption expenditure 05
Gross domestic fixed capital formation 350
Depreciation 30
Subsidy 100
Income paid to abroad 20
Change in stock 30
Net acquisition of valuables 10
 Beyond the books
Q 1. Calculate GVA at FC:

i. Sales 70
ii. Intermediate consumption 40
iii. Opening stock 15
iv. Closing stock 10
v. Subsidies 5
vi. Purchase of raw materials 25
vii. Depreciation 15
viii. Wages and salaries 10

(Ans : GVA at FC=30 lakh)

Q 2:Calculate the value added by firm X and firm Y from the following data:
(i) Sales by firm X. 100
(ii) Sales by firm Y. 500
(iii) Purchases by households from firm Y. 300
(iv)Export by firm Y. 50
(v)change in stock of firm X. 20
(vi)change in stock of firm Y. 10
(vii)imports by firm X. 70
(viii)sales by firm Z to firm Y. 250
(ix)purchases by firm Y from firm X 200
(Ans :value added by firm X=250 and by firm Y=60)
Q 3:From the following data,calculate net value added at FC
Subsidy 40
Sales 800
Depreciation 30
Exports 100
Closing stock 20
Opening stock 50
Intermediate purchases 500
(Ans :280 crores)

Q 4:Calculate the value of output from the following data:

(i) NVA at FC. 100
(ii) intermediate consumption . 75
(iii) Excise duty. 20
(iv) subsidy. 5
(v) depreciation. 10
(Ans :200)

Q 5: Calculate (a)NDP at FC and (b)private income from the following:

(i)Domestic product accruing to the government 300
(ii)wages and salaries. 1000
(iii)net current transfers to abroad. -20.
(iv)Rent. 100
(v)Interest paid by production units. 130.
(vi)national debt interest. 30
(vii)corporate taxes. 50
(viii)current transfers by the government. 40.
(ix)contributions to the social security scheme by the employers. 200
(ix)dividends. 100
(x)undistributed profits. 20.
(xI)NFIA. 0

(Ans :NDP at FC: 1600 cr. private income:1390cr)

Q 6: Find GNPmp and private income:

(i)Private final consumption expenditure. 800.
(ii)Net current transfers to abroad. 20
(iii)net factor income to abroad (-)10.
(Iv)government final consumption expenditure. 300
(v)net indirect taxes. 150
(vi) net domestic capital formation. 200
(vii) current transfers from government. 40.
(viii) depreciation. 100
(ix) net imports. 30
(x)income accruing to government. 90.
(xi)national debt interest.
50

(Ans : GNPmp=1380 cr. Private income 1110 cr)

Q 7 Calculate the national income from income method as well as expenditure method
(i) Government final consumption expenditure. 2000
(ii) Net domestic capital formation. 600
(iii) Consumption of fixed capital. 70
(iv) Net exports. 60
(v) Net indirect taxes 200.
(vi) Private final consumption expenditure. 4000.
(vii)Net factor income to abroad. 60.
(viii)Compensation of employees. 3660
(ix) Profit. 1500.
(x) Interest. 800.
(xi) Dividend. 300
(xii)Rent. 500
[Ans=6400]

Q 8:Calculate intermediate consumption from the following data

(i)value of output. 200
(ii)net Value added at factor cost. 80
(iii)sales tax. 15
(iv)subsidy. 5
(vi)depreciation. 20 (Ans=90)
Q 9:Calculate (a)private income and (b)personal disposable income from the following
500
(i)income from property and entrepreneurship accruing to
government administrative departments

(ii)savings of non departmental enterprises. 100

(iii)corporate taxes. 80.
(iv) income from domestic product accruing to private sector. 4500
(v)current transfers from government administrative departments. 200
(vi)Net factor income from abroad. -50
(Vii)direct personal taxes. 150
(viii)indirect taxes. 220
(ix) current transfers from the rest of the world. 80
(x)savings of private corporation sector 500

[Ans:private income=4730. Personal disposable income=4000]

Q 10:Calculate GNP at MP and National income from the following data:

(i)Government final consumption expenditure. 24

(ii)net indirect taxes. 23
(iii)consumption of fixed capital. 22
(iv)gross domestic capital formation. 24
(v) net exports. -4
(vi)private final consumption expenditure. 161
(vii) net factor income from abroad. -1
(viii)net change in stock. 3
[GNP at MP=204. NI=159]
Q 11:Calculate (I)national income and(ii)net national disposable income from the following data:
Factor income from abroad 15

Private final consumption expenditure 600

Consumption of fixed capital 50

Government final consumption expenditure 200

Net current transfers to abroad (-)5

Net domestic fixed capital formation 110

Net factor income to abroad 10

Net imports (-)20

Net indirect tax 70

Change in stocks (-)10

(Ans:national income:840. NNDI :915)

Q 12:Calculate (I) NDP at FC by expenditure method and (ii)GDP at MP by income method

Gross fixed capital formation 130
Private final consumption expenditure 510
Mixed income of the self employed 280
Net factor income from ROW (-)5
Exports 50
Imports 60
Compensation of employees 240
Government final consumption expenditure 70
Consumption of fixed capital 40
Indirect taxes 90
Subsidies 10
 Rent ,interest and profits 90
Change in stock 30
Interest on national debt 10

[Ans:NDP at FC:610 crores;GDP at MP:730 crores]

Q 13:Calculate National income by expenditure and output method

Gross domestic capital formation 250
Net exports -50
Private final consumption expenditure 1000
Value of output of primary sector 900
Value of output of secondary sector 800
Value of output of tertiary sector 400
Intermediate consumption of primary sector 400
Intermediate consumption of secondary sector 300
Intermediate consumption of tertiary sector 100
Consumption of fixed capital 80
Indirect taxes 100
Government final consumption expenditure 100
Subsidies 10
Net factor income from abroad -20
(Ans:national income:1110 )
 Q 14: Calculate NVA at FC from the following data:

i. Purchase of raw materials 30

ii. Depreciation 12
iii. Sales 200
iv. Excise duty 20
v. Opening stock 15
vi. intermediate consumption 48
vii. closing stock 10
(ans:115)

Q 15:From the following data estimate (i)personal income (ii)private income (iii)personal disposable inc
1. National income 2500
2. Corporate profit tax 25
3. National debt interest 30
4. Direct personal tax 75
5. Savings of private corporate sector 50
6. Income from property and entrepreneurship accruing to the 75
 government administrative departments
7. Current transfers from the government administrative departments 70
8. Savings of the non departmental public enterprises 10
9. Current transfers from the rest of the world 30
(ans:(i)personal income 2470 (ii)private income 2545 (iii)Personal disposable income 2395)

Q 16: Compute National income

Consumption 750
Investment 250
Government Purchases 100
Exports 100
Imports 200
(Ans:1000)

Q 17: Calculate Gross Domestic Product at market Prices (GDPMP) and derivenational income from the
following data (in Crores of `)
Inventory Investment 100
Exports 200
Indirect taxes 100
 Net factor income from abroad - 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
(ans:GDP at MP 5500;NI=5300)

Q 18:Find GDPMP and GNPMP from the following data (in Crores of ` ) using incomemethod. Show that it is the
same as that obtained by expenditure method.
Personal Consumption 7,314
Depreciation 800
Wages 6,508
Indirect Business Taxes 1,000
Interest 1,060
Domestic Investment 1,442
Government Expenditures 2,196
Rental Income 34
Corporate Profits 682
Exports 1,346
Net Factor Income from Abroad 40
Mixed Income 806
Imports 1,408
( Ans:10930 cr)
Q 19: From, the following data calculate the Gross National Product at MarketPrice using Value Added method
(` in Crores)
Value of output in primary sector 500
Net factor income from abroad -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

(Ans:GNP at MP=1300 cr)

Q 20: Calculate ‘Sales’ from the following data :

Particulars ` in Lakhs
Subsidies 200
Opening stock 100
Closing stock 600
Intermediate consumption 3,000
Consumption of fixed capital 700
 Profit 750
Net value added at factor cost 2,000
(Ans:Sales= 5000)

Q 21:Given the following data, determine the National Income of a countryusing expenditure method and
income method:
Particulars ` in
Crores
Private Final Consumption Expenditure 1000
Government Final Consumption Expenditure 550
Compensation of Employees 600
Net Exports -15
Net Indirect Taxes 60
Net Domestic Fixed Investment 385
Consumption of Fixed Capital Formation 65
Net Factor Income from Abroad -10
Interest 310
Rent 200
Mixed Income of Self-Employed 350
Profit 400

(Ans:1850 cr)
Unit II: The Keynesian Theory of Determination of National
Income

2.1 Introduction
In the previous unit we had discussed the ex-post(realized)
measures of national income. In this unit, we will discuss ex-
ante(anticipated/planned) values of the same.
Here,we shall focus on two issues namely, the factors that determine the
level of national income and the determination of equilibrium aggregate
income and output in an economy. A comprehensive theory to explain
these phenomena was first put forward by the British economist John
Maynard Keynes in his masterpiece ‘The General Theory of Employment
Interest and Money’ published in 1936. Before the general theory by
Keynes, economists could not explain how economic depressions
happen, or what to do about them. The classical economists believed
that the economy is self-regulating and is always capable of
automatically achieving equilibrium level at the natural level of real GDP
or output, which is the level of real GDP that is obtained when the
economic resources are fully employed. While circumstances arise from
time to time that cause the economy to fall below or to exceed the
natural level of real GDP, wage and price flexibility will bring the
economy back do the natural level of real GDP. If unemployment or
excess products exist, the wage or price of these will adjust to absorb the
excess. According to them, there will be no involuntary unemployment.
Keynes’ theory of determination of equilibrium real GDP, employment and
prices focuses on the relationship between aggregate income and
aggregate expenditure. There is a difference between equilibrium
income (the level toward which the economy gravitates in the short run)
and potential income (the level of income that the economy is
technically capable of producing without generating accelerating
inflation). Keynes argued that markets would not automatically lead to
full employment equilibrium and the resulting natural level of real GDP.
The economy could settle in equilibrium at any level of unemployment.
Keynesians believe that prices and wages are not so flexible; they are
sticky, specially downwards. The stickiness of prices and wages in the
downward direction prevents the economy’s resources from being fully
employed thereby prevents the economy from returning to the natural
level of real GDP. Therefore, output will remain at less than full
employment as long as there is insufficient spending in the economy. This
was precisely what was happening during the Great Depression.
The Keynesian theory of income determination is presented in three
models:

a. The two-sector model consisting of the household and the

business sectors.

b. The three-sector model consisting of household, business and

government sectors, and

c. The four-sector model consisting of household, business,

government and foreign sectors.

2.2 Circular Flow in a Simple Two-Sector Model

Initially we consider a hypothetical simple two-sector economy. Even

though an economy of this kind does not exist in reality, it provides a
simple and convenient basis for understanding the Keynesian theory of
income determination. The simple two sector economy model assumes
that
 there are only two sectors in the economy viz., households and
firms, with only consumption and investment outlays.
 Households own all factors of production and they sell their factor
services to earn factor incomes which are entirely spent to
consume all final goods and services produced by business firms.
 The business firms are assumed to hire factors of production from
the household; they produce and sell goods and services to the
households and they do not save.
 There are no corporations, corporate savings or retained earnings.
 The total income produced, Y, accrues to the households and
equals their disposable personal income Yd i.e., Y = Yd.
 All prices (including factor prices), a supply of capital and
technology remain constant.
 The government sector does not exist and therefore, there are no
taxes, government expenditure or transfer payments.
 The economy is a closed economy, i.e., foreign trade does not
exist; there are no exports and imports and external inflows and
outflows.
 All investment outlay is autonomous (not determined either by the
level of income or the rate of interest);
 all investment is net and, therefore, national income equals the net
national product.
 Figure 1.2.1

Circular Flow in a Two Sector Economy

Wages, Rent, Interest, Profit

The circular broken lines with arrows show factor and product flows and
present ‘real flows ‘and the continuous line with arrows show ‘money
flows’ which are generated by real flows. These two circular flows-real
flows and money flows are in opposite directions and the value of real
flows equal the money flows because the factor payments are equal to
household incomes. There are no injections into or leakages from the
system. Since the whole of household income is spent on goods and
services produced by firms, household expenditures equal the total
receipts of firms which equal value of output.

Factor Payments = Household Income = Household Expenditure = Total

Receipts of Firms = Value of Output

Equilibrium output occur when the desired amount of output demanded

by all the agents in the economy exactly equals the amount produced
in a given time period. Logically, an economy can be said to be in
equilibrium when the production plans of the firms and the expenditure
plans of the household’s match.

2.3 The Aggregate Demand Function: Two-Sector Model

In a simple two-sector economy aggregate demand (AD) or aggregate

expenditure consists of only two components:

a. Aggregate demand for consumer goods (C ), and

b. Aggregate demand for investment goods (I)

AD = C + I (2.1)

Of the two components, consumption expenditure accounts for the

highest proportion of the GDP. In a simple economy the variable / is
assumed to be determined exogenously and constant in the short run.
Therefore, the short-run aggregate demand function can be written as:

AD = C + ī (2.2)

Where ī = constant investment

2.3.1 The Consumption Function

The positive relationship between consumption spending and disposable

income is described by the consumption function. Consumption
function expresses the functional relationship between aggregate
consumption expenditure and aggregate disposable income, expressed
as:

C = f (Y) (2.3)

The private demand for goods and services accounts for the largest
proportion of the aggregate demand in an economy and plays a crucial
role in the determination of national income. According to Keynes, the
total volume of private expenditure in an economy depends on the total
current disposable income of the people and the proportion of income
which they decide to spend on consumer goods and services. The
specific form of consumption income relationship termed the
consumption function, proposed by Keynes is as follows:

C = a + bY (2.4)

Where C = aggregate consumption expenditure; Y = total disposable

income; a is a constant term which denotes the (positive) value of
consumption at zero level of disposable income; and the parameter b,
the slope of the function, (ΔC / ΔY) is the marginal propensity to consume
(MPC) i.e., the increase in consumption per unit increase in disposable
income.

Figure 1.2.2

The Keynesian Consumption Function

r

The consumption function shows the level of consumption (C)

corresponding to each level of disposable income (Y) and is expressed
through a linear consumption function, as shown by the line marked C =
f(Y) in figure 1.2.2. When income is low, consumption expenditures of
households will exceed their disposable income and households dissave
i.e., they either borrow money or draw from their past savings to purchase
consumption goods. The intercept for the consumption function, a, can
be thought of as a measure of the effect on consumption of variables
other than income, variables not explicitly included in this simple model.

The Keynesian assumption is that consumption increases with an increase

in disposable income, but that the increase in consumption will be less
than the increase in disposable income (b < 1). i.e., 0 < b < 1. This
fundamental relationship between income and consumption plays a
crucial role in the Keynesian theory of income determination.

2.3.2 Marginal Propensity to Consume (MPC)

The consumption function is based on the assumption that there is a

constant relationship between consumption and income, as denoted by
constant b which is marginal propensity to consume. The concept of
MPC describers the relationship between change in consumption (ΔC)
and the change in income (ΔY). The value of the increment to consumer
expenditure per unit of increment to income is termed the Marginal
Propensity to Consume (MPC).

ΔC
MPC = = b ( 2.5 )
ΔY

Although the MPC is not necessarily constant for all changes in income
(in fact, the MPC tends to decline at higher income levels), most analysis
of consumption generally works with a constant MPC.

2.3.3 Average Propensity to Consume (APC)

Just as marginal propensity to consume, the average propensity to

consume is a ratio of consumption defining income consumption
relationship. The ratio of total consumption to total income is known as
the average propensity to consume (APC).

Total Consumption C
APC = = ( 2.6 )
Total Income Y
 Table 2.1

Relationship between Income and Consumption

APC is calculated at various income levels. It is obvious that the

proportion of income spent on consumption decreases as income
increases. What happens to the rest of the income that is not spent on
consumption? If it is not spent, it must be saved because income is either
spent or saved; there are no other used to which it can be put. Thus, just
as consumption, saving is a function of income. S=f(Y).

Note: The conventional Keynesian MPC is assumed to have a constant

value <1 and usually >0.50
.
 2.3.4 The Saving Function

In figure 1.2.3, the consumption and saving functions are graphed. The
saving function shows the level of saving (S) at each level of disposable
income (Y). The intercept for the saving function, (-a) is the (negative)
level of saving at zero level of disposable income at consumption equal
to ‘a’. By definition, national income Y = C + S which shows that
disposable income is, by definition, consumption plus saving. Therefore,
S = Y – C. Thus, when we represent the theory of the consumption –
income relationship, it also implicitly establishes the saving – income
relationship.

The Marginal Propensity to Save (MPS)

The slope of the saving function is the marginal propensity to save. If

one-unit increase in disposable income leads to an increase of b units in
consumption, the remainder (1 – b) is the increase in saving. This
increment to saving per unit increase in disposable income (1 – b) is
called the marginal propensity to save (MPS). In other words, the
marginal propensity to save is the increase in saving per unit increase in
disposable income.
 ΔS
MPS = = 1-b
ΔY

Marginal Propensity to Consume (MPC) is always less than unity, but

greater than zero, i.e., 0 < b < 1 Also, MPC + MPS = 1; we have MPS 0 < b
< 1. Thus, saving is an increasing function of the level of income because
the marginal propensity to save (MPS) = 1 – b is positive, i.e., saving
increase as income increases.

2.1.1 Average Propensity to save (APS)

The ratio of total saving to total income is called average propensity to

save (APS). Alternatively, it is that part of total income which is saved.

Total Saving S
APS = = ( 2.8 )
Total Income Y

LET’S SOLVE
Q 1:What will be the value of APS when –
(i)C=200 at Y =1000 [ans:0.8]
(ii)S=450 at Y=1200[ans:0.375]

Q 2: Calculate MPC and MPS from the following data about an economy which is in
equilibrium:
National income = 2500, autonomous consumption expenditure = 300, investment
expenditure = 100.[ans:MPC=0.84 MPS=0.16]
Q 3: An economy is in equilibrium. Calculate national income from the following-
Autonomous consumption = 100 ; MPS= 0.2, investment expenditure = 200[ans:Y=1500]

Q 4: Suppose the consumption of an economy is given by C =20 + 0.6 Y an investment I = 10

+ 0.2 Y. What will be the equilibrium level of national income?[ans:Y=150]

Q 5: Suppose the consumption function is C = 7 + 0.5 Y, investment is ₹100, find out the
equilibrium level of income, consumption and saving.[ans:Y=214;C=114 & S=100]

Q 6: If the consumption function is C = 250 + 0.80 Y and I = 300 ,find the equilibrium level of
Y, C & S.[Y=2750;C=2450 & S=300]
Q 7: If saving function S is equal to - 10 + 0.2 Y and autonomous investment I = 50 crores. Find
the equilibrium level of income & consumption .If investment increases permanently by
rupees 5,00,00,000, what will be the new level of income and consumption?[ans:Y=300Cr.
C=250 cr; New Y=325 cr New C=270 cr]

Q 8: Given the empirical consumption function C = 100 + .75 Y and I =1000, calculate
equilibrium level of national income. What would be the consumption expenditure at
equilibrium level of national income ?[Y=4400 ;C=3400]
Aggregate Supply-
Ex ante or planned aggregate supply is the total supply of goods and services
which firms in a national economy plan on selling during a specific time. It is
equal to national income of the economy, which is either consumed or saved.
AS=C+S

2.2 The Two-Sector Model of National Income Determination

According to Keynesian theory of income determination, the equilibrium

level of national income is a situation in which aggregate demand (C +
I) is equal to aggregate supply (C + S) i.e.,

C+I=C+S
Or
I=S

In a two-sector economy, the aggregate demand (C + I) refers to the

total spending in the economy i.e., it is the sum of demand for the
consumer goods (C) and investment goods (I) by households and firms
respectively. In figure 1.2.4, the aggregate demand curve is linear and
positively sloped indicating that as the level of national income rises, the
aggregate demand (or aggregate spending) in the economy also rises.
The aggregate expenditure line is flatter than the 45-degree line
because, as income rises, consumption also increases, but by less than
the increase in income.
In figure 1.2.4 showing the consumption and saving functions, the 45º line
illustrates every single point at which planned aggregate expenditure
measured on the Y or vertical axis is equal to the planned aggregate
production, which is measured on the X or horizontal axis.
All points on the 45º line indicate that planned aggregate expenditure
equals planned aggregate output; i.e., the value of the variable
measured on the vertical axis (C+I) is equal to the value of the variable
measured on the horizontal axis (i.e., Y=C+S). Therefore the line maps out
all possible equilibrium income levels.
For all points below the 45 degree line, the planned aggregate
expenditure is lesser than GDP. And for all points above the 45 degree
line, planned aggregate expenditure is greater than GDP.
If an economy is operating on the 45 degree line, then the aggregate
product market is in equilibrium. Ideally we would like equilibrium to occur
at potential GDP, that is, at the level of full employment. Only at point E
and corresponding equilibrium levels of income and output Y0 does
aggregate demand exactly equals aggregate output. At that level of
output and income, planned spending precisely matches production.

Figure 1.2.4

Determination of Equilibrium Income: Two Sector Model

According to Keynes, aggregate demand will not always be equal to
aggregate supply. Aggregate demand depends on household’s plan
to consume and to save. Aggregate supply depends on the producers
plan to produce goods and services. For the aggregate demand and
the aggregate supply to be equal so that equilibrium is established, the
households’ plan must coincide with producer’s plan. The expectations
of businessmen are realized only when aggregate expenditure equals
aggregate income. In other words, aggregate supply represents
aggregate value expected by business firms and aggregate demand
represents their realized value. At equilibrium, expected value equals
realized value. However, Keynes held the view that there is no reason to
believe that:

a. Consumer’s consumption plan always coincides with producers’

production plan, and

b. That producers plan to invest matches always with household’s plan

to save putting it differently, there I no reason for C + I and C + S to be
always equal.

Let us consider a level of income below Y○, for example Y1, generates
consumption as shown along the consumption function. When this level
of consumption is added to the autonomous investment expenditure (I),
the aggregate demand exceeds income; i.e., the (C + I) schedule is
above the 45º line. Equivalently, at all those levels I is greater than S, as
can be seen in panel (B) of the figure 1.2.4. The aggregate expenditures
exceed aggregate output. Excess demand makes businesses to sell
more than what they currently produce. The unexpected sales would
draw down inventories and result in less inventory investment than
business firms planned. They will react by hiring more workers and
expanding production. This will increase the nation’s aggregate income.
It also follows that with demand outstepping production, desired
investment will exceed actual investment.

Conversely, at levels of income above Y○, for example at Y2, output

exceed demand (the 45º line is above the C + I schedule). The planned
expenditures on goods and services are less than what business firms
thought they would be; business firms would be unable to sell as much of
their current output as they had expected. In fact, they have
unintentionally made larger inventory investments than they planned
and their actual inventories would increase. Therefore, there will be a
tendency for output to fall. This process continues till output reaches Y○,
at which current production exactly matches planned aggregate
spending and unintended inventory shortfall or accumulation are
therefore equal to zero. At this point, consumers plan matches which
producers plan and savers plan matches with investors plan.
Consequently, there is no tendency for output to change.

Since C + S = Y, the national income equilibrium can be written as

Y=C+I (2.10)

Since at equilibrium, C = a + bY, and I is constant, by substituting a+bY for C in

Y = C + I, the equilibrium level of national income can be expressed as:

Y=C+I

Y=a+bY+𝐼 ̅

Y-bY=a+𝐼 ̅

Y(1-b)=a+𝐼 ̅

𝑎 + 𝐼̅
𝑌=
1−𝑏
1(𝑎+𝐼)̅
𝑌= 1−𝑏
&

C=a+bY
1 ̅ =a+ 𝑏 (𝑎 ̅
C=a+b[1−𝑏](a+𝐼) 1−𝑏
+ 𝐼)

The savings investment approach OR leakages-injections approach

In a two sector circular flow model, we introduce financial markets and savings
and investment which they facilitate. A leakage is referred to as an outflow of
income from the circular flow model. Leakages are that part of the income
which is not used to purchase goods and services and what households
withdraw from the circular flow. The act of saving by households is called a
leakage from the circular flow model because the income is not spent on
goods and services produced by firm and it will reduce the velocity of the
circular flow. An injection is an inflow of income to the circular flow. Due to an
injection of income in the circular flow, the volume of income increases.
Investment is an injection into the circular flow. The circular flow will be
balanced and therefore in equilibrium when the injections are equal to the
leakages. If at anytime, intended saving is greater than the intended
investment, this would mean that people are spending lesser volume of money
on consumption. As a result, the inventories of goods will pile up . Consequently,
the firms would decrease their production which would lead to a fall in output
and income of the household.
If the leakages > the injections the national income will fall
if injections > leakages, the national income will rise.
The national income will be in equilibrium only when intended saving is equal
to intended investment.
The equality between saving and investment can be seen directly from the
identities in national income accounting. Since income is either spent or saved,
Y = C + S. Without government and foreign trade, aggregate demand equals
consumption plus investment, Y = C + I.
Putting the two together, we have C + S = C + I or S = I. This last equation
indicates that equilibrium can be achieved by equating injections with
leakages.
The saving schedule S slopes upward because saving varies positively
with income, in equilibrium, planned investment equals saving.
Therefore, corresponding to this income, the saving schedule (S)
intersects the horizontal investment schedule (I). This intersection is shown
in panel (B) of figure 1.2.4.

This condition applies only to an economy in which there is no

government and no foreign trade. Without government and foreign
trade, the vertical distance between the aggregate demand (C + I) and
consumption line (C ) in the figure is equal to planned investment
spending, I. You may also find that the vertical distance between the
consumption schedule and the 45º line also measures saving (S = Y – C)
at each level of income. At the equilibrium level of income (at point E in
panel B), and only at that level, the two vertical distances are equal.
Thus, at the equilibrium level of income, saving equals (planned)
investment. By contract, above the equilibrium level of income, Y○,
saving (the distance between 45º line and the consumption schedule)
exceeds planned investment, while below Y○ level of income, planned
investment exceeds saving.

Equilibrium with unemployment or inflation

An important point to remember is that Keynesian with equality of
planned aggregate expenditures and output need not take place at full
employment. It is possible that the rate of unemployment is high. In the
Keynesian model, neither wage nor interest rates will decline in the face
of abnormally high unemployment and excess capacity. Therefore,
output will remain at less than the full employment rate as long as there
is insufficient spending in the economy. Keynes argued that this was
precisely what was happening during the Great Depression.
(i)Deflationary gap
Is the aggregate demand is for an amount of output less than the full
employment level of output, then we say there is deficient demand.
Deficient demand gives rise to a ‘deflationary gap’ or ’recessionary
gap’.
Recessionary gap also known as contractionary gap arises in the
Keynesian model of the macro economy when the equilibrium level of
aggregate production achieved in the short run fall short of what could
be produced at full employment. Recessionary gap occurs when the
economy is in a business cycle contraction or recession.

In the above figure, OQ* is the full employment level of output .For the
economy to be at full employment equilibrium, aggregate demand
should be Q*F. If the aggregate demand is Q*G, it represents a situation
of deficient demand. The resulting deflationary gap is FG. Firms will
experience unplanned buildup of inventories of unsold goods and they
will respond by cutting production and employment leading to decrease
in output and income until the underemployment equilibrium is reached
at E.
Deflationary gap is thus a measure of the extent of deficiency of
aggregate demand and it causes the economy’s income, output and
employment to decline,thus pushing the economy to underemployment
equilibrium. The macro equilibrium occurs at a level of GDP less than
potential GDP, thus there is cyclical unemployment that is rate of
unemployment is higher than the natural rate(demand deficient
unemployment is same as cyclical unemployment).

(ii)Inflationary gap
If the aggregate demand is for an amount of output greater than
the full employment level of output, then we say there is excess
demand. Excess demand gives rise to ’inflationary gap’ which is the
amount by which actual aggregate demand exceeds the level of
aggregate demand required to establish the full employment
equilibrium. This is the sort of gap that tends to occur during a
business cycle expansion and sets in motion forces that will cause
demand pull inflation.

In the above figure, the economy will be at full employment equilibrium at F

with O Q* full employment level of output and income. Suppose the aggregate
demand is for Q*G, there is excess demand and the resulting inflationary gap
FG. The real output will be constant, but the rise in the price level will cause an
increase in the nominal output until the new equilibrium is reached at point E.
Point E is an equilibrium point because the aggregate demand ME is equal to
output OM. At the new equilibrium, real output, real income and employment
will be the same; nominal output and income has increased due to inflation.

Given the intercept a, a steeper aggregate demand function – as would

be implied by a higher marginal propensity to consume – implies a higher
level of equilibrium income. Similarly, for a given marginal propensity to
consume, a high level of autonomous spending implied a higher
equilibrium level of income. Therefore, it may be inferred that a change
in aggregate spending will shift the equilibrium from one point to another
and a shift in the equilibrium which change the level of national income.
An increase in aggregate spending makes the aggregate demand
schedule shift upward. As a result, the equilibrium point would shift
upward along the AS schedule causing an increase in the national
income. Likewise, a fall in the aggregate spending causes a fall in the
national income. This relationship between the aggregate spending and
the national income is simple and straight forward.

2.3 The Investment Multiplier

In our two-sector model, a change in aggregate demand may be

caused by change in consumption expenditure or in business investment
or in both. Since Consumption expenditure is a stable function of
income, changes in income are primarily from changes in the
autonomous components of aggregate demand, especially from
changes in the unstable investment component. We shall now examine
the effect of an increase in investment (upward shift in the investment
schedule) causing an upward shift in the aggregate demand function.

Figure 1.2.5

Effect of Changes in Autonomous Investment

In figure 1.2.5, an increase in autonomous investment by Δ / shifts the
aggregate demand schedule from C + I to C + I + ΔI. Correspondingly,
the equilibrium shifts from E to E ¹ and the equilibrium income increases
more than proportionately from Y○ to Y1 . Why and how does this
happen? This occurs due to the operation of the investment multiplier.

The multiplier refers to the phenomenon whereby a change in an

injection of expenditure will lead to a proportionately larger change (for
multiple change) in the level of national income. Multiplier explains how
many times the aggregate income increases as a result of an increase in
investment. When the level of investment increases by an amount says
ΔI, the equilibrium level of income will increase by some multiple
amounts, ΔY. The ratio of ΔY to ΔI is called the investment multiplier, k.

ΔY
k = ( 2.11 )
ΔI

The size of the multiplier effect is given by ΔY = k ΔI.

For example, if a change in investment of ₹ 2000 million causes a change

in national income of ₹ 6000 million, then the multiplier is 6000/2000 = 3.
Thus, multiplier indicates the change in national income for each rupee
change in the desired investment. The value 3 in the above example
tells us that for every ₹ 1 increase in desired investment expenditure, there
will be ₹ 3 increase in equilibrium national income. Multiplier, there,
expresses the relationship between an initial increment in investment and
the resulting increase in aggregate income. Since the increase in
national income (ΔY) is the result of increase in investment (ΔI), the
multiplier is called ‘investment multiplier’.

The process behind the multiplier can be compared to the ‘ripple effect’
of water.

We find at the end that the increase in income per rupee increase in
investment is:

ΔY 1 1
= =
ΔI 1 - MPC MPS
From the above, we find that the marginal propensity to consume (MPC)
is the determinant of the value of the multiplier and that there exists a
direct relationship between MPC and the value of multiplier. Higher the
MPC, more will be the value of the multiplier, and vice-versa. On the
contrary, higher the MPS, lower will be the value of multiplier and vice-
versa. The maximum value of multiplier is infinity when the value of MPC
is 1 i.e., the economy decides to consume the whole of its additional
income. We conclude that the value of the multiplier is the reciprocal of
MPS.

For example, if the value of MPC is 0.75, then the value of the multiplier is
multiplier is:
1
= 4
0.25

Increase in income due to increase in initial investment, does not go on

endlessly. The process of income propagation slows down and ultimately
comes to a halt. Causes responsible for the decline in income are called
leakages. Income that is not spent on currently produced consumption
goods and services may be regarded as having leaked out of income
stream.

The leakages are caused due to:

a. Progressive rates of taxation which result in no appreciable increase

in consumption despite increase in income.

b. High liquidity preference and idle saving or holding of cash balances

and an equivalent fall in marginal propensity to consume.

c. Increase demand for consumer goods being met out of the existing
stocks or through imports

d. Additional income spent on purchasing existing wealth or purchase

of government securities and shares from shareholders or bond
holders.

e. Undistributed profits of corporations

f. Part of increment in income used for payment of debts

g. In Case of full employment additional investment will only lead to
inflation, and

h. Scarcity of goods and services despite having high MPC.

The MPC on which the multiplier effect of increase in income depends, is

high in under developed countries; ironically the value of multiplier is low.
Due to structural inadequacies, increase in consumption expenditure is
not generally accompanied by increase in production. E.g., increased
demand for industrial goods consequent on increased income does not
lead to increase in their real output; rather prices tend to rise.
An important element of Keynesian model is that they relate to short
period equilibrium and contain no dynamic elements. There is nothing
like Keynesian macro economic dynamics. There is no link between one
period and the next and no provision is made for analysis of processes
through time.
Lets solve
Q 9:In an economy, investment expenditure is increased by 400 crores and
MPC is 0.8. Calculate the total increase in income and savings.[ans:∆Y=2000cr
& ∆S=400 Cr]

Q 10: An increase in investment by 400 crores leads to increase in national

income by 1600 crores. Calculate MPC.[MPC=0.75]
Q 11: In an economy, investment is increased by 600 crores. If the MPC is 0.6,
calculate the total increase in income and consumption
expenditure.[ans:∆Y=1500 cr ;∆C=900 Cr]

Q 12: Suppose in a country, investment increases by rupees 100 crores &

consumption is given by C = 10 + 0.6 Y. How much increase will take place in
income ?[ans:∆Y=250 cr]

DETERMINATION OF EQUILIBRIUM INCOME:THREE SECTOR MODEL

Aggregate demand in the three sector model of closed economy consists of 3
components namely, household consumption(C), desired business investment
demand(I) and the government sector’s demand for goods and services(G).
Thus in equilibrium we have Y = C + I + G
Since there is no foreign sector, GDP and national income are equal.
The three sector, three market circular flow model which accounts for
government intervention pilot highlights the role played by the government
sector. From the above flow chart, we can find it the government sector adds
the following key flows to the model:

(i)Taxes on households and business sector to fund government

purchases
(ii) Transfer payments to household sector and subsidy
payments to business sectors
(iii) Government purchases goods and services from
business sectors and factors of production from
household sector a;nd
(iv) Government borrowing in financial markets to finance
the deficit when taxes fall short of government
purchases.
However,unlike in the two sector model, the whole of national income does
not return directly do the forms as demand for outputs .Here we have two
additional flows:
1. Leakages In addition to consumption expenditure by household,households
save as well as pay taxes to the government.
 a) the saving leakages flow into the financial markets , which means that
the part of that is saved is held in the form of some financial assets like
currency, bank deposits, bonds, equities etc
b) the tax flow goes to the government sector.

2) Injections - There are additional demands for output on the part of business
sector itself for investment and from the government sector. The purchasers
of the investment goods, typically financed by borrowing, are actually the
firms in the business sector themselves.

The three sector Keynesian model is commonly constructed assuming that

government purchases are autonomous. Determination of income can we
explain with the help of aggregate demand and aggregate supply.
AD=C+I+G
AS=C+S+T

The equilibrium national income is determined at a point where both

aggregate demand and aggregate supply are equal, that is,
AD=Y=AS
C+I+G=Y=C+S=T

The diagram below represents the determination of equilibrium level in the

three model.
1) The variables measured on the vertical axis are C, I and G where I and G
are considered constant i.e. they do not depend on income and are
exogenous variables determined by factors outside the model. The lines that
plot I & G are horizontal as their level does not depend on Y. Therefore, C +
I + G schedule lies above the consumption function by a constant amount.
2) The line S + T in the graph plots the value of savings plus taxes. This schedule
slopes upward because saving varies positively with income. Just as
government spending, level of tax receipts(T) decided by the policymakers.
3) The equilibrium level of income is shown at the point E where( C + I + G)
schedule crosses the 45 degree line, and aggregate demand is therefore
equal to income (Y). In equilibrium, it is also true that (s+T) schedule intersects
(I + G) horizontal schedule.

Why other points on the graph are not points of Equilibriom?

1) Consider a level of income below Y1. We find that it generates consumption
as shown along the consumption function. When this level of consumption
is added to the autonomous expenditures (I + G), aggregate demand
exceeds income; the (C + I + G) schedule is above the 45 degree line.
Equivalently at this point, I + G > S+T. With demand outstripping production,
desired investments will exceed actual investment and there will be
unintended inventory shortfall and therefore a tendency for output to rise
2) At levels of income above Y1, output will exceed demand, people are not
willing to buy all that is produced. Excess inventories will accumulate,
leading businesses to reduce their future production. Employment will
 subsequently decline and output will fall back to the equilibrium level . It is
only at Y1 that output is equal to aggregate demand; there is no
unintended inventory shortfall or accumulation and consequently, no
tendency for output to change .

The government sector and income determination

1. Income determination with lump sum tax-
i) We assume that the government imposes lump sum tax i.e. taxes that
do not depend on income,
ii) Government has a balanced budget G= T and
iii) that there are no transfer payments.
 The consumption function is defined as C= a+bYd where
Yd = Y-T (disposable income),T=lump sum tax
Y=a+b(Y-T)+I+G
1
Y=1−𝑏 (𝑎 − 𝑏𝑇 + 𝐼 + 𝐺)

Let’s practice some numericals

Q 13: Suppose we have the following data about a simple economy:
C=10+0.75Yd, I=50, G=T=20 where C is consumption, I is investment, Yd is
disposable income, G is government expenditure and T is tax.
a) Find out the equilibrium level of national income
b) What is the size of the multiplier ?
2: Income determination with lump sum tax and transfer payments
The consumption function is defined as
C = a+bYd
Where Yd=Y-T+TR where T is the lump sum tax and TR is autonomous transfer
payments.
C=a+b(Y-T+TR)
Y=C+I+G
Y= a+b(Y-T+TR)+I+G
Y=a+bY-bT+bTR+I+G
Y-bY=a-bT+bTR+I+G
Y(1-b)= a-bT+bTR+I+G
1
Y= 1−𝑏 ( a-bT+bTR+I+G)

Q 14: Suppose the structural model of an economy is given-

C = 100 + 0.75 Yd ;I=200;G = T = 100, TR= 50, find the equilibrium level of
income.[ans:Y=1450]
Solution:
Y=C+I+G

3: 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:
T=𝑻
̅+tY
Where 𝑻̅=autonomous constant tax
t=income tax rate
T=total tax
The consumption function is:
C=a+bYd
Where Yd=Y-T=Y-𝑻 ̅-tY
C=a+b(Y-𝑇̅-tY)
Therefore the equilibrium level of national income can be measured as-
Y=C+I+G
Y= a+bYd+I+G
Y=a+b(Y-𝑇̅-tY)+I+G
Y=a+bY-b𝑇̅-btY+I+G
Y-bY+btY=a-b𝑇̅+I+G
Y(1-b+bT)= a-b𝑇̅+I+G
1
Y=1−𝑏(1−𝑡) (a-b𝑇̅+I+G)
1
Where 1−𝑏(1−𝑡)represents the tax multiplier.

Q 15:For a closed economy,the following data is given:

C=75+0.5(Y-T),I=80,T=25+0.1 Y,G=100
a) Find out equilibrium income[ans:Y=440.91]
b) What is the Value of multiplier?[ans:1.82]

(iv)income determination with tax as a function of income, government

expenditure and transfer payments
Here consumption function is written as C = a+b(Y –𝑇̅ -tY+TR)
Y=a+b((Y –𝑇̅ -tY+TR)
1
Y=1−𝑏(1−𝑡) (a-b𝑇̅+bTR+I+G)
Q 16: Suppose C = 100 + 0.80( Y – T + TR);I= 200, T= 25 +0.1Y, TR = 50, G = 100
;find out the equilibrium level of income ?(ans:Y=1500)
Determination of equilibrium income four sector model
The four sector model includes all four macro economic sectors, the household
sector, the business sector, the government sector and the foreign sector. The
foreign sector includes households businesses and governments that reside in
other countries. The following flow chart shows the circular flow in a four sector
economy.
In the four sector model, there are three additional flows namely exports,
imports and net capital inflow which is the difference between capital outflow
and capital inflow.The C + I + G +( X – M) line indicates the aggregate demand
or the total planned expenditures of consumers, investors, governments and
foreigners( net exports) at each level income level.
 In equilibrium we have Y=C+ I + G +( X – M )
The domestic economy trades with the foreign sector through exports and
imports. Exports are the injections in the national income, while imports act as
leakages or outflows of national income. Exports represent foreign demand for
domestic output and therefore, are part of aggregate demand . Since imports
are not demands for domestic goods ,we must subtract them from aggregate
demand. The demand for imports has an autonomous consumption and is
assumed to depend on income. Imports depend upon marginal propensity to
import which is the increase in import demand per unit increase in GDP.
The demand for exports depend on foreign income and is therefore
exogenously determined and autonomous. Imports are subtracted from
exports to derive net exports which is the foreign sector’s contribution to
aggregate expenditures. Since imports has an autonomous component(𝑀 ̅ ),
and is assumed to depend on income and marginal propensity to import (m),
the import function is expressed as M =𝑀 ̅ +mY.
Marginal propensity to import m=∆𝑴⁄∆𝒀 is assumed to be constant.

At equilibrium, AD=AS
Where AD=C+I+G+(X-M)
Where C=a+b(Y-T)
M =𝑀 ̅ +MY
The equilibrium level of national income can now be expressed by
Y=C+ I + G +( X – M )
Y=a+b(Y-T)+I+G+X-𝑀̅ −mY
Y-bY+mY=a-bT+I+G+ X-𝑀 ̅
1
Y=1−𝑏+𝑚 (a-bT+I+G+ X-𝑀
̅)

The economy being in equilibrium, suppose export of country increases by ∆ X

autonomously, all factors remaining constant. By incorporating the increase in
exports by ∆ X, equation of a country can be expressed as
1
Y+∆Y=1−𝑏+𝑚 (a-bT+I+G+ X-𝑀 ̅ + ∆𝑋)

1
̅ )+ 1 ∆X
Y+∆Y=1−𝑏+𝑚 (a-bT+I+G+ X-𝑀 1−𝑏+𝑚

1
As Y=1−𝑏+𝑚 (a-bT+I+G+ X-𝑀
̅)
1
We get Y+∆Y=Y+ 1−𝑏+𝑚 ∆𝑋

1
Subtracting Y from both the sides,we get ∆Y= ∆X
1−𝑏+𝑚
∆Y 1
∴∆𝑋=1−𝑏+𝑚

1
The term 1−𝑏+𝑚 is known as foreign trade multiplier whose value is determined by
marginal propensity to consume(b) and marginal propensity to import(m).
 The greater the value of m, the lower will be the foreign trade multiplier. The more
open an economy is to foreign trade(the higher m is), the smaller will be the
 response of income to aggregate demand shocks such as change in government
spending or autonomous changes in investment demand. A change in autonomous
expenditure for example a change in investment spending will have a direct effect
on income and an induced effect on consumption with a further effect on income.
The higher the value of m, larger the proportion of this induced effect on demand
for foreign, not domestic ,consumer goods. Consequently the induced effect on
demand for domestic goods and hence on domestic income will be smaller. The
increase in imports per unit of income constitutes an additional leakage for the
circular flow of income at each round of multiplier process and reduces the value
of autonomous expenditure multiplier .
If in the model, proportionate income tax and government transfer payments are
incorporated, then only the denominator of multiplier will change. If income tax is of form
T=𝑇̅+tY where 𝑇̅ is a constant lump sum, t is the proportion of income tax and TR is
greater than zero and autonomous, then the 4 sector model can be expressed as
Y=C+ I + G +( X – M )
Where C = a+b(Y –𝑇 ̅ -tY+TR)
M =𝑀̅ +MY
The equilibrium level of national income can now be expressed as:
1
Y=1−𝑏(1−𝑡)+𝑚 (𝑎 − 𝑏𝑇̅+bTR+I+G+X-𝑀 ̅)

Equilibrium is identified as the intersection between C +I+G+(X-M)line and the

45 degree line. The equilibrium income is Y. We find that the leakages (S+T+M)
an equal to injections (I+G+X) only at equilibrium level of income.
Only net exports( X – M) are incorporated into the 4 sector model of income
determination. We know that injections increase the level of income and
leakages decrease it. Therefore, if net exports are positive, there is net
injection and national income increases. Conversely if X < M there is net
withdrawal and national income decreases.
In the figure given below ,the foreign sector is included in the model assuming
M > X, the aggregate demand schedule C + I + G shifts downward with
equilibrium point shifting from F to E . The inclusion of foreign sector with M> X
causes a reduction in national income from Y0 to Y1. Nevertheless, when X
>M, the aggregate demand schedule she C +I + G shifts upward causing an
increase in national income.

An increase in demand for exports of a country is an increase in aggregate

demand for domestically produced output and will increase equilibrium
income just as an increase in government spending or an autonomous
increase in investment.
To summarize, an increase in demand for a country’s export has an
expansionary effect on equilibrium income whereas an autonomous increase
in imports has a contractionary effect on equilibrium income.

Q 17: The consumption function is C= 40 + 0.8 Yd, T= 0.1 Y, I = 60 cr, G= 40

crores, X = 58 and M = 0.05 Y. Find out the equilibrium level of income, net
export, Net export if export were to increase by 6.25.(ans:Y=600 cr,net
export=28;net exports if exports to be increased by 6.25=33.27 cr)
Q 18: An economy is characterized by the following equation-
Consumption C=60+0.9Yd
Investment I=10
Government expenditure G=10
Tax T=0
Exports X=20
Imports M=10+0.05Y
What is the equilibrium income?Calculate trade balance and foreign trade
multiplier.[ans:Y=600;trade balance=-20;foreign trade multiplier=6.66]
CHAPTER 2

PUBLIC FINANCE

Unit I: Fiscal Functions: An Overview

THE ROLE OF GOVERNMENT IN AN ECONOMIC SYSYTEM
We first consider why an economic system should be in place. The basic
economic problem of scarcity arises from the fact that on account of
qualitative as well as quantitative constraints, the resources available to any
society cannot produce all economic goods and services,that its members
desire to have. Therefore, 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. The
modern society in general offers three alternative economic systems through
which the decision of resource reallocation may be made namely the
market, the government and a mixed system where both markets and
governments simultaneously determine the resource allocation.
Correspondingly, we have three economic systems namely, capitalism ,
socialism and mixed economy ,each with varying degrees of state
intervention in economic activities.
Adam Smith is often described as a bold advocate of free markets and
minimal governmental activity. However smith saw an important resource
allocation role for government when he underlined the role of government in
 National Defence,
 maintenance of justice and rule of law,
 establishment and maintenance of highly beneficial public institutions
and public works
which the market may fail to produce on account of lack of sufficient
profits.
Since the 1930s, more specifically as a consequence of Great
Depression, the state’s role in the economy has been distinctly gaining
importance and therefore, the traditional functions of the state as
described above, have been supplemented with economic functions
also known as fiscal functions or public financial functions. Though there
are differences among different countries in respect of the nature and
extent of government intervention in economies, all of them agree on
one point that the governments are expected to play a major role in
the economy.
Richard Musgrave, in his classic treatise,”The Theory of Public
Finance“(1959 )introduced the three branch taxonomy of the role of
the government in a market economy. Musgrave believed that, for
conceptual purposes, the functions of the government are to be
separated into three namely
 resource allocation(efficiency),
 income redistribution( fairness );and
 macroeconomic stabilization.

The allocation and distribution functions are primarily microeconomic

functions while stabilization is a macro economy function.
The allocation function aims to correct the sources of inefficiency in the
economic system while the distribution role ensures the distribution of
wealth and income is fair. Monetary and fiscal policies, the problems of
a macroeconomic stability, maintenance of high level of employment
and price stability fall under the stabilization function.

1:THE ALLOCATION FUNCTION

Resource allocation refers to the way in which the available resources
or 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.
Resource allocation is a critical problem because the resources of a
society are limited in supply, while human wants are unlimited.
Moreover, any given resource can have many alternative uses. 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.

The private sector resource allocation is characterized by market

supply and demand and price mechanism as determined by
consumer sovereignty and producer profit motives. The state’s
allocation, on the other hand, is accomplished through the revenue
and expenditure activities of governmental budgeting. In the real
world, resource allocation is both market determined and
government determined.

A market economy is subject to serious malfunctioning in several

basic respects. There is also the problem of non existence of markets
in a variety of situations. While private goods will be sufficiently
provided by the market, public goods will not be produced in
sufficient quantities by the market.

Efficient allocation of available resources in an economy takes place

only when free and competitive market structure exists and
economic agents make rational choices and decisions. Such efficient
allocation of resources is assumed to take place only in perfectly
competitive markets. But in reality, markets are never perfectly
competitive. Market failures occur due to following reasons:
 imperfect competition and presence of monopoly power in
different degrees leading to under production and higher
 prices than would exist under conditions of competition. These
distort the choices available to consumers and reduce their
welfare.
 Markets typically fail to provide collective goods which are, by
their very nature, consumed in common by all people.
 Markets fail to provide the right quantity of merit goods.
 Common property resources are overused and exhausted in
individual pursuit of self interest.
 Externalities which arise when the production and consumption
of a good or service affect people and they cannot influence
through market their decision about how much of the good or
service should be produced e.g. pollution.
 Factor immobility which causes unemployment and
inefficiency
 Imperfect information;and
 Inequalities in the distribution of income and wealth.
According to Musgrave, the stat\e is the instrument by which the needs and
concerns of the citizens are fulfilled and therefore, public finances is connected
with economic mechanisms that should ideally lead to the effective and
optimal allocation of limited resources. This makes necessary for the
government to intervene in the market to bring about improvement in social
welfare. In the absence of appropriate government intervention, market
failures may occur and the resources are likely to be misallocated with too
much production of certain goods or too little production of certain other
goods. The allocation responsibility of the governments involve common
suitable corrective action when private markets fail to provide the right and
desirable combination of goods and services. Briefly put, market failures
provide the rationale for government allocative function.

A variety of allocation instruments are available by which government can

influence resource allocation in the economy. For example
 Government may directly produce an economy good( for example
electricity and public transportation services)
 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)
 Government may influence allocation through its competition policies,
merger policies etc which affect the structure of industry and
commerce(for example the Competition Act in India promotes
competition and prevents anticompetitive activities.)
 Government regulatory activities such as licensing, controls, minimum
wages and directives on location of industry influence resource
allocation
 Government sets legal and administrative frameworks
 Any mixture of intermediate methods may be adopted by governments.
2:Redistribution Function

A major function of present-day governments involves changing the

pattern of distribution of income from what the market would offer to a
more egalitarian one. The distribution responsibility of the government
arises from the fact that, left to the market, the distribution of income and
wealth among individuals in the society is likely to be skewed and
therefore the government has to intervene to ensure a more desirable
and just distribution.

The distributive function of budget is related to the basic question for

whom should an economy produce goods and services. As such, it is
concerned with the adjustment of the distribution of income and wealth
so as to ensure distributive justice namely, equity and fairness.
Governments can redistribute either through the expenditure side or
through the revenue side of the budget. On the expenditure side,
governments may provide free or subsidized education, healthcare,
housing, food and basic goods etc to deserving people. On the revenue
side, redistribution is done through progressive taxation.

The distribution function also relates to the manner in which the effective
demand over the economic goods is divided among the various
individual and family spending units of the society. Effective demand is
determined by the level of income of the households and this in turn
determines the distribution of real output among the population.

The distribution function of the government aims at:

 Redistribution of income to achieve an equitable distribution of

societal output among households.

 Advancing the well-being of those members of the society who

suffer from deprivations of different types.

 Providing equality in income, wealth and opportunities.

 Providing security (in terms of fulfilment of basic needs)for people

who have hardships, and

 Ensuring that everyone enjoys a minimal standard of living

A few examples of the redistribution function (or market intervention for
socio-economic reasons) performed by governments are:

 Taxation policies of the government whereby progressive taxation

of the rich is combined with provision of subsidy to the poor
households.

 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)

 Employment reservations and preferences to protect certain

segments of the population,

 Unemployment benefits and transfer payments to provide support

to the underprivileged, dependent and physically handicapped.

 Families below the poverty line are provided with monetary aid and
aid in kind.

 Regulation of the manufacture and sale of certain products to

ensure the health and well-being of consumers, and

 Special schemes for backward regions and for the vulnerable

sections of the population.

Government’s redistribution policies which 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. This in turn will have negative consequences
for productivity and growth of the economy. Consequently, the
potential tax revenue may be reduced and the scope for government’s
welcome activities would get seriously limited.

Redistribution measures should be accomplished with minimal efficiency

costs by carefully balancing equity and efficiency objectives.

3:Stabilization Function
The rationale for the stabilization function of the government is derived
from the Keynesian proposition that a market economy does not
automatically generate full employment and price stability and
therefore the governments should pursue deliberate stabilization policies.
Business cycles are natural phenomena in any economy and they tend
to occur periodically. The market system has inherent tendencies to
create business cycles. The market mechanism is limited in its capacity
to prevent or to resolve the disruptions caused by the fluctuations in
economic activity. In the absence of appropriate corrective intervention
by the government, the instabilities that occur in the economy in the form
of recessions, inflation etc., may be prolonged for longer periods causing
enormous hardships to people especially the poorer sections of society.
It is also possible that a situation of stagflation (a state of affairs in which
inflation and unemployment exist side by side) may set in and make the
problem more intricate. The stabilization issue also becomes more
complex as the increased international inter-dependence causes forces
of instability to get easily transmitted from one country to other countries.
This is also known as contagion effect.

The stabilization function is one of the key functions of fiscal policy and
aims at eliminating macroeconomic fluctuations arising from suboptimal
allocation.

The stabilization function is concerned with the performance of the

aggregate economy in terms of:

 Labour employment and capital utilization

 Overall output and income
 General price levels
 Balance of international payments, and
 The rate of economic growth.

Government’s fiscal policy has two major components which are

important in stabilizing the economy.

1. 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.

2. A microeconomic effect generated by the specific policies it

adopts.
Government’s stabilization intervention may be through:

i. Monetary policy has a singular objective of controlling the size of

money supply and interest rate in the economy which in turn would
affect consumption, investment and prices.

ii. Fiscal policy attempts to direct the actions of individuals and

organizations by means of its expenditure and taxation decisions.
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.

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. The nature of the budget (surplus or deficit) also has
important implications on a country’s economic activity. While deficit
budgets are expected to stimulate economic activity, surplus budgets
are thought to slow down economic activity. Generally, governments
fiscal policy has a strong influence on the performance of the macro
economy in terms of employment, price stability, economic growth and
external balance.
 Unit II: Market Failure

2.1 The Concept of Market Failure

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. The reason for market failure lies
in the fact that though perfectly competitive markets work efficiently,
most often the prerequisites of competition are unlikely to be present in
an economy. Market failures are situations in which a particular market,
left to itself, is inefficient.

There are two aspects of market failures namely, demand-side market

failures and supply side market failures. Demand-side market failures are
said to occur when the demand curves do not take into account the full
willingness of consumers to pay for a product. For example, none of us
will be willing to pay to view a wayside fountain because we can view it
without paying. Supply-side market failures happen when supply curves
do not incorporate the full cost of producing the product. For example,
a thermal power plant that uses coal may not have to include or pay
completely for the costs to the society caused by fumes it discharges into
the atmosphere as part of the cost of producing electricity.

2.2 Why do Markets Fail?

The pertinent question here is why do markets fail? There are four major
reasons for market failure. They are:

 Market power
 Externalities
 Public goods, and
 Incomplete information

2.2.1 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. Firms that
have market power are price makers and therefore, can charge a price
that gives them positive economic profits. Excessive market power
causes the single producer or a small number of producers to produce
and sell less output than would be produced in a competitive market.
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. In the extreme case, there is the problem of nonexistence of
markets or missing markets resulting in failure to produce various goods
and services, despite the fact the such products and services are wanted
by people. For example, the markets for pure public goods do not exist.

2.2.2 Externalities

Costs or benefits which are not accounted for by the market price are
called externalities because they are “external” to the market. In other
words, 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. The unique
feature of an externality is that it is initiated and experienced not through
the operation of the price system, but outside the market. Since it occurs
outside the price mechanism, it has not been compensated for, or in
other words it is uninternalized or the cost (benefit) if it is not borne (paid)
by the parties.

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 other who are not responsible for
initiating the effect.

Externalities may be:

a. Unidirectional: If an accountant who is disturbed by loud music

but has not imposed any externality on the singers.

b. Reciprocal: Suppose a workshop creates earsplitting noise and

imposes an externality on a baker who produces smoke and
disturbs the workers in the workshop.

Externalities can be:

a. Positive: Positive externalities occur when the action of one party

confers benefits on another party.
b. Negative: Negative externalities occur when the action of one
party imposes costs on another party
The four possible types of externalities are:
 i. Negative production externalities
ii. Positive production externalities
iii. Negative consumption externalities and
iv. Positive consumption externalities

Negative Production Externalities

A negative externality initiated in production which imposes an external

cost on others may be received in consumption or in production.
 A negative production externality initiated in production and
received in consumption occurs when a factory which produces
aluminum discharges untreated waste water into a nearby river
and pollutes the water causing health hazards for people who use
the water for drinking and bathing.
 A negative production externality initiated in production received
in production occurs when pollution of river also affects fish output
as there will be less catch for fishermen due to loss of fish resources.

The firm, however, has no incentive to account for the external costs that
it imposes on consumers of river water or fishermen when making its
production decision. Additionally, there is no market in which these
external costs can be reflected in the price of aluminum.

Positive Production Externalities

A positive production externality initiated in production that confers

external benefits on others may be received in production or in
consumption. Example of positive production externality received in
production is the case of a firm which offers training to its employees for
increasing their skills. The firm generates positive benefits on other firms
when they hire such workers as they change their jobs.

A positive production externality is received in consumption when an

individual raises an attractive garden and the persons walking by enjoy
the garden. These external effects are not in fact taken into account
when the production decisions were made.

Negative Consumption Externalities

Negative consumption externalities initiated in consumption which
produce external costs on others may be received in consumption or in
production. Examples of negative consumption externality received in
consumption of smoking cigarettes in public place causing passive
smoking by others, creating litter and diminishing the aesthetic value of
the room and playing the radio loudly obstructing one from enjoying
concert.

The act of undisciplined students talking and creating disturbance in a

class preventing teachers from making effective instruction and the case
of excessive consumption of alcohol causing impairment in efficiency for
work and production are instances of negative consumption externalities
affecting production.

Positive Consumption Externalities

A positive consumption externality initiated in consumption that confers

external benefits on others may be received in consumption or in
production.

Positive consumption externality received in consumption- example, if

people get immunized against contagious diseases, they would confer
a social benefit to others as well as preventing others from getting
infected.

Positive consumption externality received in production-Consumption of

the services of a health club by the employees of a firm would result in
an external benefit to the firm in the form of increased efficiency and
productivity.

Private costs and social costs

Private cost is the cost faced by the producer or consumer directly

involves in a transaction. If we take the case of a producer, his private
cost includes direct cost of labour, materials, energy and other indirect
overheads.

Social costs refer to the total costs to the society on account of a

production or consumption activity. Social costs are private costs borne
by individuals directly involved in a transaction together with the external
costs borne by third parties not directly involved in the transaction.
 Social Cost = Private Cost + External Cost

Social benefits are the total benefits accrued to the society from an
economic activity. Social benefits can we define this private benefits plus
benefits to third parties (i.e. private benefits + total positive externalities.)

The presence of externalities creates a divergence between private and

social costs of production. When negative production externalities exist,
social costs exceed private cost because the true social cost of
production would be private cost plus the cost of the damage from
externalities. If producers do not take into account the externalities,
there will be over-production and market failure. Applying the same
logic, negative consumption externalities lead to a situation where the
social benefit of consumption is less than the private benefit.

Externalities cause market inefficiencies because they hinder the ability

of market prices to convey accurate information about how much to
produce and how much to consume.

A market exchange assumes that the participants have total control over
every aspect of their product and that the prices (or fees) they charge
represent the full cost of production plus profit. As a matter of fact, the
producers of products with extensive negative externalities are not fully
accountable for the full cost of their production which includes private
as well as social costs. Like in our earlier case of the aluminum factory
which causes pollution of river water. As a matter of fact, the prices of
aluminum tend to reflect only the private costs of the producer. Since
externalities are not reflected in market prices, they can be a source of
economic inefficiency. Production remains efficient only when all
benefits and costs are paid for. Negative externalities impose costs on
society that extend beyond the cost of production as originally intended
by the producer. Without government intervention, such a producer will
have no reason to consider the social costs of pollution. When firms do
not worry about the negative externalities associated with their
production, the result is excess production and unnecessary social costs.
The problem, though serious, does not usually float up much because:

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

Some important terms to know

 Marginal private cost(MPC) is the change in the producer’s total
cost brought about by the production of an additional unit of a
good or service. It is also known as marginal cost of production(
Represented by the supply curve)

 Marginal external cost(MEC) is the change in the cost to parties

other than the producer or buyer of a good or service due to an
additional unit of the good or service.

 Marginal social cost(MSC) is the change in society’s total cost

brought about by an additional unit of a good or service.
MSC=MPC+MEC

 Marginal private benefit(MPB) is the marginal willingness to pay

(represented by the demand curve)

 Marginal external benefit(MEB) is the change in the benefit to

parties other than the producer or buyer of a good or service due
to an additional unit of a good or service.

 Marginal social benefit(MSB) is the change in society’s total

benefits associated with an additional unit of a good or service.

MSB =MPB+MEB

 When no externality is present, there are no external costs and

marginal cost is same as the marginal private cost and marginal
social benefit is the same as the marginal private benefit. Therefore
MPC=MSC and MPB = MSB
 If an externality is present, then either MSC ≠ MPC or MSB≠ MPB or
both and hence equilibrium (where MPC=MPB) is unlikely to be
efficient.
Now the question is what is socially optimal output? It is that amount of
output which takes into account all benefits(private as well as external)
and all costs (private as well as external). When we want to find out
whether social efficiency is achieved or not, we need to compare
marginal social benefits to marginal social cost. The condition for
efficiency and optimum output is MSB= MSC. It means the last unit
produced should yield benefits to society that exactly equals the cost to
society for producing the last unit first.
The problem can be explained with the help of the figure below:

Figure 2.2.1

Negative production Externalities and Loss of Social welfare

The equilibrium level of output that would be produced by a free market is Q1

at which MPB = MPC.
We assume that there are no externalities arising from consumption,so
MPB=MSB.
So,social efficiency occurs at Q2 level of output where MSC= MSB.
Output Q1 is socially inefficient because at Q1, MSC> MSB and represents
overproduction. The shaded triangle represents the area of deadweight
welfare loss. It indicates the area of overconsumption.
Thus we conclude that when there is a negative externality,a competitive
market will produce too much output relative to the social optimum and
failed to provide the correct signals.
 2.2.3 Public Goods

Paul A. Samuelson who introduced the concept of ‘collective

consumption good’ in his path-breaking 1954 paper ‘The Pure Theory of
Public Expenditure’ is usually recognized as the first economist to develop
the theory of public goods. A public good (also referred to as collective
consumption goods or social good) is defined as one which all enjoy in
common in the sense that each individual’s consumption of such a good
lead to no subtraction form any other individual’s consumption of that
good.

Characteristics of Private Goods

 Private goods refer to those goods that yield utility to people.

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 goods 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. In other words, simultaneous
consumption of rivalrous good by more than one person is
impossible.

 Private goods are ‘excludable’ i.e., it is possible to exclude or

prevent consumers who have not paid for them from consuming
them or having access to them, in other words, those who want to
consume private goods must buy them at a price from its sellers.

 Private goods do not have the free rider problem. This means that
the private goods will be available to only those persons who are
willing to pay for it.

 Private goods can be parcelled out among different individuals

and therefore it is possible to refer to total consumption as the sum
of each individual’s consumption. Therefore, the market demand
curve for a private good is obtained by horizontal summation of
individual demand curves.

 All private goods and services can be rejected by the consumers if

their needs, preferences or budgets change.
  Additional resource costs are involved for producing and supplying
additional quantities of private goods.

 Normally, the market will efficiently allocate resources for the

production of private goods.

Most of the goods produced and consumed in an economy are private

goods. A few examples are: food items, clothing, movie ticket, television,
cars, houses etc.

Characteristics of Public Goods

 Public goods yield utility to people and are products (goods or

services) whose consumption is essentially collective in nature. No
direct payment by the consumer is involved in the case of pure
public goods.

 Public good is non-rival in consumption. It means that consumption

of a public good by one individual does not reduce the quality or
quantity available for all other individuals. When consumed by one
person, it can be consumed in equal amounts by the rest of the
persons in the society. For example, if you walk in street light, other
persons too can walk without any reduced benefit from the street
light.

 Public goods are non-excludable. If the good is provided, one

individual cannot deny other individuals’ consumption .Provision of
a public good by government means provision for all. For example,
national defence once provided, it is impossible to exclude anyone
within the country from consuming and benefiting from it.

 Public goods are characterized by indivisibility. For example, you

can buy chocolates or ice cream as separate units, but a
lighthouse, a highway, an airport, defence, clean air etc. cannot
be consumed in separate units.

 Public goods are generally more vulnerable to issues such as

externalities, inadequate property rights and free rider problems.

Once a public good is provided, the additional resource cost of another

person consuming the goods is ‘zero’.A good example is a lighthouse
near a seashore to guide the ships. Once the beacon is lit, an additional
ship can use it without any additional cost of provision.

Public goods are generally divided into two categories namely, public
consumption goods and public factors of production. A few examples
of public goods are national defence, highways, public education,
scientific research which benefits everyone, law enforcement,
lighthouses, fire protection, disease prevention and public sanitation .

Classification of Public Goods

 Goods in category A are rival in consumption and are excludable.

These are also known as pure private goods.

 Goods in category D which are characterized by both non-

excludability and non-rivalry properties are called pure public
goods. A pure public good is non-rival as well as non-excludable.
The benefit that an individual gets from a pure public good does
not depend on the number of users. The clarity of a radio
reception, for example, is generally independent of the number of
other listeners.

 Consumption goods that fall in category B are rival but not

excludable. Common resources would come under this. The
examples include public parks, public roads in a city etc.

 Goods in category C 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. A good example of
this is DTH cable TV service or Digital goods. The consumption of
these is non-rival in nature but exclusion of households who do not
pay is feasible.

Pure and Impure Public Goods

There are many hybrid goods that possess some features of both public
goods. These goods are called impure public goods and partially
rivalrous or congestible. Because of the possibility of congestion, the
benefit that an individual gets from impure public good depends on the
number of users, Consumption of these goods by another person
reduces, but does not eliminate, the benefits that other people receive
from their consumption of the same good. For example, open access
Wi-Fi networks become crowded when more people access it. Impure
public goods also differ from pure public goods in that they are often
excludable.

An example of an impure public good would-be cable television. It is

non-rivalrous because the use of cable television by other individuals will
in no way reduce your enjoyment if it. The good is excludable since the
cable TC service providers can refuse connection if you do not pay for
set top box and recharge it regularly.

Impure public goods only partially satisfy the two public good
characteristics of non-rivalry in consumption and non-excludability.

1. Since free riding can be eliminated, the impure public good may be
provided either by the market or by the government at a price or fee.
If the consumption of a good can be excluded, then, the market
would provide a price mechanism for it.

2. The provider of an impure public good may be able to control the

degree of congestion either by regulating the number of people who
may use it, or the frequency with which it may be used or both.

Two broad classes of goods have been included in the studies related to
impure public goods.

1. Club goods; first studied by Buchanan

2. Variable use public goods; first analyzed by Oakland and Sandmo

Examples of club goods are: facilities such as swimming pools, fitness

centers etc. These goods are replicable and, therefore, individuals who
are excluded from one facility may get similar services from an
equivalent provider.

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 do, the frequency of usage of the public good
can be controlled. Since they are not replicable, the facility should be
accessible to all potential users. Why should we exclude the enjoyment
of roads, bridges etc. of some people? The reason in the possibility if
congestion due to large number of vehicles and the potential reduction
of benefit to the users.

Quasi-Public Goods (Mixed Goods)

This second approach to classification of impure public goods focuses

on the mix of services that arise from the provision of the good.

The quasi-public goods or services, also called a near public good (for
e.g., education, health services) possess nearly all 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 result 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.

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. The external effect associated with the consumption
of a private good may have the characteristics of a public good.

Similarly, education will improve the individual’s earning potential and at

the same time, it may facilitate basic research creating nonrival non
excludable knowledge and information which are public goods. Other
examples of benefits to the society through education are improvement
in decision making behavior, provision of screening device for the labor
market to determine the quality of labour and better cultural
environment and heritage for future generations.
Markets for the quasi public goods are considered to be incomplete
markets and their lack of provision by free markets would be considered
as inefficiency and market failure.

Common Access Resources

Common access resources or common pool resources are a special

class of impure public goods which are non-excludable as people
cannot be excluded from using them. These are rival in nature and their
consumption lessens the benefits available for others. This rival nature of
common resources is what distinguishes them from pure public goods,
which exhibit both non-excludability and non-rivalry in consumption.
They are generally available free of charge. Some important natural
resources fall into this category.

Since price mechanism does not apply to common resources, producers

and consumers do not pay for these resources and there, they overuse
them and cause their depletion and degradation. This creates threats to
the sustainability of these resources and, therefore the availability of
common access resources for future generations.

Economists use the term ‘tragedy of the commons’ to describe the

problem which occurs when rivalrous but non excludable goods are
overused, to the disadvantage of the entire world.

Examples of common access resources are fisheries, common pastures,

rivers, sea, backwaters biodiversity etc. 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
endangering environmental sustainability. Although nations are aware
of the fact that reduced global warming would benefit everyone, they
have an incentive to free ride, with the result that nothing positive is likely
to be done to correct the problem.
Tragedy of the Commons
The problem of the tragedy of the Commons was first described and
analyzed by Garrett Hardin in his article “The tragedy of the
Commons“(1968). Economists use the term to describe the problem
which occurs when rivalrous but non excludable goods are overused to
the disadvantage of the entire world. The term “Commons “is derived
from the traditional English legal term of common land where farmers/
peasants would graze their livestock, hunt and collect wild animals and
other produce. Everyone has access to a commonly held pasture, there
are no rules about sustainable numbers for grazing. The outcome of the
individual rational economic decisions of cattle owners was market
failures because these actions resulted in degradation, depletion or even
destruction of the resource leading to welfare loss for the entire society.

Global Public Goods

There are several public goods benefits of which accrue to everyone in

the world. These goods have widespread impact on different countries
and regions, population groups and generations. These are goods
whose impacts are indivisibly spread throughout the entire globe. Global
public goods maybe
 Final public goods which are ‘outcomes’ such as ozone layer
preservation or climatic change preservation or
 Intermediate public goods, which contribute to the provision of
final public goods for example international health regulations.
T
he World Bank identifies five areas of global public goods which it seeks
to address namely,
 the environmental commons (including the prevention of climate
changes and biodiversity),
 communicable diseases (including HIV/AIDS, tuberculosis, malaria
and avian influenza),
 international trade,
 international financial architecture, and
 global knowledge for development.
The distinctive characteristic of global public goods is that there is no
mechanism (either market or government) to ensure an efficient
outcome.
The Free Rider Problem

Free riding is ‘benefiting from the actions of others without paying’. A

free rider is a consumer or producer who does not pay for nonexclusive
good in the expectation that others will pay.for e.g. Wikipedia, a free
encyclopedia faces a free rider problem. Hundreds of millions of people
use Wikipedia every month but only a small part of users pay to use it. A
large majority of Wikipedia users do not pay to use the site but are able
to benefit from the information provided by the website. The free rider
problem occurs when everyone enjoys the benefit of a good without
paying for it. Since private goods are excludable, free riding mostly
occurs in case of public goods. The free rider problem leads to under
provision of a good or service and thus causes market failure.

Public goods provide a very important example of market failure, in

which the self-interested behavior of individuals does not produce
efficient results. We shall now see how free riding is applicable in the 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. If
individuals cannot be excluded from the benefit of a public good, then
they are not likely to express the value of the benefits which they receive
as an offer to pay. In other words, they will not express to buy a particular
quantity at a price. Briefly put, there is not incentive for people to pay
for the good because they can consume it without paying for it. There is
an important implication for this behavior. If every individual plays the
same strategy of free riding, the strategy will fail because nobody is willing
to pay and therefore, nothing will be provided by the market. Then, a
free ride for anyone become impossible.

On account of the free rider problem, there is no meaningful demand

curve for public goods. If individuals make no offers to pay for public
goods, then the profit maximizing firms will not produce them.

In fact, the public goods are valuable for people. If there is no free rider
problem, people would be willing to pay for them and they will be
produced by the market. At such, if free-ride problem cannot be solved,
the following two outcomes are possible:

1. No public good will be provided in private markets

 2. Private markets will seriously under produce public goods even
though these goods provide valuable service to the society.

2.2.4 Incomplete Information

Complete information is an important element of competitive market.

Perfect information implies that both buyers and sellers have complete
information about anything that may influence their decision making.
However, this assumption is not fully satisfied in real numbers due to the
following reasons.

 Often, the nature of products and services tends to be highly

complex e.g., Cardiac surgery, financial products (such as pension
products mutual funds etc.).

 In many cases consumers are unable to quickly / cheaply find

sufficient information on the best prices as well as quality for
different products. Sometimes they misunderstand the true costs or
benefits of a product or are uncertain about the true costs and
benefits.

 People are ignorant or not aware of many matters in the market.

Generally they have inaccurate or incomplete data and
consequently make potentially wrong choices or decisions.

Information failure is widespread in numerous market exchanges. When

this happens misallocation of scarce resources takes place and
equilibrium price and quantity is not established through price
mechanism. This results in market failure.

2.2.5 Asymmetric Information

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. This phenomenon, which
is sometimes referred to as the ‘lemons problem’, is an important source
of market failure. With asymmetric information, low-quality goods can
drive high-quality goods out of the market.

Adverse Selection

Asymmetric information generates adverse selection which results from

hidden attributes that can distort the usual market process and affect a
transaction before it occurs. It generally refers to a situation in which one
party to a contract or negotiation possesses information relevant to the
contract or negotiation that the other party does not have. This leads the
party lacking relevant knowledge to make suboptimal decisions and
suffer adverse effects. Adverse selection is a situation in which
asymmetric information about quality eliminates high-quality goods from
a market. It can also lead to missing markets .

One example of adverse selection is that of health insurance. If the

health insurance companies could costlessly identify the health risk of
buyers, then there is no asymmetric information and therefore, insurers
could offer low premiums to the low risk buyers and high premiums to the
high risk buyers. As a matter of fact, compared to insurance buyers,
insurers know less about the health condition of buyers and are therefore
unable to differentiate between high risk and low risk persons. Due to the
tendency of people with higher health risks to obtain insurance coverage
to a greater extent than persons with lesser risk, the proportion of
unhealthy people in the pool of insured people increases. In such
situations, an insurance company extends insurance coverage to an
applicant whose actual risk is substantially higher than the risk known by
the insurance company. By not revealing the actual state of health, an
applicant is leading the insurance company to make decisions on
coverage or premium costs that are adverse to the insurance company’s
management of financial risks. This forces the price of insurance to rise,
so that more healthy people, aware of their low risks, choose not to be
insured. This further increases the proportion of unhealthy people among
the insured, thus raising the price of insurance up more. The process
continues until most people who want to buy insurance are unhealthy.
At that point, insurance becomes more costly or in the extreme,
insurance companies stop selling the insurance leading to missing
markets .This is a market failure.
When dealing with the problems of asymmetric information, the most
frequently cited and studied example in economics is the one
developed by George Akerlof which distinguishes cars classified as good
from those defined as “lemons’( poor quality vehicles). The owner of a
car knows much more about its quality than anyone else. By placing it
for sale, he may not disclose all that he knows about the mechanical
defects of the vehicle. Based on the probability that the car on sale is a
lemon, 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 their 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.

Moral Hazards
Moral hazard arises when there is an externality. It is about actions , made
after making a market exchange, which may have adverse impact on
the less informed person. It 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. It occurs when one
party to an agreement knows that he need not bear the consequences
of his bad behavior or poor decision making and that the consequence,
if any ,would be borne by the other party. Therefore, he engages in risky
behavior or fails to act in good faith or acts in a different way than if he
had to bear those consequences himself.

In the insurance market, moral hazards refers to a situation that increases

the probability of occurrence of a loss or a larger than normal loss
because of a change in the insurance policyholders’ behavior after the
issuance of insurance policy . When someone is protected from paying
the full costs of their harmful actions, they tend to act irresponsibly,
making the harmful consequences more likely. For example: the insured
consumers are likely to take greater risks, knowing that a claim will be
paid for by the insurance company. 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.

If the company could costlessly monitor the behavior of the insured, it

can charge higher fees for those who make more claims. The problem
lies in the fact that the insurance company cannot observe people’s
actions post- sale and therefore cannot judge without costly monitoring
whether the occurrence of an event is genuine or the outcome of lack
of effort on the part of the insured. Therefore the expected outflow is
higher and the insurance companies may be forced to increase the
insurance premiums for everyone or maybe may even refuse to sell
insurance at all in which case it is a case of missing markets.

Asymmetric information, adverse selection and moral hazard affect the

ability of markets to efficiently allocate resources and therefore lead to
market failure because the party with better information has a
completive advantage.
Unit III: Government Interventions to Correct Market Failure
p
3.1 Government Intervention to minimize Market Power

Market power – exercised either by sellers or buyers – is an important

factor that contributes to inefficiency because it results in higher prices
than competitive prices. In addition, market power also tends to restrict
output and leads to deadweight loss. Because of the social costs
imposed by monopoly, government 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
county. For example, in India, we have the Competition Act, 2002 (as
amended by the Competition (Amendment) Act, 2007) to promote and
sustain competition in markets. Such legislations generally aim at
prohibiting contracts, combinations and collusion among producers or
traders which are in restraint of trade and other anticompetitive actions
such as predatory pricing.

Other measures include:

 Market liberalization by introducing competition in previously
monopolistic sectors such as energy, telecommunication etc
 Controls on mergers and acquisitions if there is possible market
domination
 Price capping and price regulation based on firms marginal costs,
average costs, past prices, or possible inflation and productivity
growth.
 Profit or rate of return regulation
 Performance targets and performance standards
 Patronage to consumer associations
 Tough investigations into cartelisation and unfair practices such as
collusion and predatory pricing
 Restrictions on monopsony power of firms
 Reduction in Import controls
 Nationalization

Some of the regulatory responses of government to incentive failure tend

to create and protect monopoly positions of firms that have developed
unique innovations. For example, patents and copyright laws grant
exclusive rights to products or processes to provide incentives for
invention and innovation.
Policy options for limiting market power also include price regulations in
the form of setting maximum prices that firms can charge. Price
regulations 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.

3.2 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. Governments have
numerous methods to reduce the effects of negative externalities and to
promote positive externalities. We shall first examine how government
regulation can deal with the inefficiencies that raise from negative
externalities. Since the most commonly referred negative externality is
pollution, we shall take it as an exemplar in the following discussion.

Government initiatives towards negative externalities may be classified

as:

1. Direct controls that openly regulate the actions of these involved in

generating negative externalities, and

2. Market-based policies that would provide economic incentives so

that the self-interest of the market participants would achieve the
socially optimal solution.

Direct controls prohibit specific activities that explicitly create negative

externalities or require that the negative externality be limited to a
certain level, for instance limited 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.
Government may pass laws to alleviate the effects of negative
externalities. Government stipulated environmental standards are rules
that protect the environment by specifying actions by producers and
consumers. For example, India has enacted the Environment (Protect)
Act, 1986. The government may, though legislation, fix emissions
standard which is a legal limit on how much pollutant a firm can emit.
The set standard ensures that the firm produces efficiently. If the firm
exceeds the limit, it can invite monetary penalties or / and criminal
liabilities. The firms have to install pollution-abatement mechanisms to
ensure adherence to the emission standards. This means additional
expenditure to the firm leading to rise in the firm’s average cost. New
firms will find it profitable to enter the industry only if the price of the
product is greater than the average cost of production plus abatement
expenditure.

Another method is to charge an emissions fee which is levied on each

unit of firm’s emissions. The firms can minimize costs and enhance their
profitability by reducing emissions. Governments may also form special
bodies / boards to specifically address the problems: for instance, the
Ministry of Environment & Forest, the Pollution Control Board of India and
the State Pollution Control Boards.

The market-based approaches-environmental taxes and cap-and-trade

– operate through price mechanism to create an incentive for change.
In other words, they rely on economic incentives to accomplish
environmental goals at lesser costs. The market-based approaches focus
on generation of a market price for pollution. This is achieved by:

1. Setting the price directly through a pollution tax

2. Setting the price indirectly through the establishment of a cap-and-
trade system.

One method of ensuring internalization of negative externalities is

imposing pollution taxes. 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 argues 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 proceeds from the tax,
can be specifically earmarked for projects that protect or enhance
environment.

Market outcomes of Pollution Tax

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 at the level of equality
between marginal private cost and marginal private benefit. (Since
externalities are not taken into account, marginal private benefit would
be contemplated as marginal social benefit). When externalities are
present, the welfare loss to the society or dead weight loss would be the
shared area ABC. The tax imposed by government (equivalent to the
vertical distance AA1) would sift 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. Output level
Q1 is socially optimal and eliminates the whole of welfare loss on account
of overproduction.

However, there are problems in administering and efficient pollution tax.

 Pollution taxes are difficult to determine and administer because 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. If the demand for the good is inelastic, the tax may only have
an insignificant effect in reducing demand.

 The method of taxing the polluters has many limitations because it

involves the use of complex and costly administrative procedures
for monitoring the polluters.

 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.

 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.

 Pollution taxes also have potential negative consequences on

employment and investments because high pollution taxes in one
country may encourage producers to shift their production facilities
to those countries with lower taxes.

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. These permits are transferable, and their
different pollution levels are possible across the regulated entities.
Permits are allocated among firms, with the total number of permits is
chosen as to achieve surplus the desired maximum level of emissions. By
allocating fewer permits than the free pollution level, the regulatory
agency creates 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 claimed for tradable permits are:

  The system allows flexibility and reward efficiency.

 It is administratively cheap and simple to implement and ensures

that pollution is minimized in the cost cost-effective way:

 It also provides strong incentives for innovation.

 Consumers may benefit if the extra profits made by low pollution

firms are passed on to them in the form of lower prices.

The Main argument in opposition to the employment of tradable emission

permits that they do not in reality stop firms from polluting the
environment; They only provide an incentive to them to do so. Moreover,
if firms have monopoly power of some degree along with a relatively
inelastic demand for its product, the extra cost incurred for procuring
additional permits so as to further pollute the atmosphere, could easily
be compensated by charging higher prices to consumers.

The two interventions mentioned above i.e., permits and taxes make use
of market forces to encourage consumers and producers to take
externalities into account when planning their consumption and
production. In other words, the polluters are forced to consider pollution
as a private cost.

We shall now look into the case of positive externalities. A positive

consumption(production) externality occurs when consumption
(production) of a good causes positive benefits to third party. This means
that the social benefits of consumption or production exceed the private
benefits.
In the case of positive consumption externality, the MSB > MPB .
Education, preventive vaccination etc are examples of consumption
having positive externality .
In the case of positive production externality , MSC < MPC . Research
and development, production of education, health care and similar
merit goods fall under this .
The intersection of MSC&MSB determines the optimal level of output.
Though positive externality is associated with external benefits, we still
call it a market failure because, left to market, there will be less than
optimal output. In a free market without government intervention, there
will be under consumption of goods with positive consumption
externalities. In case of goods with positive production externality, the
market will produce less than the efficient quantity.
Since positive externalities promote welfare, governments implement
policies that promote positive externalities. When positive externalities
are present, government may attempt to solve the problem through
corrective subsidy to the producers aimed at either increasing the supply
of the good or through corrective subsidies to consumers aimed at
increasing the demand for goods.

Considering the example of education with high positive consumption

externalities, a competitive market in education with no government
interference would be inefficient. In panel A of the following diagram,
the horizontal axis measures the quantity of education and the vertical
axis measures the price of education. The demand curve( MPB )for
education does not reflect positive externalities of education
consumption. Without government intervention, the market reaches
inefficient equilibrium at point ‘a ‘ with Qe amount of education at Pe
prices.The distance AB is the value of the positive externalty. The efficient
level of output is Q* corresponding to Point C where MSB intersects the
supply curve. The total deadweight loss or welfare loss from all the
education not provided is the shaded triangle ‘bac’.

. The effect of a subsidy is shown in the following figure.

Effect of Government Subsidy

A government subsidy is a market based approach that changes the price of

the product and allows individual consumers to respond to those prices and
make their own decisions. Subsidies to consumers of a good with positive
externality will increase the marginal private benefit of consumption since
individuals now get paid to buy goods and increase the demand for the
good.
In panel B, a subsidy equal to the value of the positive externality is paid to
each student. The subsidy causes each student to add the same amount to
the value that he or she places on education and shifts up the demand curve
by that amount. The demand curve now rises to the level of the MSB curve
and the market equilibrium moves to Q* -the efficient number. In the new
equilibrium, the price of education rises from Pe to P; however the students
after accounting for subsidy, pay only P as service so that more of them
choose to acquire education. Thus, a subsidy on each unit of a good, equal
to the external benefits it creates can correct the positive externality and
bring the market to an efficient output level.

A corrective production subsidy involves government paying part

of the cost to the firms in order to promote the production of
goods having positive externalities. This is in fact a market based
policy as subsidies to producers would lower their cost of
production. A subsidy on a good which is substantial positive
externalities would reduce the marginal private costs of
production, increase the supply, shift the supply curve to the right,
reduce the price and increase the quantity demanded of the
subsidized good. A higher output that would equate MSB&MSC is
socially optimal.

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, fundamental
research to protect the futuristic technology interest of the society is, in
most cases, funded by government as the market may not be willing to
provide them. Governments also engage in direct production of
environmental quality. Examples are: afforestation, reforestation,
protection of water bodies, treatment of sewage and cleaning of toxic
waste sites.

3.3 Government Intervention in the case of Merit Goods

Merit goods are goods which are deemed to be socially desirable and
therefore the government deems that its consumption should be
encouraged. Substantial positive externalities are involved in the
consumption of merit goods. Left to the market, only private benefits and
private costs would be reflected in the price paid by consumers. This
means, compared to what is socially desirable, people would consume
inadequate quantities. Examples of merit goods include education,
healthcare, welfare services, housing, fire protection, waste
management, public libraries, museum and public parks.
In contrast to pure public goods, merit goods are rival, excludable,
limited in supply, rejectable 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. The following diagram will show the market
outcome for merit goods.

Figure 2.3.3

Market Outcome for Merit Goods

In the absence of government intervention, the output of the merit good

would-be Q where the marginal private cost (MPC) is equal to marginal
private benefit (MPB). The welfare loss to the society due to under
production and under consumption is the shaded area (ABC). On
account of considerable positive externalities, the optimal output is Q* at
which marginal social (MSC) cost is equal to marginal social goods.

The additional reasons for government provision of merit goods are:

 Information failure is widely prevalent with merit goods and

therefore individuals may not act in their best interest because of
imperfect information.

 Equity considerations demand that merit goods such as health and

education should be provided free on the basis of needs rather
than on the basis of individual’s ability to pay.
  There is a lot of uncertainty as to the need for merit goods E.g.,
health care. Due to uncertainty about the nature and timing of
healthcare required in future, individuals may be unable to plan
their expenditure and save for their future medical requirements.
The market is unlikely to provide the optimal quantity of health care
when consumers actually need it, because they may be short of
the necessary finances to pay the market price.

The possible government responses to under-provision of merit goods are

regulation, subsidies, direct government provision and a combination of
government provision and market provision. Regulation determines how
a private activity may be conducted. For example, the way in which
education is to be imparted is government regulated. Governments can
prohibit some type of goods and activities, set standards and issue
mandates making other oblige. For example, government may make it
compulsory to avail insurance protect. Compulsory immunization may
be insisted upon as it helps not only that individual but also the society at
large. Government could also use legislation to enforce the
consumption of a good which generates 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. A
variety of regulatory mechanisms may also be set up by government to
enhance consumption of merit goods and to ensure their quality.

When governments provide merit goods, it may give rise to large

economies of scale and productive efficiency apart from generating
substantial positive externalities and overcoming the problems
mentioned above.

When merit goods are directly provided free of cost by government,

there will be substantial demand for the same. As can be seen from the
following diagram, when people are required to pay the free market
price, people would consume only OQ quantity of healthcare. IF
provided free at zero prices, the demand OD far exceeds supply.

Figure 2.3.4

Consumption of Merit Goods at Zero Price

 3.4 Government Intervention in the cases of Demerit Goods

Demerit goods are goods which are believed to be socially undesirable.

Examples of demerit goods are cigarettes, alcohol, intoxicating drugs
etc. The consumption of demerit goods imposes significant negative
externalities on the society as whole and therefore the private costs
incurred by individual consumers are less than the social costs
experienced by the society. The production and consumption of
demerit goods are likely to be more than optimal under free markets. The
price that consumers pay for a packet of cigarettes is market determined
and does not account for the social costs that arise due to externalities.
In other words, the marginal social cost will exceed the market price and
overproduction and over consumption will occur, causing misallocation
of society’s scarce resource. However, it should be kept in mind 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.

The generally held argument is that consumers overvalue demerit goods

because of imperfect information and they are not the best judges of
welfare with respect to such goods. The government should therefore
intervene in the marketplace to discourage their production and
consumption. How do governments correct market failure resulting from
demerit goods?

 At the extreme, government may enforce complete ban on a

demerit good, e.g., Intoxicating drugs. In such cases, the
possession, trading or consumption of the good is made illegal.
  Through persuasion which is mainly intended to be achieved by
negative advertising campaigns which emphasize the dangers
associated with consumption of demerit goods.

 Through legislation that prohibit the advertising or promotion of

demerit goods in whatsoever manner.

 Strict regulations of the market for the good may be put in place so
as to limit access to the good, especially by vulnerable groups such
as children and adolescents.

 Regulatory controls in the form of spatial restrictions e.g., smoking

in public places, sale of tobacco to be away from schools and time
restrictions under which sale at particular times during the day is
banned.

Imposing unusually high taxes on producing or purchasing the goods

making them very costly and unaffordable to many is perhaps the most
commonly used method for reducing the consumption of a demerit
good. 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 (with a
cess being added on the basis tax) at much higher rates than the top
GST slab of 28 per cent.

However, there are various limitations for government to succeed in

producing the desired optimal effects in the case of demerit goods.
There are many practical difficulties in imposing taxes. In order to impose
a tax which is equivalent to the marginal external cost, the governments
need to know the exact value of the marginal external cost and then
ascribe accurate monetary value to those negative externalities. In
practice, this is extremely difficult to do.

The government can fix a minimum price below which the demerit good
should not be exchanged. The effect of such minimum price fixation
above equilibrium price is shown in the figure below:

Figure 2.3.5

Outcomes of Minimum Price for a Demerit Good

Free market equates marginal private cost with marginal private benefit
(point B) and produces an output of a demerit good Q at which marginal
social benefit (MSB) is much less than marginal private benefit (MPB). At
this level of output, there is a divergence (BC) between marginal private
benefit (MPB) and marginal social benefit (MSB). The shaded area
represents loss of social welfare. If the government determined minimum
price is P1, demand contracts and the quantity of alcohol consumed
would be reduced to Q1. At Q1 level of output, marginal social benefit
(MSB) is equal to marginal social cost (MSC) and the quantity of alcohol
consumed is optimal form the society’s point of view.

The demand for demerit goods such as cigarettes and alcohol are often
highly inelastic, so that any increase in price resulting from additional
taxation causes a less than proportionate decrease in demand. Also,
sellers can always shift the taxes to consumers without losing customers.

The effect of stringent regulation such as total ban is seldom realized in

the form of complete elimination of the demerit good; conversely such
goods are secretly driven underground and traded in a hidden market.

3.5 Government Intervention in the cases of Public Goods

Public goods which are non-excludable is 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. The non-rival nature of
consumption provides a strong argument for the government rather than
the market to provide and pay for public goods. In the case of such pure
public goods where entry fees cannot be charged, direct provision by
governments through the use of general government tax revenues is only
option.

Excludable public goods can be provided by government and the same

can be financed through entry fees. A very commonly followed method
is to grant licenses to private firms to build a public good facility. Under
this method, the goods are provided to the public on payment of an
entry fee. In such cases, the government regulates the level of the entry
fee chargeable form the public and keeps strict watch on the
functioning of the licensee to guarantee equitable distribution of welfare.

Certain goods are produced and consumed as public goods and

services despite the fact that they can be produced or consumed as
private goods. This is because, left to the markets and profit motives,
these may prove dangerous to the society. Examples are scientific
approvals of drugs, production of strategic products such as atomic
energy, provision of security at airports etc.

3.5 Price Intervention: Non-Market Pricing

Price controls are put in place by governments to influence the outcome

of a market. Very often, there is strong political demand for governments
to intervene in markets for various goods and services on grounds of
fairness and equity. Price intervention generally takes the form of price
controls which are legal restrictions on price. Price controls may take the
form of either a price floor (maximum price buyers are required to pay)
or price ceiling (a maximum price sellers are allowed to charge for a
good or service). Fixing of minimum wages and rent controls are
examples of such market intervention.

Government usually intervenes in many primary markets which are

subject to extreme as well as unpredictable fluctuation in price. For
example, in India, in the case of many crops the government has
initiated the Minimum Support Price (MSP) programme as well as
procurement by government agencies at the set support prices. The
objective is to guarantee steady and assured income to farmers. In case
the market price falls below the MSP, then the guaranteed MSP will
prevail. The following diagram will illustrate the effects of a price floor.
Nevertheless, mere announcement of higher support prices for
commodities, which are not effectively backed up by procurement
arrangement, does not serve the purpose of remunerative levels of prices
for producers.

Figure 2.3.6

Market Outcome of Minimum Support Price

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 price Rs.150/- which is much above the market determined
equilibrium price of Rs.75/-, the market demand is only Q1, but the market
supply is Q2.

When price of certain essential commodities rise excessively,

government may resort to controls in the form of price ceilings (also
called maximum price) for making a resource or commodity available to
all at reasonable prices. For example: maximum prices of good grains
and essential items are set by government during times of scarcity. A
price ceiling which is set below the prevailing market clearing price will
generate excess demand over supply. As can be seen in the following
figure, the price ceiling of Rs.75/- which is below the market determined
price of Rs.150/- leads to generation of excess demand over supply
equal to Q1-Q2.

Figure 2.3.7

Market Outcome of Price Ceiling

With the objective of ensuring stability in prices and distribution,

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.
3.6 Government Intervention for Correcting Information Failure

 Government makes it mandatory to have accurate labeling and

content disclosures by producers.e.g. Labeling on cigarette
packets and nutritional information in food packages.

 Mandatory disclosure of information. For example: SEBI requires

that accurate information be provided to prospective buyers of
new stocks.

 Public dissemination of information to improve knowledge and

subsidizing of initiatives in that direction.
  Regulation of advertising and setting of advertising standards to
make advertising more responsible, informative and less
persuasive.

3.7 Government Intervention for Equitable Distribution

One of the most important activities of the government is to redistribute

incomes so that there is equity and fairness in the society. Equity can be
brought about by redistribution of endowments with which the economic
agents enter the market. Some common policy interventions include
progressive income tax, targeted budgetary allocations, unemployment
compensation, transfer payments, subsidies, social security schemes, job
reservations, land reforms, gender sensitive budgeting etc. Government
also intervenes to combat black economy and market distortions
associated with a parallel black economy. Government intervention in
a market that reduces efficiency while increasing equity is often justified
because equity is greatly appreciated by society.

The discussion above is far from being comprehensive; yet it points

toward the numerous ways in which governments intervene in the
markets. However, we cannot be sure whether the government
interventions would be effective or whether it would make the
functioning of the economy less efficient. Government failures where
government intervention in the economy to correct a market failure
creates inefficiency and leads to a misallocation of scarce resource
occur very often. Government failure occurs where:

 Intervention is ineffective causing wastage of resources expended

for the intervention.

 Intervention produces fresh and more resource problems.

There are costs and benefits associate with any Government intervention
in the market, and it is important that policy markers consider all of the
costs and benefits of policy intervention.
Unit IV: Fiscal Policy

4.1 Introduction

Fiscal policy involves the use of government spending, taxation and

borrowing to influence both the pattern of economic activity and level
of growth of aggregate demand, output and employment. It includes
any design on the part of the government to change the price level,
composition or timing of government expenditure or to alter the burden,
structure or frequency of tax payment. In other words, fiscal policy is
designed to influence the pattern and level of economic activity in a
country. Fiscal policy is in the nature of a demand-side policy. An
economy which is producing at full-employment level does not require
government action in the form of fiscal policy.

4.2 Objectives of Fiscal Policy

The objectives of fiscal policy, like those of other economic policies of the
government, are derived from the aspirations and goals of the society .
Since nations differ in numerous aspects, the objectives of fiscal policy
also may vary from country to country. However, The most common
objectives of fiscal policy are:

 Achievement and maintenance of full employment.

 Maintenance of price stability.

 Acceleration of the rate of economic development, and

 Equitable distribution of income and wealth.

The importance as well as order of priority of these objectives may vary

from country to country and from time to time. For instance, which
stability and equality may be the priority of developed nations,
economic growth, employment and equity may get higher priority in
developing countries. Also, these objectives are not always compatible;
for instance, the objective of achieving equitable distribution of income
may conflict with the objective of economic growth and efficiency.

4.3 Automatic Stabilizers Versus Discretionary Fiscal Policy

Non-discretionary fiscal policy or automatic stabilizers are part of the
structure of the economy and are ‘built-in’ fiscal mechanisms that
operative automatically to reduce the expansions and contractions of
the business cycle.

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. 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. It involves built-in-tax or expenditure mechanism that
automatically increases aggregate demand when recession is there and
reduces aggregate demand when there is inflation in the economy.
Personal income taxes, corporate income taxes and transfer payments
(unemployment compensation, welfare benefits) are prominent
automatic stabilizers.

Automatic stabilization occurs through automatic adjustments in

government expenditures and taxes without any deliberate
governmental action. These automatic adjustments work towards
stimulating aggregate spending during the recessionary phase and
reducing aggregate spending during economic expansion. 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 expenditure increases due to increased
transfer payments like unemployment benefits. These two together
provide proportionately more disposable income available for
consumption spending to households. In the absence of such automatic
responses, household spending would tend to decrease more sharply
and the economy would in all probability fall into a deeper recession.

On the contrary, when an economic expands, employment increase,

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. Similarly, corporate profits tend to be higher during an
expansionary phase attracting higher corporate tax payments. With
higher income taxes, firms are left with lower surplus causing a decline in
their consumption and investments and thus in the aggregate demand.
Again, during expansion, unemployment falls, therefore government
expenditure by way of transfer payments falls and with lower
government expenditure inflation gets controlled to a certain extent.

Briefly put, during an expansionary phase, all types of incomes rise and
the amount of transfer payments decline resulting in proportionately less
disposable income available for consumption expenditure. The built-in
stabilizers automatically remove spending from the economy to reduce
demand-pull inflationary pressures and further expansionary stimulation.
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. Since automatic stabilizers affect disposable personal
income directly, and because changes in disposable personal income
are closely linked to changes in consumption, these stabilizers act swiftly
to reduce the extent of changes in real GDP.

However, automatic stabilizers that depend on the level of economic

activity alone would not be sufficient to correct instabilities. The
government needs to resort to discretionary fiscal policies. Discretionary
fiscal policy for stabilization refers to deliberate policy actions on the part
of government to change the levels of expenditure, taxes to influence
the level of national output, employment and prices. Governments
influence the economy by changing the level and types of taxes, the
extent and composition of spending, and the quantity and form of
borrowing.

Governments may directly as well as indirectly influence the way

resources are used in an economy. We shall now see how this happens
by investigating into the fundamental equation of national income
accounting that measures the output of an economy, or gross domestic
product (GDP), according to expenditures.

GDP = C + I + G + (X-M)

We know that GDP is the value of all final goods and services produced
in an economy during a given period of time. The right side of the
equation shows the different sources of aggregate spending or demand
namely, private consumption (C), private investment (I), government
expenditure i.e., purchases of goods and services by the government (G)
and net exports, (exports minus imports) (X-M). It is evident from the
equation that governments can influence economic activity (GD) by
controlling G directly and influencing C, I and (X-M) indirectly, through
changes in taxes, transfer payments and expenditure.

4.4 Instruments of Fiscal Policy

The tools of fiscal-policy are taxes, government expenditure, public debt

and the government budget.

4.4.1 Government expenditure as an Instrument of Fiscal Policy

Public expenditures are income generating and include all types of

government expenditure such as capital expenditure on public works,
relief expenditures, subsidy payments of various types, transfer payments
and other social security benefits. Government expenditure is an
important instrument of fiscal policy. If includes governments
expenditure towards consumption, investment and transfer payments.
Government expenditures include:

1. Current expenditures to meet the day to day running of the

government

2. Capital expenditures which are in the form of investments made by

the government in capital equipment’s and infrastructure and

3. Transfer payments i.e., government spending which does not

contribute to GDP because income is only transferred form one group
of people to another without any direct contribution from the
receivers.

Government may spend money on performance of its large and ever-

growing functions and also for deliberately bringing in stabilization.
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 involved
employment of labor as well as purchase of multitude of goods and
services. These expenditures directly generate incomes to labor 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). There is generally surplus capacity in consumer goods industries
during recession and an increase in demand for various goods leads to
expansion in production in those industries as well. Additionally, a
programme of public investment will strengthen the general confidence
of businessmen and consequently their willingness to invest. Primary
employment in public works programmes will induce secondary and
tertiary employment, and before long the economy is put on an
expansion track.

A distinction is made between the two concepts of public spending

during depression, namely, the concept of ‘pump priming’ and the
concept of ‘compensatory spending’. Pump priming involves a one-shot
injection of government expenditure into a depressed economy with the
aim of boosting business confidence and encouraging larger private
investment. It is the temporary fiscal stimulus in order to set off the
multiplier process. The argument is that with a temporary injection of
purchasing power into the economy through a rise in government
spending financed by borrowing rather than taxes it is possible for
government to bring about permanent recovery from a slump. Pump
priming was widely used by governments in the past-war era in order to
maintain full employment; however, it became discredited later when it
failed to halt rising unemployment and was held responsible for inflation.
Compensatory spending is said to be resorted to when the government
spending is deliberately 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. This is done by reducing
government expenditure when there is a fear of inflationary rise in
process. Reduced incomes on account of decreased public spending
heals to eliminate excess aggregate demand.

The government spending multiplier

Spending multiplier also known as Keynesian or fiscal policy multiplier represents
the multiple by with GDP increases or decreases in response to an increase and
decrease in government expenditures and investment, holding the real money
supply constant. Quantitatively, the government spending multiplier is the
same as the investment multiplier. It is the reciprocal of the MPS. Higher the MPS,
lower the multiplier and vice versa.
∆𝑌 1 1 1
Spending multiplier=∆𝐺 =𝑀𝑃𝑆=1−𝑀𝑃𝐶 =1−𝑏

Let’s solve:
 Q 1: assume that the MPC is equal to 0.6

a) What is the value of the government spending multiplier?[ans:2.5]

b) What impact would a 50 billion increase in government spending
have an equilibrium GDP?[125 bn]
c) What about a 50 billion decrease in government spending? [125 bn]

Q 2: If a country has MPC of 0, what is the value of fiscal multiplier?[ans:1]

Q 3: Average per capita income of a country rose from 42,300 to 50,000 and
the corresponding figures for per capita consumption rose from 35,400 to
42,500. Find the spending multiplier for this
economy.[ans:MPC=0.922;multiplier=12.83]

4.4.2 Taxes as an Instrument of Fiscal Policy

Taxes form the most important source of revenue for governments.

Taxation policies are effectively used for establishing stability in an
economy. Tax as an instrument of fiscal policy consists of changes in
government revenues or in rates of taxes aimed at encouraging or
restricting private expenditures on consumption and investment. Taxes
determine the size of disposable income in the hands of the general
public which in turn determines aggregate demand and possible
inflationary and deflationary gaps. The structure of tax rates is varied in
the context of the overall economic conditions prevailing in an
economy. 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. The extent of tax
reduction and / or increase in government spending required depends
on the size of the recessionary gap and the magnitude of the multiplier.

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. However, excessive taxation usually stifles new
investments and therefore the government has to be cautious about a
policy of tax increase.

The tax multiplier represents the multiple by which GDP increases

(decreases) in response to a decrease( increase) in taxes charged by
the government.

In the simple version of tax multiplier, it is assumed that any increase or

decrease in tax affects consumption only and has no effect on
investment, government expenditures etc .

−𝑀𝑃𝐶 −𝑀𝑃𝐶 −𝑏
Simple tax multiplier= = =
𝑀𝑃𝑆 1−𝑀𝑃𝑆 1−𝑏

Derivation
Since C=b(Y-T), if the tax rises by an amount ∆ T, change in consumption
will be:
∆C=b[Y-(T+∆T)]- b(Y-T)
=b[Y-T-∆T]-bY+bT
=bY-bT-b∆T-bY+bT=-b∆T
1 −𝑏∆T
Through multiplier,∆Y= (−𝑏∆T)=
1−𝑏 1−𝑏
∆Y −𝑏
∴ =
∆T 1−𝑏

The tax multiplier has a negative sign. It means that tax and increase in tax have
negative impact on national income.
Given the same value of MPC, simple tax multiplier will be lower than the spending
multiplier. This is because in the first round of increase in business or government
expenditures, they inject the initial amount of that spending into the income
stream and then it multiplies to the economy, while in case of decrease in taxes of
the same amount, consumption increase by a factor of MPC. So, if the government
increases spending by 10 billion, the entire 10 billion is injected into the income
stream. On the other hand, if the taxes are reduced by 10 billion, only the MPC * 10
billion is injected into the expenditure stream. For example when theMPC is 0.9,
the spending multiplier is 10 but the tax multiplier is – 9 and when MPC is 0.6, the
spending multiplier is 2.5 but the tax multiplier is -1.5.

Balanced budget multiplier

The government budget is set to be in balance win ∆ G =∆ T.
The balanced budget multiplier is always equal to 1.
The balanced budget multiplier is obtained by adding up the
government spending multiplier or fiscal multiplier and the tax multiplier.
∆𝑌 ∆Y 1 −𝑏
Balanced budget multiplier =∆𝐺 + = + =1
∆T 1−𝑏 1−𝑏

Q 4: What would be the impact on GDP if both government spending

and taxes are increased by 5 billion when the MPC is 0.9?[ output
increases by 5 billion]

4.4.3 Public Debt as an Instrument of Fiscal Policy

A rational policy of public borrowing and debt repayment is a potent

weapon to fight inflation and deflation. Public debt may be internal or
external; when the government borrows form its own people in the
country, it is called internal debt. On the other hand, when the
government borrows from outside sources, the debt is called external
debt. Public debt takes two forms namely, market loans and small
savings.

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.
The small savings represent public borrowings, which are not negotiable
and are not bought and sold in the market. In India, various types of
schemes are introduced for mobilizing small savings e.g., National Saving
Certificates, National Development Certificates, etc. 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.

4.4.4 Budget as an Instrument of Fiscal Policy

Government’s budget is widely used as a policy tool to stimulate or

contract aggregate demand as required. 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. The net effect
of a budget on aggregate demand depends on the government’s
budget balance. 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
tax es collected are equal to the injections in the form of expenditures
made.
A budget surplus that occurs when the government collects more than
what is spends, through 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.

While a budget surplus reduces national debt, a budget deficit will add
to the national debt. A nation’s debt is the difference between its total
past deficits and its total past surpluses. If a government has borrowed
money over the years to finance its deficits and has not paid it back
through accumulated surpluses, then it is said to be in debt. Deliberate
changes to the composition of revenue and expenditure components of
the budget are extensively used to change macro-economic variables
such as level of economic growth, inflation, unemployment and external
stability. For instance, a budget surplus reduces government debt,
increases savings and reduces interest rates. Higher levels of domestic
saving decrease international borrowings and lessen the current
account deficit.

4.5 Types of Fiscal Policy

Fiscal policy measures to correct different problems created by business-

cycle instability are two basic types namely, expansionary and
contractionary. Expansionary fiscal policy is designed to stimulate the
economy during the contractionary phase of a business cycle or when
there is an anticipation of a business cycle contraction. This is
accomplished by increasing aggregate expenditures and aggregate
demand through an increase in all types of government spending and /
or a decrease in taxes.

Contractionary fiscal policy is basically the opposite of expansionary

fiscal policy. Contractionary fiscal policy is designed to restrain the levels
of economic activity of the economy during an inflationary phase or
when there is anticipation of a business-cycle expansion which is likely to
induce inflation. This is carried out by decreasing the aggregate
expenditures and aggregate demand through a decrease in all types of
government spending and / or an increase in taxes. Contractionary
fiscal policy should ideally lead to a smaller government budget deficit
or a larger budget surplus. In other words, if the state of the economy is
such that its growth rate is extraordinarily high causing inflation and asset
bubbles, contractionary fiscal policy can be used to confine it into
sustainable levels.

The essence of what we learn in the rest of the unit is that:

 During inflation or when there are excessive levels of utilization of

resources, fiscal policy amins at controlling excessive aggregate
spending, and

 During deflation or during a period of sluggish economic activity

when the rate of utilization of resources is less, fiscal policy aims to
compensate the deficiency in effective demand by boosting
aggregate spending.

We shall now describe the application of each of the fiscal policy tools.

4.5.1 Expansionary Fiscal Policy

A recession is said to occur when overall economic activity declines, or
in other words, when the economy ‘contracts’. A recession sets in with a
period of declining real income, as measured by real GDP,
simultaneously with a situation of rising unemployment. If an economy
experiences a fall in aggregate demand during a recession, it is said to
be in demand-deficient recession. Due to decline in real GDP, the
aggregate demand falls and therefore, lesser quantity of goods and
resources will be produced. To combat such a slump in overall economic
activity, the government can resort to expansionary fiscal policies.

An expansionary fiscal policy is used to address recession and the

problem of general unemployment on account of business cycles. We
may technically refer to this as a policy measure to close a ‘recessionary
gap’. 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. It is a measure of output
that is lost when actual national income falls short of demand and the
aggregate demand which is required to establish the equilibrium at full
employment level of income. This gap occurs during the contractionary
phase of business-cycle and results in higher rates of unemployment. In
other words, recessionary gap occurs when the aggregate demand is
not sufficient to create conditions of full employment. Now the question
is how to changes in government expenditure (G), and taxes (T)
eliminate a recessionary gap?

We shall now look into the Keynesian arguments for combating recession
using expansionary fiscal policy. When the aggregate demand (i.e.,
economy’s appetite for buying goods and services) fall short of
aggregate supply (the economy’s capacity to produce goods and
services), it results in unemployment of resources, especially labor. In that
case, the government intervenes through an expansionary fiscal policy.
The following figure illustrates the operation of expansionary fiscal policy.

As seen in the figure below,real GDP at Y1 level lies below the natural
level, Y2. This represents a situation where the economy is initially in a
recession. There is less than full employment of the resources in the
economy. The classical economists held the view that in such a
condition flexibility of wages would cause wages to fall resulting in
reduction in costs. Consequently, suppliers would increase supply and
the short run aggregate supply curve SAS1 will shift to the right say SAS2
and bring the economy back to the level of full employment at Y2.
However, accordingly to Keynes, wages are not as flexible as what the
classical economists believed and are ‘sticky downward’, meaning
wages will not adjust rapidly to accommodate the unemployed.
Therefore, recession, once set in, would persist for a long time, how does
the government intervene? This government responds by increasing
government expenditures in adequate quantities as to cause a shift in
the aggregate demand curve to the right form AD1 to AD2. In doing so,
the government may have to incur a budget deficit by spending more
than its current receipts. As a response to the shift in AD, output increases
as the total demand in the economy increases. Firms respond to growing
demand by producing more output. In order to increase their output in
the short-run, firms must hire more workers. This has the effect to reducing
unemployment in the economy.

Expansionary fiscal policy for Combating Recession

A relevant question here is how much should be the increase in

government expenditure? Should it be exactly the same amount as the
required level of increase in output? (Y2 – Y1)? The answer is that it
depends upon the GDP gap created due to recession and also on the
size of multiplier which depends upon marginal propensity to consume.
The increase in government expenditure need not be equal to the
different between Y2 and Y1. It can be much less. The concept of ‘fiscal
multiplier’, i.e., the response of gross domestic product to an exogenous
change in government expenditures is of use to determine the required
level of government expenditure. 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.

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 an increased taxes will
reduce the disposable incomes and their aggregate demand. The
government should in such cases go for a deficit budget which may be
financed either through borrowing or though monetization 9creation of
additional money to finance expenditure). The former runs the risk of
crowding out private spending.

It may however be noted that expansionary fiscal policy will be

successful only if there is accommodative monetary policy. If interest
rates rise as a result of increased demand for money but money supply
does not rise concurrently, then private investment will be adversely
affected. If interest rates remain unchanged, private investment will not
be affected badly and a rise in government expenditure will have fill
effect on national income and employment.

4.5.2 Contractionary Fiscal Policy

When aggregate demand rises beyond what the economy can

potentially produce by fully employing it’s 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. Under such circumstances a contractionary fiscal
policy will have to be used.

Contractionary fiscal policy refers to the deliberate policy of government

applied to curtail aggregate demand and consequently the level of
economic activity. In other words, it is fiscal policy aimed at eliminating
an inflationary gap. This is achieved by adopting policy measures that
would result in the aggregate demand curve (AD) shift the to the left so
that equilibrium may be established at the full employment level of real
GDP. This can be achieved either by:

i. Decrease in government spending: With decrease in government

spending, the total amount of money available in the economy is
reduced which in turns trim down the aggregate demand.

ii. Increase in personal income taxes and/or business taxes: An

increase in personal income taxes reduces disposable incomes
leading to fall in consumption spending and aggregate demand.
An increase in taxes on business profits reduces the surpluses
available to businesses, and as a result, firms investments shrink
causing aggregate demand to fall. Increased taxes also dampen
the prospects of profits of potential entrants who will respond by
holding back fresh investments.

iii. A combination of decrease in government spending and increase

in personal income taxes and/or business taxes.

We shall analyze the overall impact of their abovementioned measures

with the help of the following figure.

Figure 2.4.2

Contractionary Fiscal policy for Combating Inflation

As real GDP rises above its natural level, (Y in the above figure), prices
also rise, prompting an increase in wages and other resource prices. This
causes the SAS curve to shirt from SAS1 to SAS2. As a result, the price level
goes up from P1 to P3. Nevertheless, the real GDP remains the same at
Y. The government now need to intervene to control inflation by
engaging in a contractionary fiscal policy designed to reduce
aggregate demand so that the aggregate demand curve (AD1) does
not shift to AD2. The government needs to reduce expenditure or raise
taxes only by a small amount because of the multiplier effects that such
actions may have. Even as expenditures are reduced, the government,
an attempt to enhance public revenues in order to generate a budget
surplus. In any economy, on account of political, social and defence
considerations government spending cannot be reduced beyond
a[particular limit. However, the government can change its expenditure
in response to inflationary pressures.

4.6 Fiscal Policy for Long-Run Economic Growth

We have been discussing so far about how fiscal policy acts as an

effective tool for managing aggregate demand in the short-run to help
maintain price stability and employment levels. However, demand-side
policies unaccompanied by policies to stimulate aggregate supply
cannot produce long-run economic growth. Fiscal policies such as those
involving infrastructure spending generally have positive supply-side
effects. When government supports building a modern infrastructure, the
private sector is provided with the requisite overheads it needs.
Government provision of public goods such as education, research and
development etc., provide momentum for long-run economic growth. A
well-designed tax policy that rewards innovation and entrepreneurship,
without discouraging incentives will promote [private businesses who
wish to invest and thereby help the economy grow.

4.7 Fiscal Policy for Reduction in Inequalities if Income and

Wealth

Many developed and developing economies are facing challenge of

rising inequality in incomes and opportunities. Fiscal policy is a chief
instrument available for governments to influence income distribution
and plays a significant role in reducing inequality and achieving equity
and social justice. The distribution of income in the society is influenced
by fiscal policy both directly and indirectly. While current disposable
incomes of individuals and corporates are dependent on direct taxes,
the potential for future earnings is indirectly influenced by the nation’s
fiscal policy choices.

Government revenues and expenditure have traditionally been

regarded as important instruments for carrying out desired redistribution
of income. We shall see a few such measures as to how each of these
can be manipulated to achieve designed distributional effects.

 A progressive direct tax system ensures that those who are greater
ability to pay contribute more towards paying the expenses of
government and that the tax burden is distributed fairly among the
population.

 Indirect taxes can be differential: for example, the commodities

which are primarily consumed by the richer income group, such as
luxuries, are taxed heavily and the commodities the expenditure
on which form a larger proportion of the income of the lower
income group, such as necessities, are taxed light.

 A carefully planned policy of public expenditure helps in

redistributing income form the rich to the poorer sections of the
society. This is done through spending programmes targeted on
welfare measures for the disadvantaged, such as:

a. Poverty alleviation programmers

b. Free or subsidized medical care, education, housing, essential

commodities etc., to improve the quality of living of poor

c. Infrastructure provision on a selective basis

d. Various social security schemes under which people are entitled

to old-age pensions, unemployment relief, sickness allowance
etc.

e. Subsidized production pf products of mass consumption

 f. Public production and/or grant of subsidies to ensure sufficient
supply of essential goods and

g. Strengthening of human capital for enhancing employability

etc.

4.8 Limitations of Fiscal Policy

1. One of the biggest problems with using discretionary fiscal policy to

counteract fluctuations is the different types of lags involved in fiscal-
policy action. There are significant lags are:

 Recognition lag: The economy is a complex phenomenon and the

state of the macro-economic variable is usually not easily
comprehensible. Just as in the case of any other policy, the
government must first recognize the need for a policy change.

 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.

 Implementation lag: even when appropriate policy measures are

decided on, there are possible delays in bringing in legislation and
implementing them.

 Impact lag: impact lag occurs when the outcomes of a policy are
not visible for some time.

2. Fiscal policy changes may be at times be badly timed due to various

lags so that it is highly possible that an expansionary policy is initiated
when the economy is already on a path of recovery and vice versa.

3. There are difficulties in instantaneously changing government’s

spending and taxation policies.

4. It is practically difficult to reduce government spending on various

items such as defence and social security as well as on huge capital
projects which are already midway.

5. 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.

6. Due to uncertainties, there are difficulties of forecast when a period

of inflation or deflation may set in and also promptly determining the
accurate policy to be undertaken.

7. There are possible conflicts between different objectives of fiscal

policy such that a policy designed to achieve one goal may
adversely affect another. For example, an expansionary fiscal policy
may worsen inflation in an economy.

4.8.1 Crowding Out

Some economists are of the opinion that government spending would

sometimes substitute private spending and when this happens the
impact of government spending on aggregate demand would be
smaller than what is should be and therefore fiscal policy may become
ineffective. An increase in the size of the government spending during
recessions will ‘crowd-out’ private spending in an economy and lead to
reduction in an economy’s ability to self-correct from the recession, and
possibly also reduce the economy’s prospects of long-run economic
growth.

Crowding out effect is the negative effect fiscal policy may generate
when money from the private sector is ‘crowded out’ to the public
sector. In other words, when spending by government in an economy
replaces private spending, the latter is said to be crowded out. For
example, if government provides free computers to students, the
demand from students for computers may not be forthcoming. When
government increases its spending by borrowing from the loanable funds
from market, the demand for loans increases and this pushes the interest
rates up. Private investments are sensitive to interest rates and therefore
some private investments spending is discouraged. Similarly, when
government increases the budget deficit by selling bonds or treasury bills,
the amount of money with the private sector decreases and
consequently interest rates will be pushed up. As a result, private
investments, especially the ones which a re interest-sensitive, will be
reduced. Fiscal policy becomes ineffective as the decline in private
spending partially or completely offset the expansion in demand
resulting from an increase in government expenditure. 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 form the market without
increasing interest rates.

Budget deficit

The Government of India, every year prepares budget which shows

the expected receipts and expenditures of the government in the
coming financial year. Receipts of the government come from taxes
(both direct and indirect), profits from various financial institutions,
government commercial undertakings, interest from loans given to
other government, local bodies etc and expenditure of the
government are on the development projects such as construction
of roads, railways, production of energy and non- developmental
expenditure on a large number of activities such as defence,
subsidies, police, law and order etc

If Receipts = Expenditure, the budget is set to be a balanced one.

If Receipts > expenditure, the budget is set to be surplus one ;
If Receipts <expenditure, the budget is set to be a deficit one.

There can be different types of deficit in a budget depending upon

the types of receipts and expenditure we take into consideration.
Accordingly, there are three concepts of deficit, namely

(i) Revenue deficit

(ii) Fiscal deficit and

(iii) Primary deficit.

Although budget deficit and revenue deficit are old ones but fiscal
deficit and primary deficit are of recent origin.

Each of them is analysed below:

Budgetary deficit is the excess of total expenditure (both revenue
and capital) over total receipts (both revenue and capital).

Following are three types (measures) of deficit:

1. Revenue deficit = Total revenue expenditure – Total revenue
receipts.

2. Fiscal deficit = Total expenditure – Total receipts excluding

borrowings.

=budget deficit+borrowings & other liabilities.

3. Primary deficit = Fiscal deficit-Interest payments.

1. Revenue Deficit:
Revenue deficit is excess of total revenue expenditure of the
government over its total revenue receipts. It is related to only
revenue expenditure and revenue receipts of the government.

Revenue deficit signifies that government’s own earning is

insufficient to meet normal functioning of government departments
and provision of services. Revenue deficit results in borrowing.
Simply put, when government spends more than what it collects by
way of revenue, it incurs revenue deficit.

2. Fiscal Deficit:
(a) Meaning:
Fiscal deficit is defined as excess of total budget expenditure over
total budget receipts excluding borrowings during a fiscal year. In
simple words, it is amount of borrowing the government has to
resort to meet its expenses. A large deficit means a large amount of
borrowing. Fiscal deficit is a measure of how much the government
needs to borrow from the market to meet its expenditure when its
resources are inadequate.

3. Primary Deficit:
(a) Meaning:
Primary deficit is defined as fiscal deficit of current year minus
interest payments on previous borrowings. In other words whereas
fiscal deficit indicates borrowing requirement inclusive of interest
payment, primary deficit indicates borrowing requirement exclusive
of interest payment .

Calculation of budget deficit & fiscal deficit

1990-91(in crores) 2009-10(in crores)

1. Revenue receipts 54,950 5,72,811

2. Capital receipts 39,010 4,51,676

of which

a. Loan
recoveries+other 5,710 33,194
receipts
b. Borrowings &
other liabilities
33,300 4,18,482

3. Total 93,960 10,24,487

receipts(1+2)

4. Revenue 73,510 9,11,809

expenditure

5. Capital 31,800 1,12,678

expenditure

6. Total 1,05,310 10,24,487

expenditure(4+5)

7. Budgetary 11,350 Nil

deficit(3-6)

8. Fiscal deficit= 44,650 4,18,482

[6-1-2(a)=7+2(b)]
Q 1. Calculate the fiscal deficit and primary deficit from the
following data: [Jan 2021,CA Inter]

Total expenditure on revenue 547.62

&capital account
Revenue receipts 226.82
Non-debt capital receipts 103.00
Interest payments 84.00

[Ans:fiscal deficit=217.8 cr;primary deficit=133.8 cr]

 MONEY MARKET

Unit I: The Concept of Money Demand

1.1 Introduction

Money is at the centre of every economic transaction and plays a

significant role in the economies. In simple terms money refers to assets
which are commonly used and accepted as a means of payment or as
a medium of exchange or of transferring purchasing power.
For policy purposes, money may be defined as the set of liquid financial
assets, the variation in the stock of which will have impact on aggregate
economic activity. As a statistical concept, money could include certain
liquid liabilities of a particular set of financial intermediaries or other issuers
(RBI manual on financial and banking statistics, 2007)

1.2 Functions of Money

Money performs many important functions in an economy.

a. Money is a convenient medium of exchange or it is an instrument that

facilitates easy exchange of goods and services. Money, though not
having any inherent power to directly satisfy human wants, by acting
as a medium of exchange, it commands purchasing power and its
possession enables us to purchase goods and services to satisfy our
wants. By acting as an intermediary, money increases the ease of
trade and reduces the inefficiency and transaction costs involved in
a barter exchange. By decomposing the single barter transaction
into two separate transactions of sale and purchase, money
eliminates the need for double coincidence of wants. Money also
facilitates separation of transactions both in time and place and this
in turn enables us to economize on time and efforts involved in
transactions.

b. Money is an explicitly defined unit of value or unit of account. Put

differently, money is a ‘common measure of value’ or ‘common
denominator of value or money functions as a numeraire. We know,
Rupee is the unit of account in India in which the entire money is
denominated. The monetary unit if the unit of measurement in terms
of which the value of all goods and services is measured and
expressed. The value of each good or service is expressed as price,
 which is nothing but the number of monetary units for which the good
or service can be exchanged. It is convenient to trade all
commodities in exchange for a single commodity. So also, it is
convenient to measure the prices of all commodities in terms of a
single unit, rather than record the relative price of every good in terms
of every other good.

c. Money serves as a unit or standard of deferred payment i.e.; money

facilitates recording of deferred promises to pay. Money is the unit in
terms of which future payments are contracted or stated. However,
variations in the purchasing power of money due to inflation or
deflation, reduce the efficacy of money in this function.

Like nearly all other assets, money is a store of value. People prefer to
hold it as an asset, that is, as part of their stock of wealth. The splitting
of purchases and sale into two transactions involves a separation in
both time and space. This separation is possible because money can
be used as a store of value or store of means of payment during the
intervening time. Again, rather than spending one’s money a present,
one can store it for use at some future time. Thus, money functions as
a temporary abode of purchasing power in order to efficiently
perform its medium of exchange function.

Money also functions as a permanent store of value. There are many

other assets such a government bonds, deposits and other securities,
land, houses etc. which also store value. Despite having the
advantages of potential income yield and appreciation in value over
time, these other assets are subject to limitations such as storage costs,
lack of liquidity and possibly of depreciation in value. Money is the
only asset which has perfect liquidity. Additionally, money also
commands reversibility as its value in payment equals its value in
receipt. All assets other than money lack perfect reversibility in the
sense that their value I payment is not equal to their value in receipt.

The effectiveness of an asset as a store of value depends on the

degree and certainty with which the asset maintains its value over
time. Hence, in order to serve as a permanent store of value in the
economy, the purchasing power or the value of money should either
remain stable or should monotonically rise over time.

There are some general characteristics that money should possess in

order to make it serve its functions as money. Money should be:
  Generally acceptable
 Durable or long-lasting
 Effortlessly recognizable
 Difficult to counterfeit i.e., not easily reproducible by people
 Relatively scarce, but has elasticity of supply
 Portable or easily transported
 Possessing uniformity; and
 Divisible into smaller parts in usable quantities or fractions
without losing value.

1.3 The Demand for Money

If people desire to hold money, we say there is demand for money. The
demand for money is in the nature of derived demand; it is demanded
for its purchasing power.

Basically, people demand money because they wish to have command

over real goods and services with the use of money. Demand for money
is actually demand for liquidity and demand to store value. The demand
for money is a decision about how much of one’s given stock of wealth
should be held in the form of money rather than as other assets such as
bonds. Although it gives little or no return, individuals, households as well
as firms hold money because it is liquid and offers the most convenient
way to accomplish their day-to-day transactions.

Why is it important to study about demand for money? Demand for

money has an important role in the determination of interest, prices and
income in an economy. The role of money in the macro economy is
usually examined in a supply / demand framework.

The quantity of nominal money or how much money people would like
to hold in liquid form depends on many factors, such as income, general
level of prices, rate of interest ,real GDP, and the degree of financial
innovation etc.
 Higher the income of individuals, higher the expenditure and richer
people hold more money to finance their expenditure. The
quantity is directly proportional to the prevailing price level,higher
the prices, higher should be the holding the money.
 One may hold his wealth in any form other than money, say as an
interest yielding asset. It follows that the opportunity cost of
holding money is the interest rate a person could earn on other
 assets. Therefore, higher the interest rate, higher would-be
opportunity cost of holding cash and lower the demand for
money.
 Innovations such as internet banking, application-based transfers
an automatic teller machines reduce the need for holding liquid
money.

1.4 Theories of Demand for Money

1.4.1 Classical Approach: The quantity Theory of Money (QTM)

The quantity theory of money, one of the oldest theories in Economics,

was first propounded by Irving Fisher of Yale University in his book ‘The
Purchasing Power of Money’ published in 1911 and later by the
neoclassical economists. Both versions of the QTM demonstrate that
there is strong relationship between money and price level and the
quantity of money is the main determinant of the price level or the value
of money. In other words, changes in the general level of commodity
prices or changes in the value or purchasing power of money are
determined first and foremost by changes in the quantity of money in
circulation.

Fishers’ version, also termed as ‘equation of exchange’ or ‘transaction

approach’ is formally stated as follows:

MV = PT

Where, M = the total amount of money in circulation (on an average)

in an economy
V = transactions velocity of circulation i.e., the average
number of times across all transactions a unit of money (say
Rupee) is spent in purchasing goods and services
P = average price level (P = MV/T)
T = the total number of transactions.

Later, Fisher extended the equation if exchange to include demand

(bank) deposits (M) and their velocity (V) in the total supply of money.
Thus, the expanded form of the equation of exchange becomes:
 MV + M’V’ = PT

Where, M’ = the total quantity of credit money

V’ = velocity of circulation of credit money
Assumptions
 Velocity of money in circulation (V) and the velocity of credit
money (V’) remain constant.
 T is a function of national income.
 Since full employment prevails, the volume of transactions T is fixed
in the short run.

Briefly put, The total supply of money in the community consists of

the quantity of actual money (M) and its velocity of circulation (V).
The total volume of transactions (T) multiplied by the price level (P)
represents the demand for money.
The demand for money (PT) is equal to the supply of money (MV +
M’V’)’.
In any given period, the total value of transactions made is equal
to PT and the value of money flow is equal to MV + M’V’.

We shall now look into the classical idea of the demand for money. Fisher
did not specifically mention anything about the demand for money; but
the same is embedded in his theory as dependent on the total value of
transactions undertaken in the economy. Thus, there is an aggregate
demand for money for transactions purpose and more the number of
transactions people want, greater will be the demand for money. The
total volume of transactions multiplied by the price level (PT) represents
the demand for money.

Q 1: Calculate M when Velocity = 19, Price= 108.5 and volume of

transactions is equal to 120 billion.[ans:M=685.26]
What will be the effect on money supply if velocity is 25?[ans:M=520.8]
Q 2: Calculate velocity of money win money supply is equal to 5000
million, price is equal to 110, volume of transactions is equal to
200?[ans:V=4.4]
What will be the outcome if volume of transaction increases to
225?[ans:V=4.95]

1.4.2 The Neo-classical Approach: The Cambridge approach

In the early 1900s Cambridge Economists Alfred Marshall, A.C. Pigou, D.H.
Robertson and John Maynard Keynes (then associated with Cambridge)
put forward a fundamentally different approach. The Cambridge
version holds that money increases utility in the following two ways:

1. Enabling the possibility of split-up of sale and purchase to two different

points of time rather than being simultaneous, and

2. Being a hedge against uncertainty.

While the first above represents transaction motive, just as Fisher

envisaged, the second points to money’s role as a temporary store of
wealth. Since sale and purchase of commodities by individuals do not
take place simultaneously, they need a ‘temporary abode’ of
purchasing power as a hedge against uncertainty. As such, demand for
money also involves a precautionary motive in Cambridge approach.
Since money gives utility in its store of wealth and precautionary modes;
one can say that money is demanded for itself.

Now, the question is how much money will be demanded? The answer
is: it depends partly on income and partly on other factors of which
important ones are wealth and interest rates. The former determinant of
demand i.e., income, points to transactions demand such that higher the
income, the greater the quantity of purchases and as a consequence
greater will be the need for money as a temporary abode of value to
overcome transactions costs. The Cambridge equation I stated as:
 Md = k PY

Where
Md = is the demand for money
Y = real national income
P = average price level of currently produced goods and
services
PY =nominal income
K = proportion of nominal income (PY) that people want
to hold as cash balances

The term ‘k’ in the above equation is called ‘Cambridge k’. It is a

parameter reflecting economic structure and monetary habits, namely
the ratio of total transactions to income and the ratio of desired money
balances to total transactions. The equation above explains that the
demand for money (M) equals k proportion of the total money income.

Thus, we see that the neoclassical theory changed the focus of the
quantity theory of money to money demand and hypothesized that
demand for money is a function of only money income. Both these
versions are chiefly concerned with money as a means of transactions or
exchange, and therefore, they present models of the transaction
demand for money.

1.4.3 The Keynesian Theory of Demand for Money

‘Keynes’ theory of demand for money is known as ‘Liquidity Preference

Theory’. ‘Liquidity preference’, a term that was coined by John Maynard
Keynes in his masterpiece ‘The General Theory of Employment, Interest
and Money’ (1936) denotes people’s desire to hold money rather than
securities or long-terms interest-bearing investments.

According to Keynes, people hold money (M) in cash for three motives:

i. Transaction’s motive
ii. Precautionary motive and
iii. Speculative motive.

a) The Transactions Motive

The transactions motive for holding cash related to ‘the need for cash for
current transactions for personal and business exchange’. The need for
holding money arises because there is lack of synchronization between
receipts and expenditures. The transaction motive is further classified into
income motive and business (trade) motive, both of which stressed on
the requirement of individuals and businesses respectively to bridge the
time gap between receipt of income and planned expenditures.

Keynes did not consider the transaction balances as being affected by

interest rates, The transaction demand for money is directly related to the
level of income. The transactions demand for money is a direct
proportional and positive function of the level of income and is stated as
follows:

Lr = kY

Where, Lr is the transactions demand for money

K is the ratio of earnings which is kept for transaction
purposes
Y is the earnings.

Keynes considered the aggregate demand for money for transaction

purposes as the sum of individual demand and therefore, the aggregate
transaction demand for money is a function of national income.

b) The Precautionary Motive

Many unforeseen and unpredictable contingencies involving money

payments occur in our day-to-day life. Individuals as well as businesses
keep a portion of their income to finance such unanticipated
expenditures. The amount of money demanded under the
precautionary motive depends on the size of income, prevailing
economic as well as political conditions and personal characteristics of
the individual such as optimism / pessimism, farsightedness etc. Keynes
regarded the precautionary balances just a balance under transactions
motive as income elastic and by itself not very sensitive to rate of interest.

c) The Speculative Demand for Money

The speculative motive reflects people’s desire to hold cash in order to
be equipped to exploit any attractive investment opportunity requiring
cash expenditure. According to Keynes, people demand to hold money
balances to take advantage of the future changes in the rate of interest,
which is the same as future changes in bond prices. It is implicit in Keynes
theory, that the ‘rate of interest’, i, is really the return on bonds. Keynes
assumed that the expected return on money is zero, while the expected
returns on bonds are of two types, namely:

i. The interest payment

ii. The expected rate of capital gain

The market value of bonds and the market rate of interest are inversely
related.
Bonds have coupon rates at or close to prevailing market interest rates
and are fixed. Low bond prices are indicators of high interest rates and
high bond prices live reflect low interest rate Market value of a bond can
be determined using the following formula:
𝑅
V=
𝑟
Where V=current market value of the bond
R= annual return on the bonds (presently what the bond is
earning)
r=prevailing market rate of interest(what the new bonds
will earn)
For e.g. If a bond of value of Rs 100 carries 4% interest and rate of interest
rises to 5%, then the current value of the bond will be :
4
V= =Rs. 80
0.05

Thus we see that a rise in the market rate of interest leads to a decrease
in the market value of the bond and vice versa.

Investors have a relatively fixed conception of the ‘normal’ or ‘critical’

interest rate and compare the current rate of interest with such ‘normal’
or ‘critical’ rate of interest.

If wealth-holders consider that the current rate of interest is high

compared to the ‘normal or critical rate of interest’, they expect a fall in
the interest rate (rise in bond prices). At the high current rate of interest,
they will convert their cash balances into bonds because:

i. They can earn high rate of return on bonds

 ii. They expect capital gains resulting from a rise in bond price
consequent upon an expected fall in the market rate of
interest in future.

Conversely, if the wealth-holders consider the current interest rate as low,

compared to the ‘normal or critical rate of interest’, i.e., if they expect
the rate of interest to rise in future (fall in bond prices), they would have
an incentive to hold their wealth in the form of liquid cash rather than
bonds because:

i. The loss suffered by way of interest income forgone is small,

ii. They can avoid the capital losses that would result from the
anticipated increase in interest rates, and

iii. The return on money balances will be greater than the return
on alternative assets

iv. If the interest rate does increase in future, the bond prices will
fall and the idle cash balances held can be used to buy
bonds at lower prices and can thereby make a capital-gain.

Summing up,
 as long as the current rate of interest > the critical rate of interest, a
typical wealthholder would hold in his asset portfolio only
government bonds; while
 if the current rate of interest < the critical rate of interest, his asset
portfolio would consist wholly of cash.
 When the current rate of interest = the critical rate of interest, a
wealth-holder is indifferent to holding either cash or bonds.

The inference from the above is that the speculative demand for
money and interest are inversely related.

The speculative demand for money of individuals can be

diagrammatically presented as follows:
 Individual’s Speculative Demand for Money

This discontinuous portfolio decision of a typical individual investor is shown in

the figure above. When the current rate of interest rn is higher than the critical
rate of interest rc, the entire wealth is held by the individual wealth-holder in the
form of government bonds. If the rate of interest falls below the critical rate of
interest rc, the individual will hold his entire wealth in the form of speculative cash
balances.

The discontinuous portfolio decision of a typical individual investor is

shown in the above figure.
 When the current rate of interest rn >the critical rate of interest rc,
the entire wealth is held by the individual wealth holder in the form
of government bonds.
 If the rate of interest rn < critical rate of interest rc , the individual
will hold his entire wealth in the form of speculative cash balances.

When we go from the individual speculative demand for money to the

aggregate speculative demand for money, the discontinuity of the
individual wealth-holder’s demand curve for the speculative cash
balances disappears and we obtain a continuous downward sloping
demand function showing the inverse relationship between the current
rate of interest and the speculative demand for money as shown in figure
below:
 Aggregate Speculative Demand for Money

According to Keynes, higher the rate of interest, lower the speculative

demand for money, and lower the rate of interest, the higher the
speculative demand for money. The sum of the transaction and
precautionary demand, the speculative demand, is the total demand
for money.

The concept of liquidity trap

At a very high interest rate,say r*, the opportunity cost of holding
money(in terms of interest foregone)is very high and therefore,people will
hold no money in speculative balances.When interest rates fall to very
low levels, it cannot go further lower and that in all possibility it will move
upwards.When interest rate rises,the bond prices will fall(interest rates
and bond prices are inversely related). To hold bonds at this low interest
rate is to take the almost certain risk of capital loss(as the interest rate
rises and the bond prices fall). Therefore, the desire to hold bonds is very
low and approaches zero, and the demand to hold money in liquid form
as alternative to bond holding approaches Infinity. In other words,
investors would maintain cash savings rather than hold bonds. The
speculative demand becomes perfectly elastic with respect to interest
rate and the speculative money demanded curve becomes parallel to
X axis. This situation is called a liquidity trap.
 In such a situation, the monetary authority is unable to stimulate the
economy with monetary policy. Since the opportunity cost of holding
money is zero, even if the monetary authority increases money supply to
stimulate the economy, people would prefer to hold money.
Consequently, excess funds may not be converted into new investments.
The liquidity trap is synonymous with ineffective monetary policy.

The sum of the transaction, precautionary and the speculative demand

is the total demand for money.
To sum up, an increase in income increases the transaction and
precautionary demand for money and a rise in the rate of interest
decreases the demand for speculative demand money.

1.5 Post-Keynesian Developments in the Theory of Demand for

Money

Inventory Approach to Transaction Balances

Baumol (1952) and Tobin (1956) developed a deterministic theory of

transaction demand for money, known as Inventory Theoretic Approach,
in which money or ‘real cash balance’ was essentially viewed as an
inventory held for transaction purposes.

Assumptions:

1) Inventory models assume that there are two media for storing
value: (a)money and
(b) an interest-bearing alternative financial asset.
2) There is a fixed cost of marking transfers between money and the
alternative assets e.g., broker charges. While relatively liquid
financial assets other than money (such as, bank deposits) offer a
positive return, the above said transaction cost of going between
money and these assets justifies holding money.
3) The bond market is perfect that is there is easy conversion of bonds
into cash and vice versa .
4) Baumol’s proposition in his theory of transaction demand for money
hold that receipt of income, say Y takes place once per unit if time
but expenditure is spread at a constant rate over the entire period
of time.
5) Excess cash over the above what is required for transactions during
the period under consideration will be invested in bonds or put in
an interest-bearing account.
Baumol used business inventory approach to analyze the behavior of
individuals. Just as businesses keep money to facilitate their business
transactions, people also hold cash balance which involves an
opportunity cost in terms of lost interest. Therefore, they hold an optimum
combination of bonds and cash balance i.e., an amount that minimizes
the opportunity cost.
How is the optimum combination determined?
Baumol Tobin model answers this question by analyzing the cost band benefit
of holding money in hands.

Factors affecting the demand for money

1) The higher the income, the higher is the average level or inventory
of money holdings.
2) The level of inventory holding also depends also upon the carrying
cost, which is the interest forgone by holding money and not
bonds, net of cost to the individual of making a transfer between
money and bonds say for example brokerage fee. An increase in
the brokerage fee raises the marginal cost of bond market
transactions and consequently lowers the number of such
transactions. The increase in the brokerage fee raises the
transactions demand for money and lower the average bond
holding over the period.
3) The average transaction balance (money) holding is a function of
the number of times the transfer between money and bonds takes
place. The more the number of times the bond transaction is
made, the lesser will be the average transaction balance holdings.
In other words, the choice of the number of times the bond
transaction is made determines the split of money and bond
holdings for a given income. The individual will choose the number
of times the transfer between money and bonds takes place in
such a way that the net profits from bond transactions are
maximized

Money holdings on an average will be lower if people hold bonds or

other interest yielding assets.

Thus,an individual combines his asset portfolio of cash and bond in such
proportions that his cost is minimized.
 1.5.1 Friedman’s Restatement of the Quantity Theory

Milton Friedman (1956) extended Keynes; speculative money demand

within the framework of asset price theory. Friedman treats the demand
for money as nothing more than the application of a more general
theory of demand for capital assets. Demand for money is affected by
the same factors as demand for any other asset, namely

1. Permanent income
2. Relative returns on assets (which incorporate risk)

Friedman maintains that it is permanent income – and not current

income as in the Keynesian theory – that determines the demand for
money. Permanent income which is Friedman’s measure of wealth is the
present expected value of all future income. To Friedman, money is a
good as any other durable consumption good and its demand is a
function of a great number of factors.
Friedman identifies the following four determinants of the demand for
money. The nominal demand for money:

 Is a function of total wealth, which is represented by permanent

income divided by the discount rate, defined as the average return
on the five asset classes in the monetarist theory world, namely
money, bonds, equity, physical capital and human capital.

 Is positively related to the price level, P, If the price level rises the
demand for money increases and vice-versa.

 Rises if the opportunity costs of money holdings (i.e., returns on

bonds and stock) decline and vice-versa.

 Is influenced by inflation, a positive inflation rate reduces the real

value of money balances, thereby increasing the opportunity costs
of money holdings.

1.5.1 The Demand for Money as Behavior toward Risk

In his classic article, ‘Liquidity Preference as Behaviors towards Risk’

(1958), Tobin established that the theory of risk-avoiding behavior of
individuals, provided the foundation for the liquidity preference and for
a negative relationship between the demand for money and the interest
rate. The risk-aversion theory is based on the principles of portfolio
management. According to Tobin, the optimal portfolio structure is
determined by

a. The risk / reward characteristics of different assets

b. The taste of the individual in maximizing his utility consistent with the
existing opportunities.

In his theory which analyzes the individual’s portfolio allocation between

money and bond holdings, the demand for money is considered as a
store of wealth. Tobin hypothesized that an individual would hold a
portion of his wealth in the form of money in the portfolio because the
rate of return on holding money was more certain than the rate of return
on holding interest earning assets and entails no capital gains or losses.
It is riskier to hold alternative assets vis-à-vis holding just money alone
because government bonds and equities are subject to market price
volatility, while money is not. Thus, bonds pay an expected return of r,
but as asset, they are unlike money because they are risky; and their
actual return is uncertain. Despite this, the individual will be willing to face
this risk because the expected rate of return from the alternative financial
assets exceeds that of money.

According to Tobin, the rational behavior of a risk-averse economic

agent induces him to hold an optimally structured wealth portfolio which
is comprised of both bonds and money. The overall expected return on
the portfolio would be higher if the portfolio were all bonds, but an
investor who is ‘risk-averse’ will be willing to exercise a trade-off and
sacrifice to some extent the higher return for a reduction in risk.
Tobin’s theory implies that the amount of money held as an asset
depends on the level of interest rate. An increase in the interest rate will
improve the terms on which the expected return on the portfolio can be
increased by accepting greater risk. In response to the increase in the
interest, the individual will increase the proposition of wealth held in the
interest-bearing asset, say bonds, and will decrease the holding of
money. Within Tobin’s framework, an increase in the rate of interest can
be considered as an increase in the payment received for undertaking
risk. When this payment is increased, the individual investor is willing to
put a greater proportion of the portfolio into the risky asset, (bonds) and
thus a smaller proportion into the safe asset, money. His analysis implies
that the demand for money as a store of wealth will decline with an
increase in the interest rate. Tobin’s analysis also indicates that
uncertainty about future changes in bond prices and hence the risk
involved in buying bonds, may be a determinant of money demand.
Just as Keynes’ theory, Tobin’s theory implies that the demand for money
as a store of wealth depends negatively on the interest rate.
Unit II: Concept of Money Supply

2.1 Introduction

The term money supply denotes the total quantity of money available to
the people in an economy. The quantity of money at any point of time
is a measurable concept. It is important to note two things about any
measure of money supply:

a. The supply of money is a stock variable i.e., It refers to the total

amount of money at any particular point of time. It is the change
in the stock of money (say, increase or decrease per month or
year,), which is a flow.

b. The supply of money always refers to the stock of money available

to the ‘public’ as a means of payments and store of value. This is
always smaller than the total stock of money that really exists in an
economy.

The term ‘public’ is defined to include all economic units (households,

firms and institutions) except the producers of money (i.e., the
government and the banking system). The government, in this context,
includes the central government and all state governments, in this
context, includes the central government and all state governments and
local bodies; and the banking system means the Reserve Bank of India
and all the banks that accept demand deposits (i.e., deposits from which
money can be withdrawn by cheque mainly CASA deposits). The word
‘public is inclusive of all local authorities, non-banking financial
institutions, and non-departmental public-sector undertakings, foreign
central banks and governments and the International Monetary Fund
which holds a part of Indian money in India in the form of deposits with
the RBI. In other words, in the standard measures of money, interbank
deposits and money held by the government and the banking system
are not included.

2.2 Rationale of measuring Money Supply

Empirical analysis of money supply is important for two reasons:

a. It facilitates analysis of monetary deployments in order to provide a

deeper understanding of the causes of money growth.
b. It is essential from a monetary policy perspective as it provides a
framework to evaluate whether the stock of money in the economy is
consistent with the standards for price stability and to understand the
nature of deviations from this standard. The central banks all over the
world adopt monetary policy to stabilize price level and GDP growth
by managing the quantity of monetary base. The success of
monetary policy depends to a large extent on the controllability of
money supply and the monetary base.

2.3 The source of Money Supply

The supply of money in the economy depends on:

a) The decision of the central bank based on the authority conferred

on it, and

b) The supply responses of the commercial banking system of the

country to the changes in policy variables initiated by the central
bank to influence the total money supply in the economy.

The central banks of all countries are empowered to issue currency and,
therefore, the central bank is the primary source of money supply in all
countries. In effect, high powered money issued by monetary authorizes
is the source of all other forms of money. The currency issued by the
central bank is ‘fiat money’ and is backed by supporting services and its
value is guaranteed by the government. The currency issued by the
central bank is, in fact, a liability of the central bank and the government.
Therefore, in principle, it must be backed by an equal value of assets
mainly consisting of gold and foreign exchange reserves. In practice,
however, most countries have adopted a ‘minimum reserve system’
therein the central bank is empowered to issue currency to any extent
by keeping only a certain minimum reserve of gold and foreign securities.

The second major source of money supply is the banking system of the
country. The total supply of money in the economy is also determined
by the extent of credit created by the commercial banks in the country.
Banks create money supply in the process of borrowing and lending
transactions with the public. Money so created by the commercial
banks is called ‘credit money’. The high-powered money and the credit
money broadly constitute the most common measure of money supply,
or the total money stock of a country.
 2.4 Measurement of Money Supply

Different countries follow different practices in measuring money supply.

The measures of money supply vary from country to country, from time
to time and from purposes to purpose.

Since July 1935, the Reserve Bank of India has been compiling and
disseminating monetary statistics. Till 1967-68, the RBI used to publish only
a single ‘narrow measure of money supply’ (M1), defined as the sum of
currency and demand deposit held by the public. From 1967-68, a
‘broader’ measure of money supply, called ‘aggregate monetary
resources’ (AMR) was additionally published by the RBI. From April 1977,
following the recommendations of the Second Working Group on Money
Supply (SWG), the RBI has been publishing data on four alternative
measures of money supply denoted by M1, M2, M3 and M4 besides the
reserve money. The respective empirical definitions of these measures
are given below:

M1(narrow money) = Currency notes and coins with the people +

demand deposits with the banking system (Current and Saving
deposit accounts) + other deposits with the RBI.

M2 = M1 + savings deposits with post office savings banks.

M3(broad money) = M1 + net time deposits with the banking system.

M4 = M3 + total deposits with the Post Office Savings Organization

(Excluding National Savings Certificates).

The RBI regards these four measures of money stock as representing

different degrees of liquidity. It has specified them in the descending
order of liquidity. M1 being the most liquid and M4 the least liquid of the
four measures.

We will briefly discuss the important components of each:

 Currency consists of paper currency as well as coins.

 Demand deposits comprise the current-account deposits and the
demand deposit portion of savings deposits, all held by the public.
 These are also called CASA deposits and these are cheapest
sources of finance for a commercial bank.
 It should be noted that it is the net demand deposits of banks, and
not their total demand deposits that get included in the measure
of money supply. The total deposits include both deposits form the
public as well as interbank deposits. Money is deemed as
something held by the ‘public’. Since interbank deposits are not
held by the public, they are netted out of the total demand
deposits to arrive at et demand deposits.
 Other deposits of the RBI are its deposits other than those held by
the government (the Central and state governments), and include
demand deposits of quasi-government institutions, other financial
institutions, balances in the account s of foreign central banks and
governments, and accounts of international agencies such as IMF
and the World Bank.

Empirically, whatever the measure of money supply,these ‘other

deposits’ of the RBI constitute a very small proportion (less than one
per cent) of the total money supply.

Following the recommendations of the Working Group on Money (1998),

the RBI has started publishing a set of four new monetary aggregates on
the basis of the balance sheet of the banking sector in conformity with
the norms of progressive liquidity. The new monetary aggregates are:

Reserve Money/high powered money/M0/monetary base =

Currency in circulation + Bankers’ deposits
with the RBI + Other deposits with the RBI

= Net RBI credit to the Government + RBI credit to

the Commercial sector + RBI’s Claims on banks
+ RBI’s net Foreign assets + Government’s currency
liabilities to The Public - RBI’s net non-monetary
Liabilities

NM1 = Currency with the public + Demand Deposits with the

banking system + Other deposits with the RBI
 NM2 = NM1 + Short-term time deposits of residents (including and
up to contractual maturity of one year)

NM3 = NM2 + Long-term time deposits on residents + Call / Term

funding from financial institutions

In the monetary literature, money is usually defined in alternative ways

ranging from narrow to broad money.

 The M1 (narrow money) is defined as the sum of currency held by

the public, demand deposits of the banks and other deposits of RBI.
Banks include commercial and cooperative banks.
 Reserve money is comprised of the currency held by the public,
cash reserves of banks and other deposits of RBI.
 On comparison, we find that there is a difference between M1 and
reserve money.Bank reserves, which are a component of monetary
base, are not included in M1. In addition, bank deposits, which are
a component of M1, are not a part of the monetary base. Reserves
are commercial banks’ deposits with the central bank for
maintaining CRR and as working funds for clearing adjustments.

Reserve money, also known as central bank money, base money or high-
powered money, plays a critical role in the determination of the total
supply of money. Reserve money determines the level of liquidity and
price level in the economy and, therefore, its management is of crucial
importance of stabilize liquidity, growth, and price level in an economy.

The central bank also measures macroeconomic liquidity by formulating

various ‘liquidity’ aggregates in addition to the monetary aggregates.
While the instruments issued by the banking system are included in
‘money’, instruments those which are close substitutes of money but are
issued by the non-banking financial institutions are also included in
liquidity aggregates.

L1 = NM3 + All deposits with the post office savings banks (excluding
National Savings Certificate)

L2 = L1 + Term deposits with term lending institutions and refinancing

institutions (FIs) + Term borrowing by FIs + Certificates of deposit
issued by FIs.
L3 = L2 + Public deposits of non-banking financial companies.

2.5 Determinants of Money Supply

There are two alternate theories in respect of determination of money

supply.
 According to the first view, money supply is determined
exogenously by the central bank.
 The second view holds that the money supply is determined
endogenously by changes in economic activities which affect
people’s desire to hold currency relative to deposits, rate of
interest, etc.

The current practice is to explain the determinants of money

supply based on ‘money multiplier approach’ which focuses on the
relation between the money stock and money supply in terms of
the monetary base or high-powered money. This approach holds
the total supply of nominal money in the economy is determined
by the joint behavior of the central bank, the commercial banks
and the public. Before we discuss the determinants of money
supply, it is necessary that we know the concept of money
multiplier.

2.6 The concept of Money Multiplier

The money supply is defined as

M = m X MB

Where M is the money supply, m is money multiplier and MB is the

monetary base or high-powered money. From the above equation we
can derive the money multiplier (m) as

Money supply
Money Multiplier (m) =
Monetary base
Money multiplier m is defined as a ratio that relates the changes in the
money supply to a given change in the monetary base. It denotes by
how much the money supply will change for a given change in high-
powered money. The money multiplier process explains how an increase
in the monetary base causes the money supply to increase by a
multiplied amount. For instance, if there is an injection of Rs.100 crore
through an open market operation by the central Bank of the country
and if it leads to an increment of Rs 500 crores of final money supply, then
the money multiplier is said to be 5. Hence, the multiplier indicates the
change in monetary base which is transformed into money supply.
The multiplier indicates what multiple of the monetary base is
transformed into money supply. In other words, money and high
powered money are related by the money multiplier. We make two
simplifying assumptions as follows:
 Banks never hold excess reserves
 Individuals and nonbank corporations never hold currency.

What determines the size of the money multiplier?

The money multiplier is the reciprocal of the reserve ratio. Deposits, unlike
currency held by people, keep only a fraction of the high powered
money in reserves and the rest is lent out and culminate in money
creation. If R is the reserve ratio in a country for all the commercial banks,
then each unit of money reserves generates 1⁄𝑅 money.
Therefore for any value of R, the money multiplier is 1⁄𝑅.

For example, if R= 10 %, the value of money multiplier will be 10.

If R= 5%, then money multiplier is 20.
Thus, the higher the reserve ratio the less of each deposit banks loan out,
and the smaller the money multiplier.

If some portion of the increase in high-powered money finds its way into
currency, this portion does not undergo multiple deposit expansion. The
size of the money multiplier is reduced when funds are held as cash rather
than as demand deposit . In other words, as rule, an increase in the
monetary base that goes into currency is not multiplied, whereas an
increase in monetary base that goes into supporting deposits is
multiplied.
 2.7 The Money Multiplier Approach to Supply of Money

The money multiplier approach to money supply propounded by Milton

Friedman and Anna Schwartz, (1963) considers three factors as
immediate determinants of money supply, namely

a. The stock of high-powered money (H)

b. The ratio of reserves to deposits or reserve ratio r = (Reserves/Deposits
R/D) and
c. The ratio of currency to deposits or currency deposits ratio, c = (C/D)

These represent the behavior of the central bank, behavior of the

commercial banks and the behavior of the general public respectively.
We shall now describe how each of the above contributes to the
determination of aggregate money supply in an economy.

a. The Behavior of the central Bank

The behavior of the central bank which controls the issue of currency is
reflected in the supply of the nominal high-powered money. Money
stock is determined by the money multiplier and the monetary base is
controlled by the monetary authority. If the behavior of the public and
the commercial banks remains unchanged over time, the total supply of
nominal money in the economy will vary directly with the supply of the
nominal high-powered money issued by the central bank.

b. The Behavior of Commercial Banks.

By creating credit, the commercial banks determine the total amount of

nominal demand deposits. The behaviors of the commercial banks in the
economy are reflected in the ratio of their cash reserves to deposits
known as the ‘reserve ratio’.
 If the required reserve ratio on demand deposits increases while all
other variables remain the same, more reserves would be needed.
This implies that banks must contract their loans, causing a decline
in deposits and hence in the money supply. If the required reserve
ratio falls, there will be greater expansions of deposits because the
same level of reserves can now support more deposits and the
money supply will increase.
  In actual practice, however, the commercial banks keep only a
part or fraction of their total deposits in the form of cash reserves.
However, for the commercial banking system as a whole, the
actual reserves ratio is greater than the required reserve ratio since
the banks keep with them a higher than the statutorily required
percentage of their deposits in the form of cash reserves as a
buffer against unexpected events requiring cash.
The excess reserves which are funds that a bank keeps back beyond
what is required by regulation form a very important determinant of
money supply. These are the difference between total reserves and
required reserves. Is total reserves at 800 billion whereas the required
reserves are 600 billion, then the excess reserves at 200 billion.

The additional units of high-powered money that goes into ‘excess

reserves’ of the commercial banks do not lead to any additional loans,
and therefore, these excess reserves do not lead to creation of money.
Therefore, 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 deposits or currency and hence no effect on money supply.

When the costs of holding excess reserves rise, we should expect the level
of excess reserves to fall; when the benefits of holding excess reserves
rise, we would expect the level of excess reserves to rise. Two primary
factors namely market interest rates and expected deposit outflows,
affect these costs and benefits and hence in turn affect the excess
reserves ratio.

The cost to a bank while holding excess reserves is in terms of its

opportunity cost, i.e., the interest that could have been earned on loans
or securities if the bank had chosen to invest in them instead of excess
reserves.
 If interest rate increases, it means that the opportunity cost of
holding excess reserves rises because the banks have to sacrifice
possible higher earnings and hence the desired ratio of excess
reserves to deposits falls.
 Conversely, a decrease in interest rate will reduce the opportunity
cost of excess reserves, and excess reserves will rise.

Therefore, we conclude that the banking system’s excess reserves

ratio e is negatively related to the market interest rate.

If banks fear that deposit outflows are likely to increase (that is, if
expected deposit outflows increase), they will want more assurance
against this possibility and will increase the excess reserves ratio.
Conversely, a decline in expected deposit outflows will reduce the
benefit of holding excess reserves and excess reserves will fall.

Money is mostly held in the form of deposits with commercial banks.

Therefore, money supply may become subject to ‘shocks on account of
behavior of commercials banks which may present variations overtime
either cyclically and more permanently. For instance, in times of financial
crisis, banks may be unwilling to lend to the small and medium scale
industries who may become credit constrained facing a higher risk
premium on their borrowings. The rising interest rates on bank credit to
the commercial sector reflecting higher risk premia can co-exist with the
lowering of policy rates by the central bank. The lower credit demand
can lead to a sharp deceleration in monetary growth at a time when the
central bank pursues an easy monetary policy.

c. The Behavior of the Public

The behavior of the public is represented by currency deposit ratio c. The

payment habits of the public determine how much currency is held
relative to deposits. The public, by their decisions in respect of the
amount of nominal currency in hand (how much money they wish to hold
as cash) is in a position to influence the amount of the nominal demand
deposits of the commercial banks. The behavior of the public influences
bank credit through the decision on ratio of currency to the money
supply designated as the ‘currency ratio’.

What would be the behavior of money supply when depositors decide

to increase currency holding, with all other variables unchanged? In
other words, if we decide to keep more money in our pocket and less
money in our bank. That means we are converting some of our demand
deposits into currency. If many people do so like us , technically we say
there is an increase in currency ratio.
As we know, demand deposits undergo multiple expansions while
currency in our hands does not. Hence, when bank deposits are being
converted into currency, banks can create only less credit money. The
overall level of multiple expansion declines, and therefore, money
multiplier also falls. Therefore, we conclude that money multiplier and
the money supply are negatively related to the currency ratio c.
The currency-deposit ratio (c) represents the degree of adoption of
banking habits by the people. This is related to the level of economic
activities or the GDP growth and is influenced by the degree of financial
sophistication in terms of ease and access to financial services,
availability of a richer array of liquid financial assets, financial innovations,
institutional changes etc.

The smaller the currency-deposit ratio, the larger would be the money
multiplier. This is because a smaller proportion of high powered money is
being used as currency and therefore, a larger proportion is available to
be reserves which get transformed into money.

The time deposit-demand deposit ratio i.e., how much money is kept as
time deposits compared to demand deposits, also has an important
implication for the money multiplier and, hence for the money stock in
the economy. An increase in TD/DD ratio means that greater availability
of free reserves and consequent enlargement of volume of multiple
deposit expansion and monetary expansion.

To summarize the money multiplier approach,

 the size of the money multiplier is determined by the required
reserve ratio (r ) at the central bank, the excess reserve ratio (e) of
commercial banks and the currency ratio (c ) of the public,
 The lower these ratios are, the larger the money multiplier is.

In other words, the money supply is determined by high powered

money (H) and the money multiplier (m) and varies directly with
changes in the monetary base, and inversely with the currency
and reserve ratios. Although these three variables do not
completely explain changes in the nominal money supply,
nevertheless they serve as useful device for analyzing such
changes. Consequently, these variables are designated as the
‘proximate determinants’ of the nominal money supply in the
economy.

We can rewrite the money multiplier including the above

variables:
M=C+D-----------------(1)
H=C+reserves--------(2)
Where C is currency and D is the deposits which are assumed to
be demand deposits. We summarize the behavior of the public,
banks and the central bank by three variables namely currency -
 deposit ratio c = C/D, reserve Ratio r= reserves/D,and stock of high
powered money H.

Rewriting equation (1) & (2) above as

M=(c+1)D
H=(c+r)D
1+𝑐
M= *H=m*H
𝑟+𝑐
1+𝑐
M=
𝑟+𝑐
When there are excess reserves, the money multiplier m is
expressed as :
1+𝑐
m=
𝑟+𝑒+𝑐

1+𝑐
money supply M= *H
𝑟+𝑒+𝑐

The money multiplier is a function of:

1) The currency ratio set by depositors c which depends on the
behavior of the public
2) Excess reserves ratio set by banks
3) The required reserve ratio set by the central bank r, which
depends on prescribed CRR and the balances necessary to
meet settlement obligations.

Numerical illustration:
(a) In Gladys land, r=10%;
Currency= 400 billion
Deposits = 800 billion
Excess reserves =0.8 billion
Money supply M i= Currency+deposits = 1200 billion
c=C/D=400 billion/800 billion=0.5 or depositors hold 50% of their money
as currency
e=0.8 billion/800 billion=0.001 or banks hold 0.1% of their deposits as
excess reserves.
1+𝑐 1+0.5
m= = =2.5
𝑟+𝑒+𝑐 0.1+0.001+0.5
Therefore, a 1 unit increase in H leads to a 2.5 units increase in M .
The simple deposit multiplier in this example would be 1/R = 1/ 0.1 = 10
The difference is due to inclusion of currency and excess reserves in
calculating the multiplier.

(b) If the reserve ratio is increased to 15%, the value of the

money multiplier will be
=1+0.5/0.15+0.001+0.5=2.3

Obviously, r & m are negatively related. m falls when r rises, and m rises
when r falls. The reason is that less multiple deposit creation can occur
when r rises, while more multiple deposit creation can occur when r falls.

Monetary policy and money supply

If the central Bank of a country wants to stimulate economic activity, it

does so by infusing liquidity into the system. Open market operations by
central bank is one of the examples of it. Purchase of government
securities by RBI from the market injects high powered money into the
system. Assuming that banks do not hold excess reserves and people do
not hold more currency than before, and also that there is demand for
loans from businesses, the credit creation process by the banking system
in the country will create money to the tune of
∆ Money supply =1/ R * ∆ Reserves

The effect of an open market sale is very similar to that of open market
purchase but in the opposite direction. In other words, an open market
purchase by central bank will reduce the reserves and thereby reduce
the money supply .

Is it possible that the value of multiplier is zero ?It may happen when the
interest rates are too low and the banks prefer to hold the newly injected
reserves as excess reserves with no risk attached to it.

2.7 Effect of Government Expenditure on Money Supply

Whenever the central and the state governments cash balances fall
short of the minimum requirement, they are eligible to avail of the facility
called Ways and Means Advances (WMA) / overdraft (OD) facility.
When the Reserve Bank of India lends to the governments under WMA /
OD, it results in the generation of excess reserves (i.e., excess balances of
commercial banks with the Reserve Bank). This happens because when
government incurs expenditure, it involves debiting the government
balances with the Reserve bank and crediting the receiver (for e.g.,
salary account of government employee) account with the commercial
bank. The excess reserves thus created can potentially lead to an
increase in money supply though the money multiplier process
.
The Credit Multiplier

The credit multiplier also referred to as the deposit multiplier or the

deposit expansion multiplier, describes the amount of additional
money created by commercial bank through the process of lending
the available money it has in excess of the central bank’s reserve
requirements. The deposit multiplier is, thus inextricably tied to the
bank’s reserve requirements. This measure tells us how much new
money will be created by the banking system for a given increase in
the high-powered money, it reflects a bank’s ability to increase the
money supply.

The credit multiplier is the reciprocal of the required reserve ration. If

reserve ratio is 20%, then credit multiplier =1/0.20 = 5.

Credit Multiplier = 1
Required Reserve Ratio

The existence of the credit multiplier is the outcome of fractional

reserve banking. It explains how increase in money supply is caused by

the commercial banks’ use of depositors’ funds to lend money. When

a bank uses the deposited money for lending, the bank generates
another claim on a given amount of deposited money.

For example., if A deposits ₹ 1000/- in cash at a bank (Bank X), this

constitutes the bank’s current total cash deposits. If the required
reserve is 10 percent, the bank would lend ₹ 900/- to B. By lending B ₹
900/-, the bank creates a deposit for ₹ 900/- that B can now use. It is as
through B owns ₹ 900/-. This in turn means that A will continue to have
a claim against ₹ 1000/- while B will have a claim against ₹ 900/-. The
bank has ₹ 1000/- in cash against claim of ₹ 900/-. In short, the bank
has created ₹ 900/- out of ‘thin air’ since these ₹ 900/- are not
supported by a genuine money. At any time, the fractional reserve
commercial banks have more cash liabilities than cash in their vaults.

Now suppose B buys goods work ₹ 900/- from C and pays C by cheque.
C places the cheque with his bank, Bank Y. After clearing the cheque,
Bank Y will have an increase in cash of ₹ 900/-, which it may take
advantage of and use to lend out ₹ 810/- to D which may again be
deposited in another bank, say Bank Z. Against 10 percent of ₹ 810/- (₹
81) has to be kept as required reserves and the remaining ₹ 719/- can
 be lent out, say to E. This sequence keeps on continuing until the initial
deposit amount ₹ 1000/- grows exactly by the multiple of required
reserves (in this case 10%). Ultimately, the expended credit availabilt8u
would be 1000 + 900 (90% of 1000) + 810 (90% of 900) + 729 (90% of 810)
+ (90% of 719) +……… This summation would end with an amount
which is equivalent to 1/10% of 1000, which is ₹ 10000/-. This, in our
example, the initial deposit is capable of multiplying itself out 10 times.
In short, we find that the fact that banks make use of demand deposits
for lending it sets in motion a series of activities leading to expansion of
money that is not backed by money proper. It is interesting to know
that there is no difference between the type of money created by
commercial banks and that which are issued by central bank,

The deposit multiplier and the money multipler though closely related
are not identical because:

a. Generally, banks do not lend out all their available money but
instead maintain reserves at a level above the minimum
required reserve.
b. All borrowers do not spend every Rupee they have borrowed.
They are likely to convert some portion of it to cash.

Let’s solve

Q 1: Calculate narrow money from the following data:

Currency with public Rs. 90000 cr
Demand deposits with banking system Rs 200000 cr
Time deposits with banking system Rs 220000 cr
Other deposits with RBI Rs 280000 cr
Saving deposits of post office saving banks Rs 60000 cr [ans:570000 cr]

Q 2: Compute the credit multiplier if the required reserve ratio is 10% and 12.5%
for every Rs 1,00,000 deposited in the banking system. What will be the total
credit money created by the banking system in each case?[ans
10,8,10,00,000,8,00,000]
Q 3: Calculate currency with the public from the following data(Rs in crores)

Notes in circulation 2496611

Circulation of rupee coin 25572
Circulation of small coin 743
Cash on hand with banks 98305
[ans:2424621]

Q 4: Calculate M2 from the following data:[Rs in crores]

Notes in circulation 2420964
Circulation of rupee coin 25572
Circulation of small coins 743
Post office saving bank deposits 141786
Cash on hand with banks 97563
Deposit money of the public 1776199
Demand deposit with banks 1737692
Other deposits with Reserve Bank 38507
Total post office deposits 14896
Time deposits with banks 178694
[ans:M1=4125915;M2=4267701]
Q 5: If the required reserve ratio is 10%, currency in circulation is Rs 400 billion,
demand deposits are Rs 1000 billion, and excess reserves total Rs 1 billion, find
the value of money multiplier.[multiplier=2.79]

Q 6: How would each of the following affect money multiplier and money
supply?
1. Commercial banks in India decide to hold more excess reserves.

2. Fearing shortage of money in ATM, people decide to hold money

3. Banks open large number ATM’s all over the country

 4. E-banking becomes very common and nearly all people use it

5. During festival season, people decide to use ATM very often

6. If banks decide to keep 100% reserves, what would be the effect on

money multiplier and money supply?

7. Suppose banks need to keep no reserves ,only 0% reserves are there.

Q 7: What will be the total credit created by the commercial banking system
for an initial deposit of rupees 1000 for required reserve ratio 0.02, 0.05 and
0.10% respectively. Compute credit multiplier.
Unit III: Monetary Policy

3.1 Monetary Policy Defined

Monetary policy refers to the use of monetary policy instruments which

are at the disposal of the central bank to regulate the availability, cost
and use of money and credit to promote economic growth, price
stability, optimum levels of output and employment, balance of
payments, equilibrium, stable currency or any other goal of
government’s economic policy. In other words, monetary policy is
essentially a programme of action undertaken by the monetary
authorities, normally the central bank, to control and regulate the
demand for and supply of money with the public and the flow of credit
with a view to achieving predetermined macroeconomic goals.
Monetary policy encompasses all actions of the central bank which are
aimed at directly controlling the money supply and indirectly at
regulating the demand for money. Monetary policy is in the nature of
‘demand-side’ macroeconomic policy and works by stimulating or
discouraging investment and consumption spending on goods and
services. It is no surprise that monetary policy is regarded as an
indispensable policy instrument in an economy.

3.2 The Monetary Policy Framework

The central bank, in its execution of monetary policy, functions within an

articulated monetary policy framework which has three basic
components, viz.,

a. The objectives of monetary policy

b. The analytics of monetary policy which focus on the transmission

mechanism and

c. The operating procedure which focuses on the operating targets

and instruments

3.2.1 The objectives of Monetary Policy

The objectives set for monetary policy are important because they
provide explicit guidance to policy makers. Monetary policy of a country
is in fact a reflection of its economic policy and therefore, the objective
of monetary policy generally coincide with the overall objectives of
economic policy. There are significant differences among different
countries in respect of the selection of objectives, implementation
procedures and tools of monetary policy either due to differences in the
underlying economies or due to differences in the financial system and
in the infrastructure of financial markets.

In the pre-Keynesian period, monetary policy, with its conventional

objective of
 establishment and maintenance of stability in prices, was the single
well-acknowledged instrument of macroeconomic policy.

The Great Depression in 1930s and the associated economic crisis

marked a turning point resulting in a major shift in the objective of
governments economic policy in favor of
 maintenance of full employment, more generally described as
economic stability.

The most commonly pursued objectives of monetary policy of the

central banks across the world are
i. maintenance of price stability (or controlling inflation)
ii. achievement of high level of economy’s growth; and
iii. maintenance of full employment.

The Reserve Bank of India Act, 1934, in its preamble sets out the objectives
of the Bank as ‘to regulate the issue of bank notes and the keeping of
reserves with a view to securing monetary stability in India and generally
to operate the current and credit system of the country to its
advantage’. It is to be noted that though price stability as an objective
is not explicitly spelt out, the monetary policy in India has evolved
towards maintaining price stability and ensuring adequate flow of credit
to the productive sectors of the economy. Price stability, as we know, is
a necessary precondition for sustainable growth. Fundamentally, the
primary objective of monetary policy has been maintenance of a
judicious balance between price stability and economic growth.

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 were incorporated as objectives of monetary policy by policy
makers in later years. 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 policy targeted
at controlling inflation is very likely to generate unemployment. As such,
based on the set national priorities, the monetary policymakers have to
exercise appropriate trade-offs to balance the conflicting objectives.

Given the development needs of developing countries, the monetary

policy of such countries also incorporates explicit objectives such as:

a. Maintenance of the economic growth

b. Ensuring an adequate flow of credit to the productive sectors
c. Sustaining – a moderate structure of interest rates to encourage
investments and
d. Creation of an efficient market for government securities.

3.2.2 Analytics of Monetary Policy

Monetary policy is intended to influence macro-economic variables

such as the aggregate demand, quantity of money and credit, interest
rates etc., so as to influence overall economic performance. The process
or channels through which the change of monetary aggregates affects
the level of product and prices is known as ‘monetary transmission
mechanism’. It describes how policy-induced changes in the nominal
money stock or in the short-term nominal interest rates impact real
variables such as aggregate output and employment. Although we
know that monetary policy does influence output and inflation, we are
not certain about hoe exactly it does so because the effects of such
policy are visible often after a time lag which is not completely
predicable.

There are mainly five different mechanisms through which monetary

policy influences the price level and the national income. These are:

a. The interest rate channel,

b. The exchange rate channel
c. The quantum channel (e.g., relating to money supply and credit)
d. The asset price channel i.e., via equity and real estate prices.
e. The expectations channel

(a)The 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

(b)In open economies, additional real effects of a policy-induced

change in the short-term interest rate come about through the
exchange rate channel. Typically, the exchange rate channel works
through expenditure switching between domestic and foreign goods.
Appreciation of the domestic currency makes domestically produced
goods more expensive compared to foreign-produced goods. This
causes net exports to fall; correspondingly domestic output and
employment also fall.

(c)Two distinct credit channels – the bank lending channel and the
balance sheet channel – also allow the effects of monetary policy
actions to spread through the real economy. Credit channel operates
by altering access of firms and households to bank credit. Most
businesses and people mostly depend on bank for borrowing money.
“An open market operation’ that leads first to a contraction in the supply
of bank reserves and then to a contraction in bank credit requires banks
to cut back on their lending. This, in turn makes the firms that are
especially dependent on banks loans to cut back on their investment
spending. Thus, there is decline in the aggregate output and
employment following a monetary contraction.

Now we shall look into how the balance sheet channel works. Logically,
as a firm’s cost of credit rises, the strength of its balance sheet
deteriorates. A direct effect of monetary policy on the firm’s balance
sheet comes through an increase in interest rates leading to an increase
in the payments that the firm must make to repay its floating rate debts.
An indirect effect occurs when the same increase in interest rates works
to reduce the capitalized value of the firm’s long-lived assets. Hence, a
policy-induced increase in the short-term interest rate not only acts
immediately to depress spending through the traditional interest rate
channel, it also acts, possibly with a time-lag, to raise each firm’s cost of
capital through the balance sheet channel. These together aggravate
the decline in output and employment.

(d)The standard asset price channel suggests that asset prices respond
to monetary policy changes and consequently affect output,
employment and inflation. A policy induced increase in the short-term
nominal interest rates makes debt instruments more attractive than
equities in the eyes of investors leading to a fall in equity prices. If stock
prices fall after a monetary tightening, it leads to reduction in household
financial wealth, leading to fall in consumption, output, and
employment.

The manner in which these different channels function in a given

economy depends on:

i. The stage of development of the economy, and

ii. The underlying financial structure of the economy.

3.2.3 Operating Procedures and Instruments

The operating framework relates to all aspects of implementation of

monetary policy. It primarily involves three major aspects namely,

i. Choosing the operating target

ii. Choosing the intermediate target and
iii. Choosing the policy instruments.

 The operating targets refers to the financial variable (for e.g.,

inflation) that can be controlled by the central bank to a large
extent through the monetary policy instruments .
 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 and which displays a
predictable and stable relationship with the goal variables.
 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. The day-to-day
implementation of a monetary policy by central banks through
various instruments is referred to as operating procedures. For
example liquidity management is the operating procedure of the
Reserve Bank of India.

For implementing monetary policy, a central bank can act directly, using
its regulatory powers, or indirectly, using its influence on money market
conditions as the issuer of reserve money (currency in circulation and
deposit balances with the central bank).
 In general, the direct instruments comprise of:

a. The required cash reserve ratios and liquidity reserve ratios

prescribed from time to time.

b. Directed credit which takes the form of prescribed targets for

allocation of credit to preferred sectors (for e.g., Credit to priority
sectors), and

c. Administered interest rates wherein the deposit and lending rates

are prescribed by the central bank.

The indirect instruments mainly consist of:

a. Repos
b. Open market operations
c. Standing facilities and
d. Market-based discount window

We shall now discuss in detail how these instruments are put to use for
meeting the stated objectives of monetary policy.

i. Cash Reserve Ratio (CRR)

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 RBI may
set the ratio in keeping with the broad objective of maintaining monetary
stability in the economy. This requirement applies uniformly to all
scheduled banks in the country irrespective of its size or financial position.
Non-Bank Financial Institution (NBFIs) are outside the purview of this
reserve requirement.

The Reserve Bank does not pay any interest on the CRR balances
maintained by the scheduled commercial banks (SCBs) with effect from
the fortnight beginning March 31, 2007; However, failure of a bank to
meet its required reserve requirements would attract penalty in the form
of penal interest charges by the RBI.

CRR has, in recent years, assumed significance as one of the important

quantitative tools aiding in liquidity management, Higher the CRR with
the RBI, lower will be the liquidity in the system and vice versa. During
 slowdown in the economy the RBI reduces the CRR in order to enable
the banks to expand credit and increases the supply of money available
in the economy. In order to contain credit expansion during periods of
high inflation, the RBI increases the CRR.

ii. Statutory Liquidity Ratio (SLR)

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:

i. Cash
ii. Gold, or
iii. Investments in un-encumbered instruments that include:

a. Treasury-bills of the Government of India.

b. Dated securities including those issued by the Government of India

from time to time under the market borrowings programme and
the Market Stabilization Scheme (MSS)

c. State Development Loans (SDLs) issued by State Governments

under their market borrowings programme

d. Other instruments as notified by the RBI. These include mainly the

securities issued by PSE.

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 in the form of a penal interest payable to RBI.

The SLR is also a powerful tool for controlling liquidity in the domestic
market by means of manipulating bank credit. 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. The SLR requirement also facilitates a captive
market for government securities.
iii. Liquidity Adjustment Facility (LAF)

A central bank is a ‘banker’s bank’. It provides Liquidity to banks when

the later 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, or other eligible
papers. This type of support earlier took the form of refinance of loans
given by commercial banks to various sectors (e.g., Exports, agriculture
etc.From June 2000, the RBI has introduced Liquidity Adjustment Facility
(LAF).

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) on an overnight basis against
the collateral of government securities including state government
securities.

The introduction of LAF is an important landmark since it triggered a rapid

transformation in the monetary policy operating environment in India. As
a key element in the operating framework of the RBI, its objective is to
assist banks to adjust their day-to-day mismatches in liquidity. Currently,
the RBI provides financial accommodation to the commercial banks
through repos / reverse repos under the Liquidity Adjustment Facility
(LAF).

Repurchase Options or in short ‘Repo’, is defined as ‘an instrument for

borrowing funds by selling securities with an agreement to repurchase
the securities on a mutually agreed future date at an agreed price which
includes interest for the funds borrowed’. In other words, 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 securities are repurchased by the
original holder. The user pays to the counter party the amount of
originally received plus the return on the money for the number of days
for which the money was used, which is mutually agreed. All these
transactions are reported on the electronic platform called the
Negotiated Dealing System (NDS). The Clearing corporation of India Ltd
(CCIL) has put in an anonymous online repo dealing system in India, with
an anonymous order matching electronic platform. Repo or repurchase
option is a collaterised lending. The rate charged by RBI for this
transaction is called the ‘repo rate’. Repo operations thus inject liquidity
into the system.

The Policy rate *

In India, the fixed repo rate quoted for sovereign securities in the
overnight segment of Liquidity Adjustment Facility (LAF) is considered
as the policy rate. (It may be noted that India has many other repo
rates in operation). The RBI uses the single independent ‘policy rate’
which is the repo rate (in the LAF window) for balancing liquidity. The
policy rate is in fact, the key lending rate of the central bank in a
country. A change in the policy rate gets transmitted through the
money market to the entire 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.

‘Reverse Repo’ is defined as an instrument for lending funds by

purchasing securities with an agreement to resell the securities on a
mutually agreed future date at an agreed price which includes interest
for the funds lent. Reverse repo operations take 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. The collaterals
used for repo and reverse repo operations consists of primarily
Government of India securities i.e., all SLR-eligible transferable
government of India dated securities / treasury bills.

The ‘repo rate’ and the reverse repo rate’ are changed only through the
announcements made during the Monetary Policy Statements of the RBI.
From May 2011 onwards, the reverse repo rate is not announced
separately, it will be linked to repro rates. The Reverse Bank also conducts
variable interest rate reverse repo auctions, as necessitated under the
market conditions.

There are three types of repo markets operating in India namely:

i. Repo on sovereign securities

ii. Repo on corporate debt securities and
iii. Other Repos

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. LAF is conducted at a fixed time on daily
basis on all working days in Mumbai (excluding Saturdays).

3. Marginal Standing Facility (MSF)

The Reserve Bank of India, being a banker’s bank, act as a lender of last
resort. The Marginal Standing Facility (MSF) announced by the Reserve
Bank of India (RBI) in its Monetary Policy, 2011-12 refers to the facility
under which 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 percent of
their net demand and time liabilities deposits (NDTL) liable to change
every year) at a penal rate of interest. This provides a safety valve against
unexpected liquidity shocks to the banking system The scheme has been
introduced by RBI with the main aim of reducing volatility in the overnight
lending rates in the inter-bank market and to enable smooth monetary
transmission in the financial system.

Banks can borrow through MSF on all working days except Saturdays,
between 7.00 pm and 7.30 pm, in Mumbai. The minimum amount which
can be accessed through MSF is ₹1 crore and more will be available in
multiples of ₹1 crore.

The MSF would be the last resort for banks once they exhaust all
borrowing options including the liquidity adjustment facility on which the
rates are lower compared to the MSF. The MSF rate being a penal rate
automatically gets adjusted to a fixed percent above the repo rate. MSF
is at present aligned with the Bank rate. Practically, MSF represents the
upper band of the interest corridor with repo rate at the middle and
reverse repo at the lower band.

5. Market Stabilization Scheme (MSS)

This instrument for monetary management was introduced in 2004

following a MoU between the Reserve Bank of India (RB) 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 buy it). Surplus liquidity of a more enduring nature arising
from large capital inflows is absorbed through sale of short dated
government securities and treasury bills. 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

Under Section 49 of the Reserve Bank of India Act 1934, the Bank Rate
has been defined as ‘the standard rate at which the Reserve Bank is
prepared to buy or rediscount bills of exchange or other commercial
paper eligible for purchase under the Act’. The bank rate once used to
be the policy rate in India i.e., the key interest rate based on which all
other short term interest rates moved. 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. Briefly put, MSF
assumed the role of bank rate and currently the bank rate is purely a
signaling rate and most interest rates are delinked from the bank rate.
Now, bank rate is used only for calculating penalty on default in the
maintenance of Cash Reserve Ration (CRR) and the Statutory Liquidity
Ratio (SLR).

6. Open Market Operation

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.

3.3 The Organizational Structure for Monetary Policy Decisions

3.3.1 The Monetary Policy Framework Agreement

The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016,
for giving a statutory backing to the Monetary Policy Framework
Agreement and for setting up a Monetary Policy Committee (MPC). The
Monetary Policy Framework Agreement is 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. The amended RBI Act (2016) provides for a
statutory basis for the implementation of the ‘flexible inflation targeting
framework’.

Announcement of the official target range for inflation is known as

inflation targeting. 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 inflation target
is to be set by the Government of India, in consultation with the Reserve
Bank, once in every five years. Accordingly,

 The Central Government has notified 4 percent Consumer Price

Index (CPI) inflation as the target for the period from August 5, 2015
to March 31, 2021 with the upper tolerance limit of 6 percent and
the lower tolerance limit of 2 percent.

 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.

 The following factors are notified by the central government as

constituting a failure to achieve the inflation target:
 a. The average inflation is more than the upper tolerance level
of the inflation target for any three consecutive quarters; or
b. The average inflation is less than the lower tolerance level for
any three consecutive quarters.

The choice of CPI was made because it closely reflects cost of living and
has larger influence on inflation expectations compared to other
anchors. With this step, India is following countries such as the New
Zealand, the USA, the UK, European Union and Brazil. Although in recent
times many of the countries are moving away from this approach and
the targeting nominal GDP growth.

3.3.2 The Monetary Policy Committee (MPC)

An important landmark in India’s monetary history is the constitution of

an empowered six-member Monetary Policy Committee (MPC) in
September, 2016, consisting of the RBI Governor (Chairperson), the RBI
Deputy Governor in charge of monetary policy, one official nominated
by the RBI Board and the remaining three central government nominees
representing the Government of India who are persons of ability, integrity
and standing, having knowledge and experience in the field of
Economics or banking or finance or monetary policy.

The committee is required to meet at least four times a year and the
decisions adopted by the MPC are published after conclusion of every
meeting of the MPC. Based on the review of the macroeconomic and
monetary developments in the economy, the MPC shall determine the
policy rate required to achieve the inflation target. Accordingly, fixing of
the benchmark policy interest rate (repo rate) is made through debate
and majority vote by this panel of experts.
With the introduction of the Monetary Policy Committee, the RBI will
follow a system which is more consultative and participative similar to the
one followed by many of the central banks in the world. The new system
in intended to incorporate:

 Diversity of views
 Specialized experience
 Independence of opinion
 Representativeness and
 accountability
The Reserve Bank’s Monetary Policy Department (MPD) assist 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. The Financial Markets Committee (FMC) meets daily to
review the liquidity conditions so as to ensure that the operating target
of monetary policy (weighted average lending rate) is kept close to the
policy repo rate.

Before the constitution of the MPC, a Technical Advisory Committee

(TAC) on monetary policy with experts for Monetary Economics, Central
Banking, Financial Markets and Public Finance advised the RBI on the
standpoint of monetary policy. However, its role was only advisory in
nature. With the formation of MPC, the TAC on Monetary Policy ceased
to exist.
 INTERNATIONAL TRADE

Unit I: Theories of International Trade

1.1 Introduction

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 system,
 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.

At present liberal international trade is an integral part of

international relations and has become an important engine of
growth in developed as well as developing countries.

The arguments in support of international trade.

How does international trade increase economic efficiency. Explain. [ CA Inter
,May ‘19]
i. International trade is a powerful stimulus to economic efficiency and
contributes to economic growth and rising incomes. The wider market
made possible owing to trade induces companies to reap the
quantitative and qualitative benefits of extended divisions of labour.
As a result, they would enlarge their manufacturing capabilities and
benefit from economies of large-scale production. The gains from
international trade are reinforced by the increased competition that
domestic producers are confronted with on account of globalization
of production and marketing requiring business to compete against
global businesses. 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 use is a direct economic advantage of foreign trade.
Greater efficiency in the use of natural, human, industrial and financial
resources ensure productivity gains. Since international trade also
tends to decrease the likelihood of domestic monopolies, it is always
beneficial to the community.

ii. Trade provides access to new markets and enables sourcing of inputs
and components internationally at competitive prices. This reflects in
innovative products at lower prices and wider choice in products and
services for consumers. Also, international trade enables consumers
to have access to wider variety of goods and services that would not
otherwise be available. It also enables nations to acquire foreign
exchange reserves necessary for imports which are crucial for
sustaining their economies.

iii. International trade enhances the extent of market and augments the
scope for mechanization and specialization. Trade necessitates
increased use of automation, supports technological change,
stimulates innovations, and facilitates greater investment in research
and development and productivity improvement in the economy.

iv. 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. Trade also provides greater stimulus to innovative
services in banking, insurance, logistics, consultancy services etc.

v. Employment generating investments, including foreign direct

investment, inevitably follow trade. For emerging economies,
improvement in the quality of output of goods and services, superior
products, finer labor and environmental standards etc. enhance the
value of their products and enable them to move up the global value
chain.

vi. Trade can also contribute to human resource development, by

facilitating fundamental and applied research and exchange of
know-how and best practices between trade partners.

vii. Trade strengthens bonds between nations by bringing citizens of

different countries together in mutually beneficial exchanges and
thus, promotes harmony and cooperation among nations.

The major arguments put forth against trade openness are:

 i. Possible negative labor market outcomes in terms of labor-saving
technological change that depress demand for unskilled workers, loss
of laborer’s bargaining power, downward pressure on wages of semi-
skilled and unskilled workers and forced work under unfair
circumstances and unhealthy occupational environments.

ii. International trade is often not equally beneficial to all nations.

Potential unequal market access and disregard for the principles of
fair-trading system may even amplify the differences between trading
countries, especially if they differ in their wealth. Economic
exploitation is a likely outcome when underprivileged countries
become vulnerable to the growing political power of corporations
operating globally.

iii. 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 at large.

iv. Probable shift towards a consumer culture and change in patterns of

demand in favor of foreign goods ,which are likely to occur in less
developed countries may have adverse effect on the development
of domestic industries and may even threaten the survival of infant
industries. Trade cycles and the associated economic crisis occurring
in different countries are also likely to get transmitted rapidly to other
countries.

v. Risky dependence of underdeveloped countries on foreign nations

impairs economic autonomy and endangers their political
sovereignty. Such reliance often leads to widespread exploitation
and loss of cultural identity. Substantial dependence may also have
severe adverse consequences in times of wars and other political
disturbances.

vi. Welfare of people may be ignored or jeopardized for the sake of

profit. Excessive exports may cause shortages of many commodities
in the exporting countries and lead to high inflation (e.g., onion price
rise in 2014). Also, import of harmful products may cause health
hazards and environmental damage (e.g., Chinese products).
vii. Too much export orientation may distort actual investments away
from the genuine investment needs of a country.

viii. Instead of cooperation among nations, trade may breed rivalry on

account of severe competition.

1.2 IMPORTANT THEORIES OF INTERNATIONAL TRADE

1.2.1 The Mercantilists View of International Trade

Mercantilism, which was the policy of Europe’s great powers, 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 an 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. The
arguments put forth by mercantilists were later proved to have many
shortcomings by later economists. Although it is still very important
theory which explains policies followed by many big and fast-growing
economies in Asia.

1.2.2 The Theory of Absolute Advantage

Adam Smith was the first to put across the possibility that international
trade is not a zero-sum game. According to Adam Smith who
supported unrestricted trade and free international competition,
absolute cost advantage is the determinant of mutually beneficial
international trade. The absolute cost advantage theory points out
that a country will specialize in the production and export of a
commodity in which it has absolute cost advantage. In other words,
exchange of goods between two countries will take place only if
each of the two countries can produce one commodity at an
absolutely lower production cost than the other country.

Smith’s thoughts on the principle of division of labour constitutes the

basis for his theory of international trade and therefore, the value of
goods is determined by measuring the labour incorporated in them.
 The theory is generally presented with an example of a hypothetical
two countries and two commodities model (2x2 model). Absolute
advantage exists between nations when they differ in their ability to
produce goods. Each nation can produce one good with less
expenditure of human labor or more cheaply than the other. As a
result, each nation has an absolute advantage in the production of
one good. Absolute advantage can be explained with a simple
numerical example given in table 4.1.1:

Figure 4.1.1

Output per Hour of Labor

As can be seen from the above table, one hour of labor time produces
6 bushels and 1 bushel of wheat respectively in country A and country B.
On the other hand, one hour of labor time produces 4 yards 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 both nations can
engage in trade with each other, each nation will specialize in the
production of the good it has absolute advantage in and obtain the
other commodity through international trade. Therefore, country A
would specialize completely in production of wheat and country B in
cloth.

If country A exchanges six bushels of wheat (6W) for six yards of country
B’s cloth (6C), then country A gains 2C or saves half an hour of 30 minutes
of labor time (since the country A can only exchange 6W for 4C
domestically). Similarly, the 6W that country B received form country A is
equivalent to or would require six hours of lobour time to produce in
country B. These same six hours can produce 30C in country B (6 hours x
5 yards of cloth per hour). By being able to exchange 6C (requiring a
little over one hour to produce in the country B) for 6W, country B gains
24C, or saves nearly five hours of work.

This example shows trade is advantageous, although gains may not be

distributed equally, because their given resources are utilized more
efficiently, and, therefore, both countries can produce larger quantities
of commodities which they specialize in.
By Specializing and trading freely, global output is, thus, maximized and
more of both goods are available to the consumers in both the countries.
If they specialize but do not trade freely, country A’s consumers would
have no wheat, and country B’s consumers would have no cloth. This is
not desirable situation.
Let’s solve
Q 1:The table below shows the number of Labour hours required to produce
wheat and cloth in two countries X&Y
Commodity Country X Country Y
1 unit of cloth 4 1
1 unit of wheat 2 2.5

i. Compare the productivity of Labour in both countries in respect

of both commodities.
ii. Which country has absolute advantage in the production of
wheat?
iii. Which country has absolute advantage in the production of
cloth?
iv. If there is trade, which commodity should these countries
produce?
v. What are the opportunity costs of each commodities?
Q 2: The price index for exports of country A in year 2012 (2000 base year)
was 116.1 and the price index for country A’s imports was 120.2 thousand
(2000 base year)
i. What do these figures mean?
ii. Calculate the index of terms of trade for country A
iii. How do you interpret the index of terms of trade for country A?

Q 3: Countries Roseland and Daisy land have a total of 4000 hours each
of Labour available each day to produce shirts and trousers. Both
countries use equal number of hours on each good each day. Roseland
produces 800 shirts and 500 trousers per day.Daisy land produces 500
shirts and 250 trousers per day.
In the absence of trade
a) Which country has absolute advantage in producing
i. shirts
ii. trousers

b) Which country has comparative advantage in producing

i. Shirts
ii. Trousers
The theory discussed above gives us the impression that mutually gainful
trade is possible only when one country has absolute advantage and the
other has absolute disadvantage in the production of at least one
commodity. What happens if a country had higher productivity in both
commodities compared to another country? Let us now think of a
situation where country A makes both wheat and cloth with fewer
resources than country B. In other words, country A has absolute
advantage in the production of both commodities and country B has
absolute disadvantage in the production of both commodities. This is the
question that Ricardo attempted to answer when he formalized the
concept of ‘comparative advantage’ to espouse(support) the
argument that even when one country is technologically superior in both
goods, it could still be advantageous for them to trade.

Assumptions of Theory of Absolute advantage and comparative

advantage:
1. There are only two nations producing two goods only.
2. There is input factor mobility.
3. There are no transportation costs.
4. Resource prices are identical in both the countries.
5. Resources can move from the production of one good to another within
a country.

1.2.3 The Theory of Comparative Advantage

David Ricardo developed the classical theory of comparative

advantage in his book ‘Principles of Political Economy and Taxation’
published in 1817. The law of comparative advantage states that even
if one nation is less efficient than (has an absolute disadvantage with
respect to) the other nation in the production of all commodities, there is
still scope for mutually beneficial trade. The first nation should specialize
in the production and export of the commodity in which its absolute
disadvantage is smaller (this is the commodity of its comparative
advantage) and import the commodity in which its absolute
disadvantage is greater (this is the commodity of its comparative
disadvantage). Comparative advantage differences between nations
are explained by exogenous factors which would be due to the
differences in national characteristics. Labour differs in its productivity
internationally and different goods have different labor requirements, so
comparative labor productivity advantage was Ricardo’s predictor of
trade.

The theory can be explained with a simple example give in table 4.1.2.

Figure 4.1.2

Output per Hour of Labor

Table 4.1.2 differs from table 4.1.1 only in one respect i.e., in this example,
country B can produce only two yards of cloth per hour of labour.
Country B has only 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 in greater in
wheat (6:1) than in cloth (4:2), country A has a comparative advantage
in production and exporting wheat.

In a two-nation, two-commodity world, once it is established that one

nation has a comparative advantage in one commodity, then the other
nation must necessarily have a comparative advantage in the other
commodity. In other words, country A’s absolute advantage is greater
in wheat, and so country A has a comparative advantage in producing
and exporting wheat. Country B’s absolute disadvantage is smaller in
cloth, so its comparative advantage lies in cloth production. According
to the law of comparative advantage, both nations can gain if country
A specializes in the production of wheat and exports some of it in
exchange for country B’s cloth. Simultaneously, country B should
specialize in the production of cloth and export some of it in exchange
for country A’s wheat.
How do these two countries gain from trade by each country specializing
in the production and export of the commodity of its comparative
advantage? We need to show that both nations can gain from trade
even if one of them (in this case country B) is less efficient than the other
in the production of both commodities.

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 need to
show now that country B would also gain from trade. We can observe
form table 4.1.2 that the 6W that the country B received from the country
A would require six hours of labor time to produce in country B. With
trade, county B can instead use these six hours to produce 12C and give
up only 6C for 6W form the country A. Thus, the country b would gain 6C
or save three hours of labor time and country A would gain 2C. However,
the gains of both countries are not likely to be equal.

However, we need to recognize that this is not the only rate of exchange
at which mutually beneficial trade can take place. Country A would
gain if it could exchange 6W for more than 4C from country B.; because
6W for 4C is what it can exchange domestically (both require the same
one-hour labour time). The more C it gets, the greater would be the gain
from trade. Conversely, in country B, 6W = 12C (in the sense that both
require 6 hours of produce). Anything less than 12C that country B must
give up to obtain 6W form country A represents a gain from trade for
more than 4C from the country B. Country B gains to the extent that it
can give up less than 12C for 6W from country A. Thus, the range for
mutually advantageous trade is 4C < 6W < 12C.

The spread between 12C and 4C (i.e., 8C) represents the total gains form
trade available to be shared by the two nations by trading 6W for 6C.
The closer the rate of exchange is to 4C = 6W (the domestic, or internal
rate in country A), the smaller is the share of the gain going to country A
and the larger is the share of the gain going to country B. Alternatively,
the closer the rate of exchange is to 6W = 12C (the domestic or internal
rate in country B), the greater is the gain of country A relative to that of
country B. However, if the absolute disadvantage that one nation has
with respect to another nation is the same in both commodities, there will
be no comparative advantage and no trade.

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, nor is it
used in the same fixed proportion in the production of all commodities.

In 1936, Haberler resolved this issue when he introduced the opportunity

cost concept form Microeconomic theory to explain the theory of
comparative advantage in which no assumption is made in respect of
labour as the source of value. Opportunity cost is basically the value of
the forgone option. It is the ‘real ‘cost in microeconomic terms, as
opposed to cost given in monetary units. 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 procure one unit
of good Y. That is, how much Y do we have to give up in order to produce
one more unit of good X. Logically, the nation with a lower opportunity
cost in the production of a commodity has a comparative advantage in
that commodity (and a comparative disadvantage in the second
commodity).

In the above example, we find that country A must give up two-thirds of

a unit of cloth to release just enough resource to produce one additional
unit of wheat domestically. Therefore, the opportunity cost of wheat is
two-thirds of a unit of cloth (i.e., 1W = 2/3C in country A).
Similarly, in country B, we find that 1W = 2C, and therefore, 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 a two-nation, two-commodity world, if country A has a comparative
advantage in wheat, then country B will have a comparative advantage
in cloth. Therefore, country A should consider specializing in producing
wheat and export some of it in exchange for cloth produced in country
B. By such specialization and trade, both nations will be able to consume
more of both commodities than what would have been possible trade.

In summary, international differences in relative factor- productivity are

the cause of comparative advantage and the country exports goods
that it produces relatively efficiently. This fact points to a tendency
towards complete specialization in production. Ricardo demonstrated
that for two nations without input factor mobility, specialization and trade
could result in increased total output and lower costs than if each nation
tried to produce in isolation. Trade generates welfare gains and both
countries can potentially gain from trade. Therefore international trade
need not be a zero sum game.

Limitations of theory of comparative advantage

 Its emphasis is on supply conditions and excludes demand patterns.
 The theory does not examine why countries have different costs.
 The theory of comparative advantage also does not answer the
important question “Why does a nation have comparative
advantage in the production of another?”
The answer to this question is provided by the Heckscher-Ohlin
theory.

1.2.4 The Heckscher-Ohlin Theory of Trade(Modern Theory)

The Heckscher-Ohlin theory of trade, (named after two Swedish

economists, Eli Heckscher and his student Bertil Ohlin), also referred to as
Factor-Endowment Theory of Trade or Modern Theory of Trade is
considered as a very important theory of international trade. In view of
the contributions made by P.A. Samuelson, this theory is also sometimes
referred to as Heckscher-Ohlin-Samuelson theorem.

The Heckscher-Ohlin (H-O) model studies the case that two countries
have different factor endowments under identical production function
and identical preferences. The difference in factor endowment results in
two countries having different factor prices in the beginning.
Consequently, H-O model implies that the two countries will have
different cost functions. The Heckscher-Ohlin theory of trade states that
comparative advantage in cost of production is explained exclusively by
the differences in factor endowments of the nations.

In a general sense of the term, ‘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.

According to this theory, international trade is but a special case of inter-

regional trade. Different regions have different factor endowments, that
is, some regions have abundance of labour, but scarcity of capital;
whereas other regions have abundance of capital, but scarcity of
labour. 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.
A region is not suitable for production of those goods for whose
production it has relatively scarce or zero supply of essential factors.

Hence different regions have different capacity to produce different

commodities. Therefore, difference in factor endowments is the main
cause of international trade as well as inter-regional trade.
Accordingly, 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. The
cause of difference in the relative prices of goods is the difference in the
amount of factor endowments, like capital and labour, between two
countries.

The theory states that a country’s exports depend on its resource’s

endowment i.e., whether the country is capital abundant or labor-
abundant. If a country is a capital abundant one, it will produce and
export capital-intensive goods relatively more cheaply than another
country. Likewise, a labor-abundant country will produce and export
labor-intensive goods relatively more cheaply than another country. The
labor-abundant countries have comparative cost advantage in the
production of goods which require labor-intensive technology and by
the same reasoning, capital-abundant countries have comparative cost
advantage in the production of goods that need capital-intensive
technology.

Assumptions of H-O Theorem

1. The two countries share the same production technology.
2. Markets are perfectly competitive
3. There are no restrictions on trade
4. The consumers preference as well as demand patterns are
unchanged
5. The transport cost element is ignored
6. Better stable economy and fiscal policies in the participating
nations.
7. There is a perfect mobility of factors.
The Heckscher-Ohlin theory of foreign trade can be stated in the form of
two theorems namely,
I. Heckscher-Ohlin Trade Theorem and
II. Factor-Price Equalization Theorem.

I. The 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.

II. The Factor-Price Equalization Theorem states that international

trade tends to equalize the factor price between the trading
nations. In the absence of foreign trade, it is quite likely that
factor prices are different in different countries. International
trade equalizes the absolute and relative returns to
homogeneous factors of production and their prices. In other
words, the wages of homogeneous labour and returns of
homogeneous capital will be same in all these nations which
engage in trading.
The factor price equalization theorem says that if the prices of the output
of goods are equalized between counties engaged in free trade, then
the price of the input factors will also be equalized between countries.
This implies that the wages and rents will converge across the countries
with free trade, or in other words trade in goods is a perfect substitute for
trade in factors. The Heckscher-Ohlin theorem, this, postulates that
foreign trade eliminates the factor price differentials. The factor price
equalization theorem is in fact a corollary to the Heckscher-Ohlin trade
theory. It holds only so long as Heckscher-Ohlin Theorem holds.

The opening up to trade for a labor-abundant country will increase the

price of labor-intensive goods, say clothes, and thus, lead to an
expansion of clothes production. As there is demand for exports of
clothes in foreign markets, the demand for factors of production
increases in the clothes sector. Because clothes are labour-intensive
goods, an increase demand for labour in the factor market will attract
labour from the capital-intensive industry, say machine tools. The
expanding clothes industry absorbs relatively more labour than the
amount released by the contracting machine tools industry. The price of
labour goes up, and whilst its relative price increases, the relative price
of capital declines. As a result, the factors of production will become
more labour-intensive in both sectors leading to a decline in the marginal
productivity of capital and an increase in that of labour in both sectors.
Similarly, when country B increases its specialization in the production of
capital-intensive commodity its demand for capital increases causing
capital returns to increase in relation to wage rate. This means that
specialization leads to change in relative factor prices.

When the prices of the output of goods are equalized between countries
as they move to free trade, then the prices of the factors (capital and
labor) will also be equalized between countries. It means that product
mobility and factor mobility become perfect substitutes. Whichever
factor receives the lowest price before two countries integrate
economically and effectively become one market, will therefore tend to
become more expensive relative to other factors in the economy, while
those with the highest price will tend to become cheaper.

The table 4.1.3 presents a comparison of the theory of comparative costs

and modern theory.

Figure 4.1.3

Comparison of Theory of Comparative Costs and Modern Theory

 1.2.5 New Trade Theory – An Introduction

New trade Theory (NTT) is an economic theory that was developed in the
1970s as a way to understand international trade patterns. It was
developed by an American economist Paul Krugman for which he was
awarded Nobel Prize in Economics in 2008 for his contribution in modeling
these ideas. NTT came about to help us understand why developed and
big countries are trade partners when they are trading similar goods and
services. These countries constitute more than 50% of world trade.

This is particularly true in key economic sectors such as electronics, IT,

food, and automotive. We have cars made in the India, yet we
purchase many cars made in other countries.

These are usually products that come from large, global industries that
directly impact international economies. Th mobile phones we use are
a good example. India produces them and also imports them. NTT
argues that, because of substantial economies of scale and network
effects, it pays to export phones to sell in another country. Those
countries with the advantages will dominate the market, and the market
takes the form of monopolistic competition.

Monopolistic competitions tell us that the firms are producing a similar

product that isn’t exactly the same, but awfully close. According to NTT,
two key concepts give advantages to countries that import goods to
compete with products from the home country:

 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, then it can reap the benefit
of large scale of production consequently the profits are likely to
be higher.

 Network effects are the way one person’s value of a good or

service is affected by the value of that good or service to others.
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’. Consumers like more choices, but they also
want products and services with high utility, and the network effect
offers increased utility form these products over others. A good
example will be Mobile App such as Whatsapp and software like
Microsoft Windows.
 Unit II: The Instruments of Trade Policy

2.1 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.

Import duties being pervasive than export duties, tariffs are often
identified with import duties.

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.

The main goals of tariffs are to raise revenue for the government and
more importantly to protect the domestic import- competing industries.

2.2.1 Forms of Import Tariffs

i. Specific Tariff: 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 ₹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 ₹5000/-, then the rate of tariff is 20%; if
due to inflation, the price of bicycle raised to ₹10000/- the specific
tariff is only 10% of the value of the import. Since the calculation of
these duties does not involve the value of merchandise, customs
valuation is not applicable in this case.

ii. Ad valorem tariff: An ad valorem tariff is levied as a constant

percentage of the monetary value of one unit of the imported good.
As 20% ad valorem tariff on any bicycle generates a ₹1000/- payment
on each imported bicycle prices at ₹5000/- in the world market; and
 if the price rises to ₹10000/-, it generates a payment of ₹2000/-. While
ad valorem tariff preserves the proactive value of tariff on home
producer, it gives incentives to deliberately undervalue the good’s
price on invoices and bills of lading to reduce the tax burden.
Nevertheless, ad valorem tariffs are widely used the world over.

There are many other variations of the above tariffs, such as:

a. 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 (or least income
at times) for the nation. For example, duty on cotton: 5 percent
ad valorem or ₹3000/- per ton, whichever is higher.

b. Composed Tariff or a Compound Duty is a combination of an ad

valorem and a specific tariff. That is, the tariff is calculated on the
basis of both the value of the imported goods (an ad valorem
duty) and a unit of measure of the imported goods (a specific
duty). It is generally calculated by adding up a specific duty to an
ad valorem duty.Thus ,on an import with quantity q and price p,a
compound tariff collects a revenue equal to 𝑡𝑠 q +𝑡𝑎 pq ,where 𝑡𝑠
is the specific tariff and 𝑡𝑎 is the ad valorem tariff. For example:
Duty on cheese at 5 percent ad valorem plus 100 per kilogram.

c. Technical/Other Tariff: These are calculated on the basis of the

specific contents of the imported goods i.e., the duties are
payable by its components or related items. For example, ₹3000/-
on each solar panel plus ₹50/- per kg on the battery.

d. Tariff Rate Quotas: Tariff rate quotas (TRQs) combine two policy
instruments: quotas and tariffs. Imports entering under the
specified quota portion are usually subject to a lower (sometimes
zero), tariff rate, imports above the quantitative threshold of the
quota face a much higher tariff.

e. Most-Favored Nation Tariffs: MFN tariffs are what countries promise

to impose on imports from other members of the WTO, unless the
country is part of a preferential trade agreement (such as a free
trade area or customs union). This means that, in practice, MFN
rates are the highest (most restrictive) that WTO members charge
one another. Some countries import higher tariffs on countries that
are not part of the WTO.
f. Variable tariff: A duty typically fixed to bring the price of an
imported commodity up to the domestic support price for the
commodity.

g. 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 CUSMA ( Canada, USA and Mexico agreemen
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 forms specified
developing countries. The Generalized system of Preferences
(GSP) is one such systems which is currently prevailing.

h. 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. A bound tariff ensures transparency
and predictability.

i. Applied Tariff: An ‘applied tariff’ is the duty that is actually charges

on imports on a most-favored nation (MFN) basis. A WTO member
can have an applied tariff for a product that differs from the
bound tariff for that project as long as the applied level is not
higher than the bound level. The gap between the bound and
applied MFN rates is called the binding overhang.
Applied tariff ≤bound tariff

j. Escalated Tariff structure refers to 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, i.e.,
 the tariff on a product increase as that product moves through eh
value-added chain. This practice protects domestic processing
industries and discourages the development of processing activity
in the countries where the raw materials originate.
For example, a 4% tariff on iron ore or iron ingots 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. This has special relevance to trade between developed
countries and developing countries. Developing countries are thus
forced to continue to be suppliers of raw materials without much
value addition.

k. Prohibitive tariff: A prohibitive tariff is one that is set so high that no

imports will enter.

l. 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 (i.e., a negative import tariff).

m. Tariffs as Response to trade distortions: 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. The following sections relate to
such tariff responses to distortion related to foreign dumping and
export subsidies.

 Anti-dumping Duties: Dumping occurs when manufacturers

sell goods in foreign country
o below the sales prices in their domestic market or
o below their full average cost of the product.

Dumping may be persistent, seasonal, or cyclical. Dumping may also be

resorted to as a predatory pricing practice to drive out established
domestic producers from the market and to establish monopoly position.
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, This is unfair and
constitutes a threat to domestic producers and therefore when dumping
is found, 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 (that is,
the associated costs to consumers would be less than the benefits that
would accrue to producers). 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. If a foreign country
does not have a comparative advantage in a particular
good and a government subsidy allow the foreign firm to be
an exporter of the product, then the subsidy generates a
distortion form the free-trade allocation of resources. In such
cases, CVD is charged in an importing country to negate the
advantage that exporters get form subsidies to ensure fair
and market-oriented pricing of imported products and
thereby protecting domestic industries and firms. For
example, in 2016, in order to protect its domestic industry,
India imported 12.5% countervailing duty on gold jewelry
imports form ASEAN.
Let’s solve
Q 1 (i)Which of the three exporters engage in anticompetitive act in the
international market while pricing its export of goods 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 of domestic sale 31.2 31.1 30.9
Price charged in country D 31.9 30.6 30.6
 Q 2: (i) What do you think the implications on trade will be if India pays
an export subsidy of rupees 400 on every pair of cotton trousers exported
by it to Germany?
(ii) Suppose Germany charged an equivalent CVD on every pair of
cotton trousers imported from India, do you think world welfare will be
affected?

2.2.2 Effect of Tariffs

a. Tariff barriers create obstacles to trade, decrease the volume of

imports and exports and therefore of international trade. The
prospect of market access of the exporting country is worsened
when an importing country imposes a tariff.

b. By making imported goods more expensive, tariffs discourage

domestic consumers form consuming imported foreign goods.
Domestic consumers suffer a loss in consumer surplus because they
must now pay a higher price for the good and also because
compared to free trade quantity, they now consume lesser
quantity of the good.

c. Tariffs encourage consumption and production of the

domestically produced import substitutes and thus protect
domestic industries.

d. Producers in the importing country experience an increase in well-

being as a result of imposition of tariff. The prices increase of their
product in the domestic market increases producer’s surplus in the
industry. They can also charge higher prices than would be
possible in the case of free trade because foreign competition has
reduced.

e. The price increase also induces an increase in the output of the

existing firms and possibly addition of new firms due to entry into the
 industry to take advantage of the new high projects and
consequently an increase in employment in the industry.

Tariffs cause trade distortions by disregarding comparative

advantage and present countries form 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.

f. Tariffs increase government revenues of the importing country by

the value of the total tariff it charges.

2.3 Non – Tariff Measuring (NTMS)

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 (UNCTAD, 2010). Non-tariff measures comprise all types of measures
which alter the conditions of international trade, including policies and
regulations that restrict trade and those that facilitate it. NTMs consist of
mandatory requirements, rules or regulations, that are legally set by the
government of the exporting, importing or transit country.

NTMs are not the same as non-tariff barriers (NTBs), NTMs are sometimes
used as means to circumvent free trade rules and favour domestic
industries at the expense of foreign competition. In this case they are
called NTBs . In other words, non tariff barriers are discriminatory non tariff
measures imposed by governments to favour domestic over foreign
suppliers. NTBs arev thus a subset of NTMs that have a ‘protectionist or
discriminatory’ intent. Compared to non-tariff barriers , non-tariff
measures encompass a broader set of measures.

Depending on their scope and / or design ,NTMs are categorized as:

i. Technical Measures: Technical measures refer to product-specific

properties such as characteristics of the product, technical
specifications and production processes. These measures are
intended for ensuring product quality, food safety, environmental
protection, national security and protection of animal and plant
health.
 ii. Non-technical Measures: Non-technical measures relate to trade
requirements; for example, shipping requirements, custom
formalities, trade rules, taxation policies etc.

These are further distinguished as:

a) Hard measures (e.g., price and quantity control measures).

b) Threat measures (e.g., Anti-dumping and safeguards) and
c) Other measures such as trade-related finance and investment
measures.

Furthermore, the categorization also distinguishes between:

i. Import-related measures which relate to measures imposed by the

importing country, and
ii. Export-related measures which relate to measures impose by the
exporting country itself.
iii. In addition, to these, there are procedural obstacles (PO) which
are practical problems in administration, transportation, delays in
testing, certification etc. that may make it difficult for businesses to
adhere to a given relations.

2.3.1 Technical Measures

i. 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.

These include ban or prohibition of import of certain goods, all

measures governing quality and hygienic requirements, production
processes, and associated compliance assessments. 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.

ii. Technical Barriers to Trade (TBT): Technical Barriers to Trade (TBT)

which cover both food and non-food traded products refer to
mandatory ‘Standards and Technical Regulations’ that define the
specific characteristics that a product should have, such as its size,
 shape, design, labelling / marking / packaging, functionality or
performance and production methods, excluding measures
covered by the SPS Agreement. 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. This involves
compulsory quality, quantity and price control of goods before
shipment from the exporting country.
Just as SPS, TBT measures are standards-based measures that
countries use to protect their consumers and preserve natural
resources, but 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.

2.3.2 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 to the importing country. Following are the most commonly
practiced measures in respect of imports:

i. Import Quotas: 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, usually one
year. 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.

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 and the imports can take place any time of the year. No
condition is attached to the country of origin of the product. For
example: 1000 tons of fish import of which can take place any time
of the year from any country. When country allocation is specified,
 a fixed volume or value of the product must originate in one or
more countries. Example: A quota of 1000 tons of fish that can be
imported a time of the year, but where 750 tons must originate in
country A and 250 tons in country B. in addition, there are seasonal
quotas and temporary quotas.

With a quota, the government, of course, receives no revenue. The

profits received by the holders of such import licenses are known as
‘quota rents’. While tariffs directly interfere with prices that can be
charged for an imported good in the domestic market, import
quota interferes with the market prices indirectly. Obviously, an
import quota at all times raises the domestic price of the imported
good. 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.

The welfare effects of quotas are similar to that of tariffs. If a quota

is set below free trade level, the number 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.
Producers in the importing country are better-off as a result of the
quota. The increase in the price of the product increases producer
surplus in the industry. 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.

ii. Price Control Measures: Price control measures (including

additional taxes and charges) are steps taken to control or
influence the prices of imported goods in order to support the
domestic price of certain products when the import prices of these
goods are lower. These are also known as ‘para-tariff’ measures
and include measures, other than the 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.

iii. Non-automatic Licensing and Prohibitions: These measures are

normally aimed at limiting the quantity of goods that can be
imported, regardless of whether they originate from different
 sources or from one particular supplier. 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 form / to Iraq. Also,
India prohibits many items (mostly of animal origin) falling under 60
EXIM codes.

iv. Financial Measures: The objective of financial measures is to

increase import costs by regulating the access to and cost of
foreign exchange for imports and to define the terms of payment.
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 form 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.

v. Measures Affecting Competition: These measures are aimed at

granting exclusive or special preferences or privileges to one or a
few limited groups of economic operators. It may include
government imposed special import channels or enterprises, and
compulsory use of national services. 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. When a state agency
or a monopoly import agency sells on the domestic market at
prices above those on the world market, the effect will be similar to
an import tariff.

vi. Government Procurement Policies: Government procurement

policies may interfere with trade if they involve mandates that the
whole of a specified percentage of government purchases should
be from domestic firms rather than foreign firms, despite higher
prices than similar foreign suppliers. In accepting public tenders, a
government may give preferences to the local tenders rather than
foreign traders.

vii. Trade-Related Investment Measures: These measures include rules

on local content requirements that mandate a specified fraction
of a final good should be produced domestically.
 a) Requirement to use certain minimum levels of locally made
components (25 percent of components of automobiles to be
sourced domestically)

b) Restricting the level of imported components, and

c) Limiting the purchase or use of imported products to an amount

related to the quantity or value of local products that is exports.
(A firm may import only up to 75% of its export earnings of the
previous year).

viii. Distribution Restrictions: Distribution restrictions are limitations

imposed on the distribution of goods in the importing country
involving additional license or certification requirements. These
may relate to geographical restrictions or restrictions as to the type
of agents who may resell. For example: a restriction that imported
fruits may be sold only through outlets having refrigeration facilities.

ix. Restriction on Post-sales Services: Producers may be restricted form

providing after-sales services for exported goods in the importing
country. Such services may be reserved to local service companies
of the importing country.

x. Administrative Procedures: Another potential obstruction to free

trade is the costly and time-consuming administrative procedures
which are mandatory for import of foreign goods. These will
increase transaction costs and discourage imports. The domestic
import-competing industries gain by such non-tariff measures.
Examples include specifying particular procedures and formalities,
requiring licenses, administrative delay, red-tape and corruption in
customs clearing frustrating the potential imports, procedural
obstacles linked to prove compliance etc.

xi. Rules of origin: Rules of origin are the criteria needed by

governments of importing countries to determine the national
source of a product. Their importance is derived from the fact that
duties and restrictions in several cases depend upon the source of
imports. 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.
xii. 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. Restrictions must be
for a limited time and non discretionary.

xiii. 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 or indefinite period. This may be done due
to political reasons or for other reasons such as health, religious
sentiments. This is the most extreme form of trade barrier.

2.4 Export-Related Measures

i. Ban on exports: Export-related measures refer to all measures

applied by the government of the exporting country including both
technical and non-technical measures. For example: during
periods of shortages, export of agricultural products such as onion,
wheat etc. may be prohibited to make them available for
domestic consumption. Export restrictions have an important effect
on international markets. By reducing international supply, export
restrictions have an important effect on international markets. By
reducing international supply, export restrictions have been
effective to increase international prices.

ii. Export Taxes: An export tax is a tax collected on exported goods

and may be either specific or ad valorem, The effect of an export
tax is to raise the price of the goods and to decrease exports. Since
an export tax reduces exports and increases domestic supply, it
also reduces domestic prices and leads to higher domestic
consumption.

iii. Export Subsidies and Incentives: We have seen that tariffs on

imports hurt exports and therefore countries have developed
compensatory measures of different types for exporters like export
subsidies, duty drawback, duty-free access to imported
intermediates etc. Governments or government bodies also
usually provide financial contribution to domestic producers in the
form of grants, loans equity infusions etc., or give some form of
income or price support. If such policies on the part of governments
are directed at encouraging domestic industries to sell specified
products or services abroad, they can be considered as trade
policy tools.
iv. 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 of time. Such restraints
originate primarily from political considerations and are imposed
based on negotiations of the importer with the exporter. The
inducement for the exporter to agree to a VER is mostly to appease
the importing country and to avoid the effects of possible
retaliatory trade restraints that may be imposed by the importer.
VERs may arise when the import-competing industries seek
protection from a surge of imports from particular exporting
countries. VERs cause, as do tariffs and quotas, domestic prices to
rise and cause loss of domestic consumer surplus.
Unit III: Trade Negotiations

3.1 Taxonomy of Regional Trade Agreements (RTAS)

Regional Trade Agreements (RTAs) are defined as groupings of countries,

(not necessarily belonging to the same geographical region) which are
formed with the objective of reducing barriers to trade between member
countries. In other words, it is a treaty between two or more governments
that define the rules of trade for all signatories.

Trade negotiations result in different types of agreements namely:

1. Unilateral trade agreements under which an importing country

offers trade incentives in order to encourage the exporting country
to engage in international economic activities that will improve the
exporting country’s economy. E.g., Generalized System of
Preferences(GSP)
GSP is a preferential tariff system extended by developed countries( also
known as preference giving countries or donor countries) to developing
countries(also known as preference receiving countries or beneficiary
countries) .It involves reduced MFN tariffs or duty free entry of eligible
products exported by beneficiary country to the market of donor
countries.

2. Bilateral Agreements are agreements which set rules of trade

between two countries, two blocs or a bloc and a country. These
may be limited to certain goods and services or certain types of
market entry barriers. E.g., EU-South Africa Free Trade Agreements;
ASEAN-India Free Trade Area.

3. Regional Preferential Trade Agreements among a group of

countries reduce trade barriers on a reciprocal and preferential
basis for only the members of the group. E.g., Global System of
Trade Preferences among Developing Countries (GSTP)

4. Trading Bloc has a group of countries that have a free trade

agreement between themselves and may apply a common
external tariff to other countries Example: Arab League (AL),
European Free Trade Association (EFTA)

5. Free-trade area is a group of countries that eliminate all tariff and

quota barriers on trade with the objective of increasing exchange of
 goods with each other .The trade among the member states flow
tariff free, but the member states maintain their own distinct external
tariff w.r.t. imports from the rest of the world. In other words, the
members retain independence in determining their tariffs with non
members,e.g.USMCA.

6. A customs union is a group of countries that eliminate all tariff

barriers on trade among themselves but maintain a common
external tariff on trade with countries outside the union (thus
technically violating MFN).The common external tariff which
distinguishes the customs union from a free trade area implies
that,generally,same tariff is charged wherever a member imports
goods from outside the customs union.The EU is a customs union;its
27 member countries form a single territory for the customs
purposes.Other examples are Gulf cooperation council(GCC)
,Southern common market( MERCOSUR).

7. Common Market: A Common Market deepens a customs union by

providing for the free flow of output and of factors of production
(labour , capital and other productive resources)by reducing or
eliminating internal tariff on goods and by creating a common set
of external tariffs. The member countries attempt to harmonize
some institutional arrangements and commercial and financial
laws and regulations among themselves. There are also common
barriers against non-members (e.g., EU, ASEAN).

8. Economic and Monetary Union-For a common market, the free

transit of goods and services through the borders increases the
need for foreign exchange operations and results in higher
financial and administrative expenses of firms operating within the
region. The next stage in the integration sequence is formation of
some form of monetary union. In an economic and monetary
union, the members share a common currency. Adoption of the
common currency also makes it necessary to have a strong
convergence in macroeconomic policies. For example, the
European Union countries implement and adopt a single currency.

3.2 The General Agreement on Tariffs and Trade (GATT)

Despite wide ranging benefits, a number of countries hinder the free flow
of international trade by imposing trade barriers. It was felt necessary
that all countries embark on cooperative economic relations for
establishing mutual self-interest. The General Agreement on Tariffs and
Trade (GATT) provided the rules for much of world trade for 47 years, from
1948 to 1994; but it was only a multilateral instrument governing
international trade or a provisional agreement along with the two full-
fledged ‘Bretton Woods” institutions, the World Bank and the
International Monetary Fund. The original intention to create an
International Trade Organization (ITO) as a third institution to handle the
trade side of international economic cooperation did not succeed for
want of endorsement by some national legislatures, especially the US.
Eight rounds of multilateral negotiations known as ‘trade rounds’ held
under the auspices GATT resulted in substantial international trade
liberalization. Though the GATT trade rounds in earlier years
contemplated tariff reduction as their core issue, later on the Kennedy
Round in the mid-sixties, and the Tokyo Round in the 1970s led to massive
reductions in bilateral tariffs, establishment of negotiation rules and
procedures on dispute resolution, dumping and licensing. The
arrangements were informally referred to as ‘codes’ because they were
not acknowledged by the full GATT membership. A number of codes
were ultimately amended in the Uruguay Round and got converted into
multilateral commitments accepted by all WTO members. The eighth,
the Uruguay Round of 1986-94, was the last and most consequential of
all rounds and culminated in the birth of WTO and a new set of
agreements.

The GATT lost its relevance by 1980s because [CA INTER MAY’18 ]

 It was obsolete to the fast-evolving contemporary complex world

trade scenario characterized by emerging globalization.

 International investments had expanded substantially

 Intellectual property rights and trade in services were not covered

by GATT

 World merchandise trade increased by leaps and bounds and was

beyond its scope

 The ambiguities in the multilateral system could be heavily

exploited

 Efforts at liberalizing agricultural trade were not successful

  There were inadequacies in institutional structure and dispute
settlement system

 It was not a treaty and therefore terms of GATT were binding only
in so far as they are not incoherent with a nation’s domestic rules.

3.3 The Uruguay Round and the Establishment of WTO

The need for a formal international organization which is more powerful

and comprehensive was felt by many countries by late 1980s. Having
settled the most ambitious negotiating agenda that covered virtually
every outstanding trade policy issue, the Uruguay Round brough about
the biggest reform on the world’s trading system. Members established
15 groups to work on limiting restrictions in the areas of tariffs, non-tariff
barriers, tropical products, nature resource products, textiles and
clothing, agriculture, safeguards against sudden ‘surges’ in imports,
subsidies and countervailing duties, trade related intellectual property
restrictions, trade related investment restrictions, services and four other
areas dealing with GATT itself, such as, the GATT system, dispute
settlement procedures and implementation of the NTB Codes of the
Tokyo Round, especially on anti-dumping.

The Round started in Punta del Este in Uruguay in September 1986 and
was scheduled to be completed by December 1990. However, due to
many differences and especially due to heated controversies over
agriculture, no consensus was arrived at. Finally, in December 1993, the
Uruguay Round, the eighth and the most ambitious and largest ever
round of multilateral trade negotiations in which 123 countries
participated, was completed after seven years of elaborate
negotiations. The agreement was signed by most countries on April 15,
1994, and took effect on Jan 1, 1995. It was also marked the birth of the
World Trade Organization (WTO) which is a single institutional framework
encompassing the GATT, as modified by the Uruguay Round.

3.4 The World Trade Organization (WTO)

The most important outcome of the Uruguay Round agreement was the
replacement of the General Agreement on Tariffs and trade (GATT)
secretariat with the World Trade Organization (WTO) in Geneva with
authority not only in trade in industrial products but also in agricultural
products and services. The bulk of the WTO’s present operations come
from the 1986-94 negotiations called the Uruguay Round and earlier
negotiations under the General Agreement on Tariffs and Trade (GATT).
Despite the fact that the WTO replaced GATT as an international
organization, the General Agreement still exists as the WTO’s umbrella
treaty for trade in goods, updated as a result of the Uruguay Round
negotiations.
The principal objective of the WTO is to facilitate the flow of international
trade smoothly, freely, fairly and predictably.
The WTO has six key objectives: [CA INTER MAY’18 ,JULY’21]
i. To set and enforce rules for international trade
ii. To provide a forum for negotiating and monitoring further trade
liberalization
iii. To resolve trade disputes
iv. To increase the transparency of decision making processes
v. To cooperate with other major international economic institutions
involved in global economic management
vi. To help developing countries benefit fully from the global trading
system.
The objectives of the WTO agreements as acknowledged in the
preamble of the Agreement creating the World Trade Organization
include:
 raising standards of living,
 ensuring full employment and
 a large and steadily growing volume of real income and effective
demand and
 expanding the production of and trade in goods and services.

3.4.1 The Structure of the WTO

The WTO activities are supported by a Secretariat located in Geneva,

headed by a Director General. It has a three-tier-system of decision
making.
The WTO’s top level decision-making body is the Ministerial Conference
which can take decisions on all matters under any of the multilateral
trade agreements. The Ministerial Conference meets at least once every
two years.
The next level is the General Council which meets several times a year at
the Geneva headquarters. The General council also meets as the Trade
Policy Review Body and the Dispute Settlement Body.
At the next level, the Goods Council, Services Council and Intellectual
Property (TRIPS) Council report to the General Council. These councils
are responsible for overseeing the implementations of the WTO
agreements in their respective areas of specialization. Numerous
specialized committees, working groups and working parties deal with
the individual agreements and other areas such as the environment,
development, membership applications and regional trade
agreements.

The WTO accounting for about 95% of world trade currently has 164
members, of which 117 are developing countries or separate customs
territories accounting for about 95% of world trade. Around 25 others are
negotiating membership. The WTO’s agreements have been ratified in
all members; parliaments.

3.4.2 The Guiding Principles of World trade Organization (WTO)

Right from its inception, the WTO has been driven by a number of
fundamental principles which are the foundations of the multilateral
trading system. Following are the major guiding principles.

a. Trade without discrimination: (treating others equally)Most-favored-

nation (MFN): Originally formulated as Article 1 of GATT,MFN is also
a priority in Article 2 of GATS(General agreement on trade in
services) and Article 4 of TRIPs (Agreement on trade related
aspects of Intellectual Property Rights). Together these three
agreements cover all the main areas of trade handled by WTO .
This principle states that any advantage, favour, privilege or
immunity granted by any contracting party to any product
originating in or destined for any other country shall be extended
immediately and unconditionally to the like product originating or
destined for the territories of all other contracting parties. Under the
WTO agreements, countries cannot normally discriminate between
their trading partners. If a country lowers trade barrier or opens up
a market, it has to do so for the same goods or services for all other
WTO members. Under strict conditions various permitted exceptions
are allowed. For example, countries may enter into free trade
agreements and trading may be done within the group
discriminating against goods form outside, a country can raise
barriers against products that are considered to be traded unfairly
from specific countries; or they may give special market access to
developing countries.

b. The National Treatment Principle (NTP)(treating foreigners and

nationals equally -The National Treatment Principle is
complementary to the MFN principle. GATT Article III requires that
with respect to internal taxes, internal laws, etc., applied to imports,
treatment not less favorable than that which is accorded to like
 domestic products must be accorded to all other members. In
other words, a country should not discriminate between its own
and foreign products, services or nationals. This principle is also
found in article 17 of GATS and Article 3 of TRIPS.

For instance, once imported apples reach Indian market, they

cannot be discriminated against and should be treated at par in
respect to marketing opportunities, product visibility or any other
aspect with locally produced apples.

c. Freer trade: Lowering trade barriers for opening up markets is one

of the most obvious means of encouraging trade. But by the 1980s,
the negotiations had expanded to cover non-tariff barriers on
goods, and to the new areas such as services and intellectual
property. Since these require adjustments, the WTO agreements
permit countries to bring in change gradually, though ‘progressive
liberalization’. Developing countries are generally given longer
time to confirm to their obligations.

d. Predictability: Investments will be encouraged only if the business

environment is stable and predictable. The foreign companies,
investors and governments should be confident that the trade
barriers will not be raised arbitrarily. This is achieved through
‘binding’ tariff rates, discouraging the use of quotas and other
measures used to set limits on quantities of imports establishing
market-opening commitments and other measures to ensure
transparency. A country can change its bindings, but only after
negotiating with its trading partners, which could mean
compensating them for loss of trade.

e. Principle of general prohibition of quantitative restrictions: One

reason for this prohibition is that quantitative restrictions are
considered to have greater protective effect than tariff measures
and are more likely to distort the free flow of trade.

f. Greater competitiveness: This is to be achieved by discouraging

“unfair” practices such as export subsidies, dumping etc. The rules
try to establish what is fair or unfair, and how governments can take
action, especially by charging additional import duties intended to
compensate for injury caused by unfair trade.

g. Tariffs as legitimate measures for the production of domestic

industries: The imposition of tariffs should be the only method of
 protection, and tariff rates for individual items should be gradually
reduced through negotiations ‘on a reciprocal and mutually
advantageous’ basis. Member countries bind themselves to
maximum rates and the imposition of tariffs beyond such maximum
rates (bound rates) in the unilateral raise in bound rates are
banned.

h. Transparency in Decision Marking: The WTO insists that any

decision by members in the sphere of trade or in respect of matters
affecting trade should be transparent and verifiable. Such
changes in matters of trade or of trade related rules have to be
invariably and without delay be notified to all the trading partners.
In case of any opposition to such changes, they should be
appropriately addressed and any loss occurring to the affected
members should be suitably compensated for.

i. Progressive Liberalization: Many trade issues of a controversial

nature similar to labor standards, non-agricultural market access,
etc. on which there was general disagreement among trading
partners were left unsettled during the Uruguay Round. These are
to be liberalized during consecutive rounds of discussion.

j. Market Access[Nov’19]: The WTO aims to increase world trade by

enhancing market access by converting all non-tariff barriers into
tariffs which are subject to country specific limits. Further, the major
multilateral agreements like the agreement on Agriculture (AOA),
to specific targets have been specified for ensuring market access.

k. Special Privileges to less developed countries: With majority of WTO

members being developing countries and countries in transition to
market economies, the WTO deliberations favour less developed
countries by giving them greater flexibility, special privileges and
permission to phase out the transition period. Also, these countries
are granted transition periods to make adjustments to the not so
familiar and intricate WTO provisions.

l. Protection of Health & Environment: The WTO agreements support

measures to protect not only the environment but also human,
animal as well as plant health with the stipulation that such
measures should be non-discriminatory and that members should
not employ environmental protection measures as a means of
disguising protectionist policies.
 m. A transparent, effective and verifiable dispute settlement
mechanism: Trade relations frequently involve conflicting interests.
Any dispute arising out of violation of trade rules leading to
infringement of rights under the agreements or misunderstanding
arising as regards the interpretation of rules are to be settled
through consultation. In case of failures, the dispute can be
referred to the WTO and can pursue a carefully mapped out,
stage-by-sage procedure that includes the possibility of a
judgment by a panel of experts, and the opportunity to appeal the
ruling on legal grounds. The decision of the dispute settlement
body is final and binding.

3.5.3 Overview of the WTO agreements

a. Agreement on Agriculture aims at strengthening GATT disciplines

and improving agricultural trade. It includes specific and binding
commitments made by WTO Member governments in the three
areas of market access, domestic support and export subsidies.

b. Agreement on the Application of Sanitary and Phytosanitary (SPS)

Measures establishes multilateral frameworks for the planning,
adoption and implementation of sanitary and phytosanitary
measures to prevent such measures from being used for arbitrary
or unjustifiable discrimination or for camouflaged restraint on
internal trade and to minimize their adverse effects on trade.

c. Agreement on Textiles and Clothing replaced the Multi-Fiber

Arrangement (MFA) which was prevalent since 1974 which
entailed import protection policies. ATC provides that textile trade
should be deregulated by gradually integrating it into GATT
disciplines over a 10-year transition period.

d. Agreement on Technical Barriers to trade (TBT) aims to prevent

standards and conformity assessment systems from becoming
unnecessary trade barriers by securing their transparency and
harmonization with international standards. Often excessive
standards or misuse of standards in respect of manufactured goods
and safety / environment regulations act as trade barriers.

e. Agreement on Trade-Related Investment Measures (TRIMs)

expands disciplines governing investment measures in relation to
cross-border investments by stipulating those countries receiving
 foreign investments shall not impose investment measures such as
requirements, conditions and restrictions inconsistent with the
provisions of the principle of national treatment and general
elimination of quantitative restrictions. For example, measures such
as local content requirements and trade balancing requirements
should not be applied on investing corporations.

f. General Agreement on Trade in Services (GATS): This agreement

provides the general obligations regarding trade in services such
as most-favored-nation treatment and transparency. In addition,
it enumerates service sectors and stipulates that in the service
sectors for which it has made commitments, a member country
cannot maintain or introduce market access restrictions measures
and discriminatory measures that are severer than those that were
committed during the negotiations.

g. Agreement on Trade-Related Aspects of Intellectual Property

Rights (TRIPs): This agreement stipulates most-favored-nation
treatment and national treatment for intellectual properties, such
as copyright, trademarks, geographical indications, industrial
designs, patents, IC layouts design and undisclosed information. In
addition, it requires member countries to maintain high level of
intellectual property protection and to administer a system of
enforcement of such rights. It also stipulates procedures for the
settlement of disputes related to the agreement.

h. Understanding on Rules and Procedures Governing that Settlement

of Disputes related to the WTO agreements. It aims to strengthen
dispute settlement procedures by prohibiting unilateral measures,
establishing dispute settlement panels whose reports are
automatically adopted, setting time frames for dispute settlement,
establishing the Appellate Body etc.

i. Trade Policy Review Mechanism (TPRM) provides the procedures

for the trade policy review mechanism to conduct periodical
revises of members; trade policies and practices conducted by the
Trade Policy Review Body (TPRB)

j. Plurilateral Trade Agreements:

 Agreement on Trade in Civil Aircraft Negotiations were

ongoing alongside the Uruguay Round to revise the civil
Aircraft Agreement (an agreement from the Tokyo Round)
 and to strengthen disciplines on subsidies. However, no
agreement has yet been reached an agreement reached
under the Tokyo Round continues.

 Agreement on Government Procurement: This agreement

requires national treatment and non-discriminatory
treatment in the area of government procurement and calls
for fair and transparent procurement procedures. The
agreement covers the procurement of services (in addition
to goods) and the procurement by sub-central government
entities and government-related agencies (in addition to
central government).

3.5 The Doha Round

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

3.6 25 years of The WTO : Achievemets and Concerns

The WTO has helped transform international economic relations to a great
extent over the past 25 years of its existence.
There has been spectacular growth in world trade in goods and services. Since
1995, the dollar value of world trade has increased nearly four-fold, while the
real volume of 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 half, from 10.5 percentage to 6.4 percentage during this period.

Remarkable increase in global value chains(GVCs) has been made possible

by the predictable market conditions fostered by the WTO along with improved
communication. Businesses, being assured of the possibility of movement of
components and associated services across multiple locations, have been
able to disaggregate manufacturing production across countries and regions.

At present, trade within these value chains for almost 70% of total merchandise
trade. The rise of the global value chains being a significant factor in enabling
the catch up growth in developing economies. Also, these have resulted in
increased purchasing power and consumer choice in all countries. For the
economy that joined the WTO after its creation, accession involved far
reaching reforms and market opening commitments and research suggests
that these have enabled a lasting boost to national income.

Over the past 25 years, there has been the fastest poverty reduction in history:
in 1995 over 1 in 3 people living around the world fell below the World Bank’s
1.90 dollar threshold for extreme poverty. Today the extreme poverty rate is less
than 10%, the lowest ever.

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, a plausible alternative. Moreover,
contemporary trade barriers are much more complex and difficult
to negotiate in a multilateral forum. Logically, these issues are
found easier to discuss 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 achievements in liberalizing trade in
agriculture, textiles, and apparel, and in many other areas of
international commerce has been negligible.

d. The latest 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 have 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 the implementing the present agreements.

 The North-South divide apparent in the WTO ministerial meets

has fueled the apprehensions 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.

A Summary of Agreements in the Final Act of the Uruguay Round

1. Agreement Establishing the WTO

2. General Agreement on tariffs and Trade 1994
3. Uruguay Round Protocol GATT 1994
4. Agreement on Agriculture
5. Agreement on Sanitary and Phytosanitary Measures
6. Agreement on Textiles and Clothing (terminated on 1 January
2005)
7. Agreement on Trade-Related Investment Measures
8. Agreement on Implementation of Article VI (Anti-dumping
9. Agreement on implementation of Article VII (Customs valuation)
10. Agreement on Pre-shipment Inspection
11. Agreement on Rules of Origin
12. Agreement on Import Licensing procedures
13. Agreements on Subsidies and Countervailing Measures
14. Agreements on Safeguards
15. General Agreement on trade in Services
Unit IV: Exchange Rate and its Economic Effects
Foreign exchange refers to money denominated in any currency other than
the domestic country. Foreign exchange has a price. The exchange rate is the
price of one currency expressed in terms of units of another currency and
represents the number of units of one currency that exchanges for a unit of
another. It is the rate at which the currency of one country exchanges for the
currency of another country. It is the minimum number of units of one country’s
currency required to purchase one unit of the other country’s currency.

Nominal Exchange rate

Direct quote /European currency Indirect quote /American currency

quotation-it is the number of units of a quotation- It is the number of units of
local currency exchangeable for one a foreign currency exchangeable for
unit of a foreign currency. one unit of a local currency. e.g. ₹1 =0.
e.g,1 $=76 rs 0151$
here the foreign currency is the base here the domestic currency is the base
currency and the domestic currency is currency and the foreign currency is
the counter currency the counter currency.

Cross rate- Two pairs of currencies with one currency being common between
the two pairs. For example exchange rates may be given between a pair X&Y
and another pair X&Z. The rate between Y&Z is obtained from the given rates
of the two pairs and is called cross rate.

For example $1 is equal to ₹73 and 1.4 dollars is equal to £1 . Calculate the
exchange rate of a pound to rupees.

Unique or unified rate- there is no difference between the buying and the
selling rate.
Generally there are two rates- selling rate and buying rate. Selling rate is
generally higher than the buying rate .The difference is the Commission of the
money exchanger.

Exchange rate regime

An exchange rate regime is the system by which a country manages its
currency in respect to foreign currencies. It refers to the method by which the
value of the domestic currency in terms of foreign currencies is determined.
There are two major types of exchange rate regimes at the extreme ends.
1. floating exchange rate regime ( flexible exchange rate)
2. fixed exchange rate regime ( pegged exchange rate)

Floating exchange rate regime Fixed exchange rate regime

1:The equilibrium value of the 1: A country’s central bank and
exchange rate of the country’s /or government announces what
currency is market determined i.e. its currency will be worth in terms
the demand for and supply of the of either another countries
currency relative to other currency or a basket of currencies
currencies determine the or another measure of value such
exchange rate. as gold.
2: There is no interference on 2: The central bank intervenes
the part of the government or in the foreign exchange market
the central bank of the country in order to maintain the
in the determination of exchange rate at the
exchange rate. Any intervention predetermined level. It is willing
by the central bank in foreign to buy foreign reserves
exchange rate is intended for whenever the market demand
only moderating the rate of for foreign currency is lesser
change and preventing undue than the supply of foreign
fluctuations in the exchange currency and vice versa.
rate.
3: Nearly all advanced countries 3:
follow floating exchange rate
regimes. For example New
Zealand, Sweden, The United
states etc

Intermediate exchange rate regime: This lies between the two extremes (
fixed and flexible). For example, a central bank can implement soft peg
and hard peg policies. A soft peg refers to an exchange rate policy under
which the exchange rate is generally determined by the market, but in case
the exchange rate tend to move speedily in one direction ,the central bank
will intervene in the market. With a hard peg exchange rate policy, trade
policy, the central bank sets a fixed and unchanging value for the
exchange rate. Both soft peg and hard peg policy require that the central
bank intervene in the foreign exchange market.
IMF Classifications and definitions of exchange rate regimes
Exchange rate regimes Description
Exchange arrangements with no Currency of another country
separate legal tender.(13 circulates as sole legal tender or
countries) member belongs to a monetary or
E.g. Kosovo-Euro currency union in which same legal
Ecuador,El Salvador-US dollar tender is shared by members of the
union.
Currency board arrangement(11 Based on explicit national
countries) commitment to exchange
Hong Kong,Dominica,Grenada etc domestic currency for a specified
-Dollar foreign currency at a fixed
Bosnia,Bulgaria exchange rate.
Other conventional fixed peg Country pegs its currency( formal
arrangements( 43 countries) or defacto) at a fixed rate to a major
For example -Oman,Qatar, Saudi currency or a basket of currencies
Arabia, United Arab Emirates etc to where exchange rate fluctuates
US dollars within a narrow margin or at most
Mali,Niger,Senegal,Cameroon etc +/-1 % around central rate
-Euro
Pegged exchange rates within Value of the currency is maintained
horizontal bands (1 country) Tonga within margins of fluctuation
around a formal or de facto fixed
peg that are wider than +/- 1%
around central rate
Crawling pegs (3 countries) Currency is adjusted periodically in
Honduras, Nicaragua, Botswana small amounts at a fixed , pre
announced rate in response to
changes in certain quantitative
indicators.
Crawl like arrangements (15 Currency is maintained within
countries) for example Iran, Costa certain fluctuation margins say +/-
Rica 1-2 % around the central rate that
is adjusted periodically
Other managed arrangement (13
countries) for example Cambodia,
Liberia, Zimbabwe
Floating 35 countries for example Monetary authority influences the
India, Philippines, New Zealand, movements of the exchange rate
Malaysia through intervention in foreign
exchange markets without
specifying a pre announced path
for the exchange rate
 Free floating(31 countries)E.G.US Exchange rate is market
,Japan,New Zealand,UK etc determined, with foreign exchange
intervention aimed at moderating
the rate of change and preventing
undue fluctuations in the exchange
rate, rather than at establishing a
level for it.

The main advantages of fixed regime are:

1. A fixed exchange rate avoids currency fluctuations and eliminates
exchange rate risk and transaction costs that could impede
international flow of trade and investments. International trade and
investment and less risky under fixed trade regime as profits are not
affected by the exchange rate fluctuations.
2. A fixed exchange rate can greatly enhance international trade and
investment.
3. There will be a reduction in speculation on exchange rate movements if
everyone believes that exchange rates will not change .
4. The government can encourage greater trade and investment ass
stability encourages investment.
5. A fixed exchange rate system imposes discipline on a country’s
Monetary Authority and therefore is more likely to generate lower levels
of inflation.
6. However, in this case, the central bank is required to stand ready to
intervene in the foreign exchange market and also to maintain an
adequate amount of foreign exchange reserves for this purpose.

The main advantages of floating exchange rate regime are:

1. It has the greatest advantage of allowing a central bank and or
government to pursue its own independent monetary policy.
2. It allows exchange rate to be used as a policy tool for example
policymakers can adjust the nominal exchange rate to influence the
competitiveness of the tradeable goods sector.
3. As there is no obligation or necessity to intervene in the currency
markets, the central bank is not required to maintain a huge foreign
exchange reserves.
However, the greatest disadvantage of a flexible exchange rate regime is
that volatile exchange rates generate a lot of uncertainties in relation to
international transactions and add a risk premium to the costs of goods and
assets traded across borders.
In short, a fixed rate brings in more currency and monetary stability and
credibility but it lacks flexibility. On the contrary, a floating exchange rate has
greater policy flexibility but less stability.
Nominal versus real exchange rates
Nominal exchange rate Real exchange rate
 It is the rate at which a person 1: It is the rate at which a person can
can trade the currency of one trade the goods and services of one
country for the currency of country for the goods and services
another country. For any of another.
country, there are many
nominal exchange rates
because its currency can be
used to purchase many
foreign currencies. While
studying exchange rate
changes, economists make
use of indexes that average
these many exchanges. An
exchange rate index turns
these many exchange rates
into a single measure of the
international value of
currency.
2: It can be used to find the 2: It describes how many of good or
domestic price of foreign goods. service in one country can be
traded for one of that good or
service in a foreign country.
3:It does not affect the trade flows. 3: It affects the trade flows. It is the
key determinant of a country’s net
exports of goods and services.

nominal exchange rate∗domestic price

Real exchange rate= foreign price

While studying the economy as a whole, we use price indices which measure
the price of a basket of goods and services. Real exchange rate will then be:
nominal exchange rate∗domestic price index
Real exchange rate= foreign price index

Another exchange rate concept, the real effective exchange(REER) is the

nominal effective exchange rate( a measure of the value of a domestic
currency against a weighted average of various foreign currencies) divided
by a price deflator or index of costs. An increase in our REER implies that
exports become more expensive and imports become cheaper therefore, an
increase in REER indicates a loss in trade competitiveness.

4.1 The Foreign Exchange Market

The wide-reaching collection of markets and institutions that handle the
exchange of foreign currencies is known as the foreign exchange
market. In this market, the participants use one currency to purchase
another currency. The foreign exchange market operates worldwide
and is by far the largest market in the world in terms of cash value traded.
Being an over-the-counter market, it is not a physical place; rather, it is
an electronically linked network of big banks dealers and foreign
exchange brokers who bring buyers and sellers together. With no central
trading location and no set hours of trading, the foreign exchange
market involves enormous volume of foreign exchange trading
worldwide. The participants such as firms, households, and investors who
demand and supply currencies represent themselves through their banks
and key foreign exchange deals who respond to market signals
transmitted instantly across the world. The foreign exchange markets
operate on very narrow spreads between buying and selling prices. But
since the volume trades are very large, the traders in foreign exchange
markets stand to make huge profits or losses.

The Major participants in the exchange market are central banks,

commercial banks, governments, foreign exchange Dealers,
multinational corporations that engage in international trade and
investments, nonbank financial institutions such as asset-management
firms, insurance companies, brokers, arbitrageurs and speculators. The
central banks participate in the foreign exchange markets, not to make
profit, but essentially to contain the volatility of exchange rate to avoid
sudden and large appreciation or depreciation of domestic currency
and to maintain stability in exchange rate in keeping with the
requirements of national economy. If the domestic currency fluctuates
excessively, it causes panic and uncertainty in the business world.
Commercial banks participate in the foreign exchange market either on
their own account or for their client’s. When they trade on their own
account, banks may operate either as speculators or arbitrageurs / or
both. The bulk of currency transactions occur in the interbank market in
which the banks trade with each other.
Foreign exchange brokers participate in the market as intermediaries
between different dealers or banks. Arbitrageurs profit by discovering
price differences between pairs of currencies with different dealers or
banks. Speculators, who are bulls or bears, are deliberate risk-takers who
participate in the market to make gains which results from unanticipated
change in exchange rates. Other participants in the exchange market
are individuals who form only a very insignificant fraction in terms of
volume and value of transactions.
In the foreign exchange market, there are two types of transactions:

 Current transaction which are carried out in the spot market and
the exchange involves immediate delivery, and

 Contracts to buy or sell currencies for future delivery which are

carried out in forward and / or future markets.

Exchange rates prevailing for spot trading (for which settlement by and
large takes two days) are called spot exchange rates. The exchange
rates quoted in the foreign exchange transactions that specify a future
date are called forward exchange rates. The currency forward contracts
are quoted just like spot rate, however the actual delivery of currencies
take place at the future. When a party agrees to sell ‘euro for dollars’ on
a future date at a forward rate agreed upon, he has ‘sold euros forward’
and’ bought dollars forward’.
A forward premium is set to occur when the forward exchange rate is
more than a spot exchange rate.
If the forward trade is quoted at a lower rate than the spot rate, then
there is a forward discount.

4.2 Determination of Nominal Exchange Rate[MAY’19;DEC’21]

The key framework for analyzing prices is the operation of forces of supply
and demand in markets. Usually, the supply of and demand for foreign
exchange in the domestic foreign exchange market determine the
external value of the domestic currency, or in other words, a country’s
exchange rate.

Individuals, institutions and governments participate in the foreign

exchange market for a number of reasons. On the demand side, people
desire foreign currency to:

 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.

The participants on the supply side operate for similar reasons. Thus, the
supply of foreign currency to the home country results from purchases of
home exports, unilateral transfers to home country, investment income
payments, foreign direct investments and portfolio investments,
placement of bank deposits and speculation.

Figure 4.4.1

Determination of Nominal Exchange Rate

The equilibrium rate of exchange is determined by the interaction of the

supply and demand for a particular foreign currency. In figure 4.4.1, the
demand curve (D$) and supply curve (S$) if dollars intersect to determine
equilibrium exchange rate eeq with Qe as the equilibrium quantity of
dollars exchanged.

4.3 Changes in exchange rates

Changes in exchange rate portray depreciation or appreciation of one

currency. The terms, ₹ ‘currency appreciation’ and ‘currency
depreciation’ describe the movements of the exchange rate. Currency
appreciates when its value increases with respect to the value of another
currency or a basket of other currencies. On the contrary, currency
depreciates when its value falls with respect to the value of another
currency or a basked of other currencies. We shall try to understand this
with the help of an example.

Now suppose, the Rupee dollar exchange rate in the month of January
is $1 = ₹65. And, we find that the month of April it is $1 = ₹70. What does
this indicate? In April, you will have to exchange a greater amount of
Indian Rupees (₹70) to get the same 1 US dollar. As such, the value of the
Indian Rupee has gone down or Indian Rupee has depreciated in its
value. Rupee depreciation here means that the rupee has become less
valuable with respect to the US dollar. Simultaneously, if we look at the
value of dollar in terms of Rupees, you find that the value of the US dollar
has increased in terms of the Indian Rupee. One dollar will now fetch ₹70
instead of ₹65 earlier. This is called appreciation of the US dollar.
When one currency depreciates against another, the second currency
must simultaneously appreciate against the first.

To put it more clearly:

 Home -currency depreciation (which is the same as foreign -

currency appreciation) takes place when there is an increase in
the home currency price of the foreign currency (or, alternatively,
a decrease in the foreign currency price of the home currency).
The home currency thus becomes relatively less valuable.

 Home-currency appreciation or foreign-currency depreciation

takes place when there is a decrease in the home currency price
of foreign currency (or, alternatively, an increase in the foreign
currency price of home currency). The home currency thus
becomes relatively more valuable.

Under a floating rate system, if for any reason, the demand curve for
foreign currency shifts to the right representing increased demand for
foreign currency, and supply curve remains unchanged, then the
exchange value of foreign currency rises and the domestic currency
depreciates in value. This is illustrated in figure 4.4.2.
 Figure 4.4.2
Determination of Nominal Exchange Rate

The market reaches equilibrium at point E with equilibrium exchange rate

eq. An increase in domestic demand for the foreign currency, with
supply of dollars remaining constant, is represented by a rightward shift
of the demand curve to D1$. The equilibrium exchange rate rises to e¹.
It means that more units of domestic currency (here Indian Rupees) are
required to buy a unit of foreign exchange (dollar) and that the domestic
currency (the Rupee) has depreciated.

We shall now examine what happens when there is an increase in the

supply of dollars in the Indian market. This is illustrated in figure 4.4.3

Figure 4.4.2

Determination of Nominal Exchange Rate

An increase in the supply of foreign exchange shifts the supply curve to
the right to S¹$ and as a consequence, the exchange rate declines to
e¹. It means, that lesser units of domestic currency (here Indian Rupees)
are required to buy a unit of foreign exchange (dollar), and that the
domestic currency (the Rupee) has appreciated.

4.4 Devaluation (Revaluation )VS Depreciation (Appreciation)

Devaluation is a deliberate downward adjustment in the value of the

country’s currency relative to another currency, group of currencies or
standard. It a monetary policy tool used by countries that have a fixed
exchange rate or nearly fixed exchange rate regime and involves a
discrete official reduction in the otherwise fixed par value of a currency.
The monetary authority formally sets a new fixed rate with respect to a
foreign reference currency or currency basket. In contrast, depreciation
is a decrease in a currency’s value (relative to other major currency
benchmarks) due to market forces under a floating exchange rate and
not due to any government or central bank policy actions.

Revaluation is the opposite of devaluation and the term refers to a

discrete raising of the otherwise fixed par value of a nation’s currency.
Appreciation, on the other hand, is an increase in a currency’s value
(relative to other major currencies) due to market forces under a floating
exchange rate and not due to any government or central bank policy
interventions.

4.5 Impacts of exchange Rate fluctuations on Domestic

Economy

a. Exchange rate have a very significant role in determining the

nature and extent of a country’s trade. Changes in import and
export prices will lead to changes in import and export volumes,
causing changes in import spending and export revenue.

b. Fluctuations in the exchange rate affect the economy by

changing the relative prices of domestically-produced and
foreign-produced goods and services. All else equal (or other
things remaining the same), an appreciation of a country’s
 currency raises the relative price of its exports and lowers the
relative price of its imports. Conversely, a depreciation lowers the
relative price of a country’s exports and raises the relative price of
its import. When a country’s currency depreciates, foreigners find
that its exports are cheaper and domestic residents find that
imports from abroad are more expensive. An appreciation has
opposite effects i.e., foreigners pay more for the country’s products
and domestic consumers pay less for foreign products. For
example: assumes that there is devaluation or depreciation of
Indian Rupee from $1 = Rs 65/- to $1 = Rs70/-. A foreigner who
spends ten dollars on buying Indian goods will, post devaluation,
get goods worth Rs.700/- instead of Rs.650/- prior to depreciation.
An importer has to pay for his purchases in foreign currency, and,
therefore, a resident of India, who wants to import goods worth $1
will have to pay Rs.70/- instead of Rs65/- prior to depreciation.
Importers will be affected most as they will have to pay more
rupees on importing products. On the contrary, exporters will be
benefitted as goods exported abroad will fetch dollars which can
now be converted to more rupees.

c. Exchange rate changes affect economic activity in the domestic

economy. A depreciation of domestic currency primarily increases
the price of foreign goods relative to goods produced in the home
country and diverts spending from foreign goods to domestic
goods. Increased demand, both for domestic import-competing
goods and for export encourages economic activity and creates
output expansion. Overall, the outcome of exchange rate
depreciation is an expansionary impact on the economy at an
aggregate level. The positive effect of currency depreciation,
however, largely depends on whether the switching of demand
has taken pace in the right direction and in the right amount, as
well as on the capacity of the home economy to meet the
additional demand by supplying more goods to meet the
increased domestic demand.

d. By lowering export prices, depreciation helps increase the

international competitiveness of domestic industries, increases the
volume of exports and promotes trade balance. However, a point
to be noted is that the price changes in exports and imports may
counterbalance or offset each other only if trade is in balance and
terms of trade are not changed. In the case of country’s imports
exceed exports, the net result is a reduction in real income within
the country.
e. For an economy where exports are significantly high, a
depreciated currency would mean a lot of gain. In addition, if
exports originate from labour-intensive industries, increased export
prices will have positive effect on employment income and
potentially on wages.

f. When a country’s currency depreciates, production for exports

and of import substitutes becomes more profitable. Therefore,
factors of production will be induced to move into the tradable
goods sectors and out of the non-tradable goods sectors. The
reverse will be true when the currency appreciates. These types of
resource movements involve economic wastes.

g. A depreciation or devaluation is also likely to affect a country’s

terms of trade. (Terms of trade is the ratio of the price of a country’s
export commodity to the price of its import commodity). Since the
prices of both exports and imports rise in terms of the domestic
currency as a result of depreciation or devaluation, the terms of
trade of the nation can rise, fall or remain unchanged, depending
on whether price of exports rises by more than, less than or same
percentage as price of imports.

h. Companies that have borrowed in foreign exchange through

external commercial borrowings (ECBs) but have been careless
and did not sufficiently hedge these loans against foreign
exchange risks would also be negatively impacted as they would
require more domestic currency to repay their loads. A
depreciated domestic currency would also increase their debt
burden and lower their profits and impact their balance sheets
adversely. These would signal investors who will be discouraged
from investing in such companies.

i. Countries with foreign currency denominated government debts,

currency depreciation will increase the interest burden and cause
strain to the exchequer for repaying the servicing foreign debt.
Fortunately, India has small proportion of public debt in foreign
currency.

j. Exchange rate fluctuations make financial forecasting more

difficult for firms and larger amounts will have to be earmarked for
insuring against exchange rate risks through hedging.
 k. With growth of investments across international boundaries,
exchange rates have assumed special significance. Investors who
have purchased a foreign asset, or the corporation which floats a
foreign debt, will find themselves facing foreign exchange risk.
Exchange rate movements have become the single more
important factor affecting the value of investments on an
international level. They are critical to business volumes, profit
forecasts, investment plans and investment outcomes.
Depreciating currency hits investor sentiments and has radical
impact on patterns of international capital flows.

The other impacts of currency depreciation are:

a. Windfall gains for export-oriented sectors (such as IT sector, textile,

pharmaceuticals, gems and jewelry in the case of India) because
depreciating currency fetches more domestic currency per unit of
foreign currency.

b. Remittances to homeland by non-residents and businesses abroad

fetches more in terms of domestic currency.

c. Depreciation would enhance movement revenues from import

related taxes, especially if the country imports more of essential
goods.

d. Depreciation would result in higher amount of local currency for a

given amount of foreign currency borrowings of government.

e. Depreciation also can have a positive impact on country’s trade

deficit as it makes imports more expensive for domestic consumers
and exports cheaper for foreigners.

f. Depreciation also can have a positive impact on controlling

spiraling gold imports (mostly wasteful) and thereby improve trade
balance.

An appreciation will have the following consequences on real economy:

a. An appreciation of currency raises the price of exports and

therefore, the quantity of exports would fall. Since imports become
cheaper, we may expect an increase in the quantity of imports.
Combining these two effects together, the domestic aggregate
 demand falls and therefore, economic growth is likely to be
negatively impacted.

b. The outcome of appreciation also depends on the stage of the

business cycle as well, if appreciation sets in during the recessionary
phase, the result would be a further fall in aggregate demand and
higher levels of unemployment. If the economy is facing a boom,
an appreciation of domestic currency would trim down inflationary
pressures and soften the rate of growth of the economy.

c. An appreciation may cause reduction in the levels of inflation

because imports are cheaper. Lower price of imported capital
goods, components and raw materials lead to decrease in cost of
production which reflects on decrease in prices. Additionally,
decrease in aggregate demand tends to lower demand pull
inflation. Living standards of people are likely to improve due to
availability of cheaper consumer goods.

d. With increasing export prices, the competitiveness of domestic

industry is adversely affected and, therefore, firms have greater
incentives to introduce technological innovations and capital-
intensive production to cut costs to remain competitive.

e. Increasing imports and declining exports are liable to cause larger

deficits and worsen the current account. However, the impact of
appreciation on current account depends upon the elasticity of
demand for exports and imports. Relatively inelastic demand for
imports and exports may lead to an improvement in the current
account position. Higher the price elasticity of demand for exports,
greater would be the fall in demand and higher will be the fall in
the aggregate value of exports. This will adversely affect the
current account balance.

f. Loss of competitiveness will be insignificant if currency appreciation

is because of strong fundamentals of the economy.

Let’s solve:
Q 1: Explain the implications of the following on the demand and supply
of foreign exchange and the exchange rate in spot market foreign
exchange market:
i. Maryland’s exports remained more or less stagnant in the years
2005- 06 to 2016-17. However, due to heavy thrust on
industrialization, import of machinery, raw materials and
 components as well as associated services of different types
increased.

ii. The investors of Maryland find investments in financial assets in UK

highly attractive and the government of Maryland which has a
liberal attitude on foreign investments permits such investments.

iii. Many foreign investors who had previously acquired roselands

financial assets sell them.

iv. Effect on country Y if country X borrows 10 billion dollars from

country Y.

Q 2: Explain how the exchange rate value of Indian rupee will be

affected in each of the following cases. What are the possible
consequences on exports and imports?
i. The spot exchange rate changes from rupees 61 for $1 to Rs.64 for
$1
ii. The spot exchange rate changes from rupees 66 for $1 to rupees
63 for $1
Q 3: In 1983 Australia decided to float its dollars. Assuming free trade,
explain the effects of features of following on the spot exchange rate
between AUD and USD:
i. There is a substantial increase demand in Australia for US exports of
services. Since Australia manufacturers were favored over others,
there is a proportionate increase in exports of Australian products
to the US.

ii. Investors in Australia perceive that the returns on investments in the

US would be much more lucrative than elsewhere. As a result there
is a huge increase in demand for investments in U.S. dollars
denominated financial investments.

iii. Political uncertainties in the US due to presidential elections caused

large scale shift of Australian financial investments back into
Australia.

iv. An epidemic in some parts of Australia made the US evoke SPS

measures and banned the entry of a number of food items to the
US.
Unit V: International Capital Movements

Types of foreign capital

The term’ foreign capital’ includes any inflow of capital into the home country
from abroad. Foreign capital may flow into the economy in different ways.
Some of the important components of foreign capital flows are:
1: foreign aid or assistance which may be:
a. Bilateral or direct Inter government grants
b. Multilateral aid from many governments who pool funds with
international organizations like the World Bank.
c. Tied with strict mandates regarding the use of money or untied aid where
there are no such stipulations
d. Foreign grants which are voluntary transfer of resources by governments,
institutions, agencies or organizations.
2: Borrowings which may take different forms such as:
a. Direct inter government loans
b. Loans from international institutions (for example World Bank, IMF, ADB)
etc.
c. Soft loans for example from affiliates of World Bank such as IDA
d. External commercial borrowings and
e. trade credit facilities.
3: Deposits from NRIs
4: Investments in the form of:
a. Foreign portfolio investment in bonds, stocks and securities; and
b. Foreign direct investment in industrial, commercial and similar other
enterprises.

Foreign direct Investment (FDI)

International investments are of two types- foreign direct investment and
foreign portfolio investment.

FDI refers to the act of acquisition or construction of physical capital by a firm

from one (source) country in another (host) country. It sometimes refers to the
flow per unit time, and sometimes to the accumulated stock of capital. It is
defined as a process whereby the resident of one country (i.e., home or source
country) acquires ownership of an asset in another country (i.e., The host
country and such movement of capital involves ownership, control as well as
management of assets in the host country.

As per the IMF & OECD (Organization for Economic Cooperation and
development), acquisition of at least 10%of the shares of the target asset is FDI.
Direct investment comprises not only the initial transaction establishing the
relationship between the investor and the enterprise, but also all subsequent
transactions between them and among affiliated enterprises, both
incorporated and unincorporated. India also follows the same pattern of
classification.
FDI has 3 components i.e., equity capital, reinvested earnings and other direct
capital in the form of intra-company loans between direct investors (parent
enterprises) and affiliate enterprises.

Foreign direct investors may be

 individuals,
 incorporated or unincorporated private or public enterprises,
 associated groups of individuals or enterprises,
 governments or government agencies,
 estates, trusts or other organizations or any combination of the above-
mentioned entities.

The main forms of direct investments are:

 opening up overseas companies, including the establishment of
subsidiaries or branches;
 creation of joint ventures on a contract basis,
 joint development of natural resources, and
 purchase or annexation of companies in the country receiving foreign
capital.
Direct investments are real investments in factories, assets, land, inventories etc.
and involve foreign ownership of production facilities. The investor retains
control over the use of the invested capital and also seeks the power to
exercise control over decision making to the extent of its equity participation.
The lasting interest implies the existence of a long-term relationship between
the direct investor and the enterprise and the significant degree of influence
by the investor on the management of the enterprise.

Types of FDI:
i. Horizontal direct investment- It is said to take place when the investor
establishes the same type of business operation in a foreign country as it
operates in the home country. For example, a cell phone service
provider based in the United States moving to India to provide the same
service; Coke, Pepsi, Samsung etc. expanded internationally by ways of
horizontal FDI.
ii. Vertical FDI- Here the investor establishes or acquires a business activity
in a foreign country which is different from the investor’s main business
activity yet in some way supplements its major activity. There are two
types of vertical FDI-
a. Forward vertical FDI- In this, the FDI brings the company nearer
to market for example Toyota buying a car distributorship in US.
b. Backward vertical FDI-The international integration goes
backward towards raw material for example Toyota getting a
majority stake in a tyre manufacturer company.
iii. Conglomerate FDI- In this, an investor makes a foreign investment in a
business that is unrelated to its existing business in its home country. This is
often in the form of a joint venture with a foreign firm already operating
in the industry as the investor has no previous experience. This form of FDI
 requires overcoming 2 barriers simultaneously-(i) entering a foreign
market and (ii)working in a new industry.
Yet another category of investments is two way direct foreign investments
which are reciprocal investments between countries that occur when some
industries are more advanced in one nation( for example the computer
industries in the US )while other industries are more efficient in other nations( like
automobile industry in Japan ).

horizontal direct
investment forward vertical
FDI

Types of FDI vertical direct

investment

backward
vertical FDI
conglomerate
FDI

Foreign portfolio investment(FPI)

Foreign portfolio investment is the flow of ‘ financial capital’ rather
than real capital and does not involve ownership or control on the
part of the investor. Examples of FPI are
 the deposit of funds in an Indian or British bank by Italian
company,
 the purchase of a bond of a Swiss company or the Swiss
government by the citizen or company based in France.
Unlike FDI, FPI moves to investment in financial stocks, bonds
and other financial instruments and is effected largely by
individuals and institutions through the mechanism of capital
market. These flows of financial capital have their immediate
effects on balance of payments or exchange rates rather
than on production or income generation.

FPI is not concerned with either manufacture of goods or provision

of services . Such investors also do not have any intention of
exercising voting power or controlling or managing the affairs of the
company in whose securities they invest. The sole intention of a
foreign portfolio investor is to earn a remunerative return through
investment in foreign securities and is primarily concerned about
 the safety of their capital,
 the likelihood of appreciation its value and
 the return generated.
Logically, FPI moves to a recipient country which has revealed its
potential for higher returns and profitability.

FPIs are characterized by lower stake in companies with a total

stake in a firm at below 10%. These investments are typically of short
term nature and therefore not intended to enhance the productive
capacity of an economy by the creation of capital assets. They are
speculative. Once investor confidence is shaken, such capital has
a tendency to speedily shift from one country to another,
occasionally creating financial crisis for the host country.

FDI FPI
Investment involves creation of Investment is only in financial
physical assets . assets
Has a long term interest and Only short term interest and
therefore remains invested for generally remains invested for
long short periods
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by Not accompanied by
technology transfer technology transfer
Direct impact on employment No direct impact on
of Labor and wages employment of Labor and
wages
Enduring interest in No abiding interest in
management and control management and control
Securities are held with Securities are held purely as
significant degree of influence financial investment and no
by the investor on the significant degree of influence
management of the enterprise on the management of the
enterprise
May be made directly through May be made directly or
automatic route through foreign institutional
or through the approval of the investors(FII)
competing government
department(Government
route)

5.1 Reasons for Foreign direct investment

a. Desire to reap economies of large-scale operations arising from

technological growth.

b. Shared common language or common boundaries and possible

saving in time and transport costs because of geographical
proximity.

c. Necessity to retain complete control over its trade patents and to

ensure consistent quality and services for creating monopolies in a
global context.

d. Promoting optimal utilization of physical, human, financial and

other resources

e. Desire to capture large and rapidly growing high potential

emerging markets with substantially high and growing population
 f. Lower environmental standards in the host country and the
consequent relative saving in costs.

g. Stable political environment and overall favorable investment

climate in host country

h. The strategy to obtain control of strategic raw materials or

resources so as to ensure their uninterrupted supply at the lowest
possible price; usually a form of vertical integration

i. Desire to secure access to minerals or raw material deposits

located elsewhere and earn profits through processing them to
finished form (e.g., FDI in petroleum)

j. Lower level of economic efficiency in host countries and

identifiable gaps in development.

k. Tax differentials and tax policies of the host country which support
direct investment. However, a law tax burden cannot compensate
for a generally fragile and unattractive FDI environment.

l. Prevalence of high standards of social amenities and possibility of

good quality of life in the host country.

Factors in the host country discouraging inflow of foreign investments

(deterrents to FDI) CA Inter May’18 (2 marks)
1) Poor macro economic environment
a. Infrastructure lags,
b. high rates of inflation,
c. balance of payment deficits,
d. unfavorable tax regime,
e. poor track record of investments,
f. small size of market and
g. lack of potential for its growth, double taxation etc

2) Unfavorable resources and labor market conditions such as:

a. Poor literacy and low labour skills
b. Rigidity in the labour market
c. Language barriers
d. High rates of industrial disputes

3) Unfavorable legal and regulatory framework such as

a. Bureaucracy and corruption
 b. Cumbersome legal formalities and delays
c. Absence of well-defined property rights
d. Political instability

4) Lack of trade country openness

a. Prevalence of non-tariff barriers
b. stringent regulations
c. Lack of openness
d. Lack of security to life and property
e. Lack of facilities for immigration and employment of foreign
technical administrative personnel
f. Lack of a general spirit of friendliness towards foreign
investors.

Modes of FDI CA Inter Nov’18(3 marks)

FDIs can be made in a variety of ways such as:

o Opening of 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(M&A)
o Joint venture with a foreign company
o Greenfield investment (establishment of a new overseas affiliate for
freshly starting production by a parent company)
o Brownfield investments in form of FDI which makes use of the
existing infrastructure by merging, acquiring or leasing instead of
developing a completely new one. for example, In India 100% FDI
under automatic route is allowed in brownfield airport projects.

5.2 Benefits of foreign Direct Investment (arguments in favour of FDI

w.r.t developing countries) [CA Inter July’21]

a. Entry of foreign enterprise usually fosters competition and

generates a competitive environment in the host country. The
domestic enterprises are compelled to compete with the foreign
enterprises operating in the domestic market. This results in positive
outcomes in the form of cost reducing and quality improving
innovations, higher efficiency and increasing variety of better
products and services at lower prices ensuring wider choice and
welfare for consumers.
b. From the perspective of emerging and developing countries, FDI
can accelerate growth and foster economic development by
providing the much-needed capital, technological know-how,
management skills and marketing methods and critical human
capital skills in the form of managers and technicians. The spillover
effects of the new technology usually spread beyond foreign
corporations. In addition, the new technology can clearly enhance
the recipient country’s production possibilities.

c. Since FDI involves setting up of production base (in terms of

factories, power plants etc.) it generates direct employment in the
recipient country.

d. FDI not only creates direct employment opportunities but also,

through backward and forward linkages generate indirect
employment opportunities. This impact is particularly important if
the recipient country is a developing country with an excess supply
of Labor caused by population pressure.

e. Foreign direct investments also promote relative higher wages for

skilled jobs,

f. There is also greater possibility for the promotion of ancillary units

resulting in job creation and skill development for workers

g. If the host country is in a position to implement effective tax

measures, the foreign investment projects also would act as a
source of new tax revenue which can be used for development
projects.

h. Since FDI has a distinct advantage over the external borrowings, it

is considered to have a favorable impact on the host country’s
balance of payment position, and

i. Better work culture and higher productivity standards brought in by

foreign firms may possibly induce productivity related awareness
and may also contribute to overall human resources development.
5.3 Potential problems Associated with foreign Direct
Investment/Costs of FDI [CA Inter, July ’21]

a. FDIs are likely to concentrate on capital intensive methods of

production and service so that they need to hire only relatively few
workers. Such technology is inappropriate for labour abundant
country as it does not support generation of jobs which is a crucial
requirement to address the two fundamental areas of concern for
the less developed economies namely poverty and
unemployment .

b. The inherent tendency of FDI flows to move towards regions or

states which are well endowed in terms of natural resources and
availability of infrastructure has the potential to accentuate
regional disparity. Foreign Capital is also criticized for accentuating
the already existing income inequalities in the host country

c. Often the foreign firms may partly finance their domestic

investments by borrowing funds in the host country’s capital
market. This action can cause interest rates in the host country and
lead to a decline in domestic investments through ‘crowding-out;
effect. Moreover, suppliers of funds in developing economies
would prefer foreign firms due to perceived lower risks and such
shifts of funds may divert capital away from investments which are
crucial for the development needs of the country.

d. Jobs that require expertise and entrepreneurial skills for creative

decision making may generally be retained in the home country
and therefore the host country is left with routine management jobs
that demand only lower level so skills and ability.

e. High profit orientation of foreign direct investors tends to promote

a distorted pattern of production and investment such that
production could get concentrated on items of elite and popular
consumption and on non-essential items

f. Foreign entities are usually accused of being anti-ethical as they

frequently resort to methods like aggressive advertising and
anticompetitive practices which would induce market distortions.

g. FDI usually involves domestic companies ‘off-shoring’ or shifting jobs

and operations abroad in pursuit of lower operating costs and
 consequent higher profits. This has deleterious effects on
employment potential of home country.

h. FDI is also held responsible by many for ruthless exploitation of

natural resources and possible environmental damage.

FDI in India

FDI is an important source for India’s economic development . The import

substitution strategy of industrialization followed by India post- independence,
stressed on an extremely careful and selective approach while formulating
FDI policy. Extensive controls imposed by the government severely restricted
the inflow of foreign capital to India. The enactment of Foreign Exchange
Regulation Act, 1973 consolidated the regulatory framework with stipulations
of up to 40% of foreign equity holding in a joint venture. The industrial policy
announcements of 1980 and 1982 and the Technology policy statement 1983
provided for a moderately lenient attitude towards foreign investments by
endorsement of manufacturing exports as well as modernisation of industries
through liberalized imports of capital goods and technology.
The most important shift in investment policy occurred when India embarked
upon economic liberalization and reforms programme in 1991 to raise its
growth potential and to integrate with the world economy. Further reforms in
subsequent years put in place a series of measures directed towards
liberalizing foreign investments and for ensuring access to foreign technology
and funding.
The government’s strategy favoring foreign investments and the prevalent
robust business environment have ensured that foreign capital keeps flowing
into the country. The government initiatives such as
 automatic approval of FDI,
 simplification of procedures,
 setting up of foreign investment promotion board (FIPB abolished
with effect from May 2017,)
 signing of multilateral investment guarantee agency protocol for
protection of foreign investments,
 permitting use of foreign trademarks and brand names,
 100% FDI in multitude of sectors, enactment of foreign exchange
management act 1999,
 passing of the SEZ (special economic zones) act in 2005,
 support to mergers, acquisitions and Greenfield investments and
encouragement to foreign technology collaboration agreements
are such few measures.

Apart from being a critical driver of economic growth, FDI is a major source of
non-debt financial resources for the economic development of India.
According to the latest World Investment report 2020 by UNCTAD, India
jumped from 12th position in 2018 to 9th position in 2019 among the world’s
largest FDI recipient.
According to the RBI bulletin, July 2020, the Gross inflows to India amounted
to 74390 million U.S. dollars. India received the maximum FDI equity inflow
from Singapore, followed by Mauritius, Netherlands, USA and Japan.
The services sector (finance, banking, insurance, non-finance, business
outsourcing, R&D, Courier etc.) attracted the highest amount of FDI with
17.45% of the total; followed by computer hardware and software.

Currently, an Indian company may receive FDI either through automatic

route without any prior approval of the government or the Reserve Bank of
India or through government route with prior approval of the government.

An Indian company can receive foreign investment by issue of FDI compliant

instruments namely equity shares, fully and mandatorily convertible
preference shares and debentures, partly paid equity shares and warrants.
These have to be issued in accordance with the provisions of the Companies
Act 2013 and the SEBI guidelines as applicable.

In India, Foreign investment is prohibited in the following sectors: [CA Inter

July’21]
1. Lottery business including government or private lottery, online lotteries
etc.
2. Gambling and betting including casinos etc.
3. Chit funds
4. Nidhi company
5. Trading in Transferable Development Rights (TDRs)
6. Real estate business or construction of farmhouse. Real estate business
shall not include development of townships, construction of residential
or commercial premises, roads or bridges and REITs(Real Estate
Investment Trusts) registered and regulated under SEBI (REITs)
regulations 2014.
7. Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco
or of tobacco substitutes.
8. Activities or sectors not open to private sector investment for example
Atomic Energy and railway operations (other than permitted activities)

Overseas direct investment by Indian companies.

Integration of the Indian economy with the rest of the world is evident not
only in terms of higher level of FDI inflows but also in terms of increasing level
of FDI outflows. The overseas FDI’s by the Indian entrepreneurs are called out-
bound investments. Direct investments outside India means investments,
either under the automatic route or the government approval route,
 by way of the contribution to the capital or
 subscription to the memorandum of a foreign entity or
 by way of purchase of existing shares of a foreign entity either by
market purchase or private placement or through Stock Exchange,
signifying a long-term interest in the foreign entity (joint venture or
wholly owned subsidiary).
 Indian corporates can also invest overseas other than by way of direct
investments. Listed Indian companies can invest up to 50% of their net
worth as of the date of the last audited balance sheet in overseas
company, listed on a recognized Stock Exchange, or in the rated debt
securities issued by such companies. Outbound investments from India
have undergone substantial changes not only in terms of size but also
in terms of geographical spread and sectoral composition. The total
financial commitment on outward foreign direct investment (OFDI)from
India stood at 805.86 million US dollars in the month of June 2020.

The overseas investments have been primarily driven by resource

seeking, market seeking or technology seeking motives. Many Indian IT
firms like TCS, Infosys, WIPRO acquired global contracts and established
overseas offices in developed economies to be close to their key
clients. Recently there has been a surge in resource seeking overseas
investments by Indian companies, especially to acquire energy
resources in Australia, Indonesia and Africa. Indian entrepreneurs are
also choosing investment destinations in countries like Mauritius,
Singapore, British Virgin Islands and the Netherlands on account of the
tax benefits they provide.