CHAPTER 7

PUBLIC FINANCE
UNIT 1: FISCAL FUNCTIONS: AN OVERVIEW
Role of Government in an Economic System

Governments play a crucial role in addressing fundamental economic problems like resource
allocation, income distribution, and economic stabilization. These roles are outlined in three
key functions:

1. Allocation Function: Governments intervene to ensure efficient allocation of

resources, especially when market failures occur due to issues like imperfect
competition, externalities, and public goods. They use tools like direct production,
incentives, and regulations to guide resource distribution.
2. Redistribution Function: To achieve equity and social welfare, governments
redistribute income and wealth through taxation, public spending, and policies
targeting disadvantaged groups. This aims to provide equal opportunities and a
minimum standard of living for all.
3. Stabilization Function: Through fiscal and monetary policies, governments work to
stabilize the economy by managing inflation, employment, and economic growth.
They adjust spending and taxes to influence aggregate demand and ensure
macroeconomic stability.

Centre and State Finance in India

India's fiscal framework is structured around a federal system, with powers and
responsibilities divided between the central and state governments.

• Constitutional Division of Powers: The Constitution divides legislative powers into

the Union List, State List, and Concurrent List, with financial powers primarily
governed by Articles 268 to 293.
• Revenue and Expenditure Responsibilities: The central government controls major
revenue sources like income tax and customs duties, while states manage local taxes
such as land revenue and excise duties on specific goods.
• Inter-governmental Transfers: States rely on the central government for financial
support through mechanisms like tax sharing and grants-in-aid, overseen by the
Finance Commission.
• Finance Commission: A constitutional body that recommends how central tax
revenue is distributed among states and determines grants to ensure fiscal equity.
• Goods and Services Tax (GST): Introduced in 2017, GST unifies indirect taxes
across India. It is collected as Central GST (CGST), State GST (SGST), and
Integrated GST (IGST), impacting revenue for both the Union and states.
• Borrowing and Loans: The central government borrows within limits set by
Parliament, while states can borrow with the Centre's consent if they owe the central
government.
Overall, India's fiscal system aims to balance economic efficiency, equity, and stabilization
across different levels of government, ensuring resource allocation and addressing disparities.

UNIT 2:
MARKET FAILURE AND GOVERNMENT INTERVENTION
TO CORRECT 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.

Reasons for market failure

There are four major reasons for market failure. They are,

1 Market power,
2 Externalities,

3 Public goods,
4 Incomplete information

Market Power

Market power refers to a firm's ability to raise the price of a good or service above its
marginal cost, thus generating economic profits. Firms with market power are price makers,
unlike competitive firms, which are price takers. Excessive market power leads to
inefficiency by reducing output and raising prices compared to a competitive market, where
output is higher, and prices are lower.

Externalities

Externalities are costs or benefits from an activity that affect third parties not involved in the
activity itself. They can be positive (beneficial) or negative (harmful) and may be either
unidirectional or reciprocal.

Types of Externalities:

1. Negative Production Externalities in Consumption: Costs from production affect

consumers.
2. Negative Production Externalities in Production: Costs from production affect
other producers.
3. Positive Production Externalities in Consumption: Benefits from production affect
consumers.
4. Positive Production Externalities in Production: Benefits from production affect
other producers.
 5. Negative Consumption Externalities in Consumption: Costs from consumption
affect other consumers.
6. Negative Consumption Externalities in Production: Costs from consumption affect
producers.
7. Positive Consumption Externalities in Consumption: Benefits from consumption
affect other consumers.
8. Positive Consumption Externalities in Production: Benefits from consumption
affect producers.

Private vs. Social Costs:

• Private Cost: Direct costs borne by the producer or consumer involved in a

transaction.
• Social Cost: Total costs to society, including both private costs and external costs.

Social Cost = Private Cost + External Cost

Public Goods

Public goods are non-rivalrous and non-excludable, meaning one person's consumption does
not reduce availability for others, and it is difficult to prevent people from using them.
Examples include national defense, highways, and public sanitation. Public goods are prone
to free rider problems, where individuals benefit without paying, leading to underproduction
if left to the market.

Characteristics of Public Goods:

• Collective consumption
• Non-rivalrous and non-excludable
• Indivisible
• Prone to externalities and free rider problems

Characteristics of Private Goods:

• Private property rights

• Rivalrous and excludable
• Divisible
• No free rider problem

Incomplete Information

Markets require complete information to function efficiently, but in reality, information is

often incomplete, leading to market failures. This can result in the misallocation of resources
and prevent equilibrium prices and quantities from being established.

Asymmetric Information: Imbalance in information between buyers and sellers, leading to

distorted choices. For example, sellers might know more about a product's defects than
buyers.
Adverse Selection: A situation where asymmetric information leads to low-quality goods
dominating the market, as high-quality goods are withheld.

Moral Hazard: Occurs when one party takes advantage of another due to unobserved
actions, often leading to inefficiency

GOVERNMENT INTERVENTION TO CORRECT MARKET FAILURE

I) Market Power

Market power arises when firms can influence prices, leading to inefficiencies. Government
interventions include:

1. Regulation and Promotion of Competition: Laws like the Competition Act in India,
Antitrust laws in the US, and the Competition Act in the UK prevent anti-competitive
practices.
2. Price Regulation: In cases of natural monopolies (e.g., utilities), governments set
maximum prices to prevent firms from overcharging.

II) Externalities

Externalities occur when third parties are affected by economic activities. Government
interventions are tailored to address both negative and positive externalities:

A) Negative Externalities

1. Direct Controls: Governments impose regulations to limit harmful activities, such as

banning smoking in public places and enforcing environmental standards (e.g., the
Environment Protection Act in India).
2. Market-Based Approaches:
o Pollution Taxes: Taxes imposed on polluters to internalize external costs,
though challenges include determining the right tax level and potential
inflationary effects.
o Cap-and-Trade Systems: Firms receive permits to emit a limited amount of
pollutants. They can trade permits, incentivizing firms to reduce emissions.

B) Positive Externalities

1. Subsidies: Governments provide financial support to encourage the production of

goods with positive externalities, reducing costs and increasing output.
2. Direct Production: In cases of significant positive externalities, such as fundamental
research or environmental protection, governments may directly produce goods and
services.

III) Merit Goods

Merit goods are socially desirable but under-consumed due to market failures. Government
interventions include:
 1. Subsidies and Direct Provision: Providing subsidies or directly offering goods and
services like education and healthcare to ensure equitable access.
2. Regulation: Mandating certain levels of consumption or providing goods based on
need rather than ability to pay.

IV) Demerit Goods

Demerit goods are considered socially undesirable. Government measures include:

1. Bans and Regulations: Complete bans on certain substances (e.g., drugs) or strict
regulations on advertising and accessibility (e.g., tobacco and alcohol).
2. High Taxes: Imposing high taxes to discourage consumption, making goods like
tobacco and sugary drinks more expensive.

V) Public Goods

Public goods are non-excludable and non-rivalrous, often provided by governments to

prevent underproduction:

1. Direct Provision: Governments fund public goods through taxation (e.g., national
defense, public sanitation).
2. Excludable Public Goods: Charging entry fees for certain public goods that can be
controlled, such as national parks.

VI) Correcting Information Failure

Information asymmetry leads to inefficient markets. Government interventions include:

1. Mandatory Labeling and Disclosure: Ensuring accurate product information, such

as nutritional labels and financial disclosures.
2. Regulation of Advertising: Setting standards to ensure advertising is informative and
responsible.

VII) Equitable Distribution

Governments address income inequality and ensure equitable distribution through:

1. Progressive Taxation: Higher taxes on the wealthy to redistribute income.

2. Social Welfare Programs: Initiatives like unemployment compensation, subsidies,
and social security schemes to support disadvantaged groups.
3. Combating the Black Economy: Measures to reduce market distortions associated
with unreported economic activities.

Overall, government intervention is essential to correct market failures, ensure fair

competition, and promote social welfare. Through regulations, subsidies, and direct
provision, governments address inefficiencies and improve market outcomes
Unit III. THE PROCESS OF BUDGET MAKING
A budget is a statement that outlines where money comes from and where it goes. The
government budget of India is a document presented for approval and legislation, containing
estimates of proposed expenditures and means of financing them. It serves as a financial plan for
the following year.
Process of Budget Making
Introduction
The budget process in India is a comprehensive exercise controlled by the Ministry of Finance. It
involves preparing, presenting, and executing the budget in consultation with the NITI Aayog and
other relevant ministries. Although the Indian Constitution does not explicitly mention the term
"budget," Article 112 mandates the President to lay an "Annual Financial Statement" before both
houses of Parliament, detailing the estimated receipts and expenditures for the government each
year.
Budgetary Procedures
The budgetary procedures in India are divided into three main stages:
1. Preparation of the Budget: This involves an administrative process where the Ministry
of Finance, along with various stakeholders, prepares the budget and accompanying
documents.
2. Presentation and Enactment: This legislative process involves passing the budget in
Parliament after discussions.
3. Execution of the Budget: Once approved, the budget is implemented according to the
plan.

Preparation Process
The preparation of the budget begins as early as August-September of the previous year. The
Ministry of Finance's Budget Division prepares a comprehensive schedule for the entire budget
preparation process.
Key Steps in Preparation:
• Budget Circular: The process begins with the Budget Division issuing a budget circular.
This document contains detailed instructions and formats for preparing estimates to all ministries,
states, union territories, and autonomous bodies.
• Estimate Preparation: Each ministry and department prepares detailed estimates of
receipts and expenditures based on their assessment of requirements for the upcoming year.
• Pre-Budget Consultations: The Union Finance Minister conducts consultations with
various stakeholders, including state finance ministers, industry associations, agricultural and
social sector representatives, labor organizations, NITI Aayog experts, and economists. These
consultations are aimed at gathering suggestions and feedback on the proposed budget.
Presentation and Enactment
The budget is presented in Parliament, typically on February 1st, or another suitable date decided
by the government. The presentation follows a format determined by the Ministry of Finance
after considering suggestions from the Estimates Committee.
Budget Documents:
1. Budget Estimates (BE): Estimates of receipts and expenditures for the current and
upcoming financial year.
2. Revised Estimates (RE): Adjustments to the current year's budget.
3. Actuals: Financial data from the year preceding the current year.

Budget Speech:
The Finance Minister delivers a detailed budget speech in the Lok Sabha, outlining the
government's proposed policies and programs. The speech is divided into two parts:
• Part A: Discusses the macroeconomic situation, budget estimates, government priorities,
and expenditure allocations.
• Part B: Details progress on developmental measures, future policy directions, and tax
proposals.

Annual Financial Statement:

The Annual Financial Statement is a crucial document showing receipts and expenditures,
divided into three accounts:
1. Consolidated Fund of India
2. Contingency Fund of India
3. Public Account

Other Budget Documents:

• Demands for Grants (DG)
• Finance Bill
Statements under FRBM Act: Macro-Economic Framework Statement
Medium-Term Fiscal Policy cum Fiscal Policy Strategy Statement

Additionally, nine other explanatory documents support the mandated documents.

Parliamentary Process
In an election year, the budget may be presented twice: an interim budget (Vote on Account) and
a full-fledged budget. The budget discussion in the Lok Sabha occurs in two stages:
1. General Discussion: A broad discussion on the budget, after which the House is adjourned
for a fixed period.
1. Standing Committee Review: During the adjournment, standing committees review
demands for grants from various ministries and departments. The committees present reports
to the House for further discussion and voting.

Voting and Approval:

• Lok Sabha: Has the power to approve, refuse, or reduce grants. It conducts detailed
discussions and votes on demands for grants.
• Rajya Sabha: Engages in general discussion but does not vote on demands for grants.

Appropriation Bill and Finance Bill:

After the general discussion and voting, the government introduces the Appropriation Bill to
authorize expenditure from the Consolidated Fund of India. The Finance Bill, detailing tax
proposals, is introduced and must be passed within 75 days of its introd uction.
Guillotine:
On the final day for grant discussions, the Speaker puts all outstanding demands to a vote in a
process known as "Guillotine," ending debates within a specified time.
Role of Rajya Sabha:
The Finance Bill is sent to the Rajya Sabha for recommendations. As a money bill, the Rajya
Sabha must return it within 14 days, with or without recommendations, which the Lok Sabha may
accept or reject.
Recent Reforms
Since 2017-18, the budget presentation date was advanced to February 1st, and the Railway
Budget was merged with the General Budget for greater efficiency.
Sources of Revenue
The Department of Revenue under the Ministry of Finance oversees the administration and
enforcement of tax-related matters in India, including direct and indirect taxes. It operates
through two statutory boards:
1. Central Board of Direct Taxes (CBDT): Responsible for the levy and collection of
direct taxes.
2. Central Board of Indirect Taxes and Customs (CBIC): Manages the levy and
collection of indirect taxes such as Goods and Services Tax (GST), customs, and excise
duties.

Categories of Government Receipts

Government receipts are classified into two main categories:
1. Revenue Receipts: Include tax revenue and non-tax revenue.
2. Capital Receipts: Comprise debt receipts and non-debt capital receipts.
Key Sources of Revenue
• Tax Revenue: Corporation tax
• Income tax
• Wealth tax
• Customs duties
• Union excise duties
• Goods and Services Tax (GST), including GST compensation cess
• Taxes on union territories
•
• Non-Tax Revenue: Interest receipts
• Dividends and profits from public sector enterprises
• Surplus transfers from the Reserve Bank of India
• Other non-tax revenues, including receipts from union territories
•
• Capital Receipts: Non-Debt Capital Receipts: ▪ Recoveries of loans and advances
• ▪ Miscellaneous capital receipts (e.g., disinvestment proceeds)
•
• Debt Capital Receipts: ▪ Market loans
• ▪ Short-term borrowings (Treasury bills)
• ▪ Securities issued against small savings
• ▪ State provident funds
• ▪ Net external debts
• ▪ Other receipts (e.g., Sovereign Gold Bond Scheme, savings bonds)
•
•

Public Expenditure Management

Effective public expenditure management is crucial for achieving economic growth and fiscal
responsibility, especially in developing economies like India. It involves designing and
implementing public expenditure programs to achieve specific objectives at minimum cost.
Objectives and Challenges
• Objectives: Ensure fiscal responsibility
• Allocate resources to socially desirable areas
• Maintain a sustainable macroeconomic framework
•
• Challenges: Larger deficits
• Higher taxation levels
• Lower economic growth
• Greater debt burden
•

Role of the Department of Expenditure

The Department of Expenditure is responsible for overseeing the public financial management
system and state finances. Its functions include:
• Implementing recommendations from the Finance Commission and Central Pay
Commission
• Monitoring audit comments and preparing central government accounts
• Assisting ministries/departments in cost control and optimization of public expenditure

Expenditure Classification
The central government expenditure is classified into six categories:
• Centre’s Expenditure: Establishment expenditure
• Central sector schemes
• Other central expenditures (e.g., CPSEs, Autonomous Bodies)
•
• Centrally Sponsored Schemes and Transfers: Centrally sponsored schemes
• Finance Commission transfers
• Other transfers to states
•

Public Debt Management

Public debt management in India involves managing internal and external borrowing to finance
fiscal deficits while maintaining macroeconomic stability.
Key Aspects
• Definition: Public debt refers to the borrowing undertaken by the government from
internal and external sources to finance its expenditures.
• Objective: The central government's debt management policy aims to meet financing
needs at the lowest long-term cost while supporting the development of a vibrant domestic bond
market.
Pillars of Debt Management Strategy: Low cost of borrowing
Risk mitigation
Market development

Institutions Involved
1. Reserve Bank of India (RBI): Manages domestic marketable debt, including dated
securities and treasury bills.
2. Ministry of Finance (MoF): Manages external debt and other liabilities.
3. Internal Debt Management Department (IDMD) of RBI: Handles domestic debt for
the central and state governments.

Debt Management Practices

• Domestic Debt: Managed through the issuance of market loans and treasury bills.
• External Debt: Managed by the Department of Economic Affairs, sourced primarily
from multilateral agencies like the International Bank for Reconstruction and Development and
the Asian Development Bank.
• Fiscal Responsibility and Budget Management (FRBM) Act, 2003: Provides a
legislative framework for reducing deficits and debt to sustainable levels.

Recent Developments
• The government increased its borrowing during the COVID-19 pandemic to support
health and social sector expenditures.
• The RBI launched the 'RBI Retail Direct' facility in 2021 to improve retail investor
participation in government securities markets.

Debt Position (as of March 2023 and 2024)

• Internal Debt and Other Liabilities: Increased from ₹147,77,724.43 crores in 2023 to
₹164,23,983.04 crores in 2024.
• External Debt: Increased from ₹4,83,397.69 crores in 2023 to ₹5,22,683.81 crores in
2024.

Types of Budgets
Balanced Budget
• Definition: A balanced budget is one where revenues are equal to expenditures, meaning
there is neither a deficit nor a surplus.
• Condition: Revenue = Expenditure

Unbalanced Budget
• Definition: A budget is unbalanced when there is either a surplus or a deficit.

Surplus Budget
• Definition: A surplus budget occurs when estimated government receipts exceed
estimated government expenditures.
• Condition: Revenue > Expenditure

Deficit Budget
• Definition: A deficit budget occurs when estimated government receipts are less than the
estimated government expenditures.
• Condition: Revenue < Expenditure
• Prevalence: Most modern economies operate with a deficit budget.

Capital Receipts
• Definition: Receipts that lead to a reduction in government assets or an increase in
liabilities. Examples include recoveries of loans, earnings from disinvestment, and debt.
Revenue Receipts
• Definition: Receipts that neither create liabilities nor reduce government assets. Sources
include tax revenues and non-tax revenues.

Revenue Expenditure
• Definition: Expenditure for purposes other than creating physical or financial assets. It
includes expenses for government operations, interest payments on debt, and grants.

Capital Expenditure
• Definition: Expenditures that result in the creation of physical or financial assets or
reduce financial liabilities. Examples include spending on land, buildings, machinery, and loans
to state governments or PSUs.

Measures of Deficit
Budgetary Deficit
• Definition: The excess of total estimated expenditure over total estimated revenue,
encompassing both revenue and capital.

Revenue Deficit
• Definition: The excess of government revenue expenditure over revenue receipts.
• Formula: Revenue Deficit = Revenue Expenditure - Revenue Receipts

Fiscal Deficit
• Definition: The excess of total expenditure over total receipts, excluding borrowings. It
indicates the total borrowing requirement of the government.
Formula: Fiscal Deficit = Total Expenditure - Total Receipts (excluding borrowings)
Fiscal Deficit = (Revenue Expenditure + Capital Expenditure) - (Revenue Receipts + Capital
Receipts excluding borrowings)
Fiscal Deficit = Revenue Deficit + (Capital Expenditure - Capital Receipts excluding borrowings)

Primary Deficit
• Definition: Fiscal deficit minus interest payments on previous borrowings. It indicates
the borrowing requirement exclusive of interest payments.
• Formula: Primary Deficit = Fiscal Deficit - Net Interest Liabilities
Budget-Related Terms
Finance Bill
• Definition: A bill detailing the imposition, abolition, alteration, or regulation of taxes
proposed in the budget, presented immediately after the union budget.

Outcome Budget
• Definition: Links budgetary allocations to annual performance targets, measuring
development outcomes and the effectiveness of fund usage.

Guillotine
• Definition: A process where, after the prescribed period for discussion of expenditure
demands, all outstanding demands are put to vote without further discussion.

Cut Motions
• Definition: Motions to reduce sums requested by the government, used to voice
grievances or highlight differences in policy.

Consolidated Fund of India

• Definition: The primary fund for all government revenues and loans. Expenditures from
this fund require parliamentary approval.

Contingency Fund of India

• Definition: A fund for urgent unforeseen expenditures, available at the President's
discretion. Advances from this fund require subsequent parliamentary approval for recoupment.

Public Account
• Definition: An account used for funds where the government acts as a banker, such as
Provident Funds and Small Savings, which do not belong to the government and are returned to
depositors.

UNIT 4 - FISCALPOLICY
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.

Objectives of Fiscal Policy:

1. Achieve and maintain full employment.

2. Maintain price stability.
3. Accelerate economic development.
4. Ensure an equitable distribution of income and wealth.

Instruments of Fiscal Policy:

1. Government Expenditure:
o Current Expenditures: Day-to-day running of the government.
o Capital Expenditures: Investments in infrastructure and equipment.
o Transfer Payments: Social security benefits, subsidies, etc.
2. Taxes:
o Affect disposable income, aggregate demand, and economic activity.
 o During recessions, reducing taxes can stimulate consumption and investment.
3. Public Debt:
o Internal Debt: Borrowing from within the country.
o External Debt: Borrowing from foreign sources.
o Includes market loans and small savings.
4. Budget:
o A statement of government revenues and expenditures.
o Can be balanced, surplus, or deficit, influencing national debt and economic
stability.

Types of Fiscal Policy:

1. Expansionary Fiscal Policy:

o Used during recessions to increase government spending or reduce taxes.
o Aims to boost aggregate demand and reduce unemployment.
2. Contractionary Fiscal Policy:
o Used to combat inflation by decreasing government spending or increasing
taxes.
o Aims to reduce aggregate demand and control inflation.

Fiscal Policy for Long-Term Economic Growth:

• Invest in infrastructure and human capital.

• Design tax policies that encourage saving and investment.
• Address market failures and support economic development through subsidies and
environmental taxes.

Fiscal Policy for Reducing Inequalities:

• Implement progressive taxation and targeted public spending.

• Fund welfare programs, subsidize essential services, and improve public
infrastructure.

Limitations of Fiscal Policy:

• Lags: Recognition, decision, implementation, and impact lags.

• Timing Issues: Risk of policies being enacted at the wrong time.
• Difficulty in Adjustment: Challenges in modifying spending and taxation policies
quickly.
• Conflicts in Objectives: Policies aimed at one goal may negatively impact another.
• Crowding Out: Government borrowing may lead to higher interest rates, reducing
private investment.

Crowding Out:

• Occurs when increased government borrowing raises interest rates, thereby reducing
private sector investment and consumption
 CHAPTER 8 – MONEY MARKET
UNIT: 1
The concept of Money Demand: Important Theories
Functions of money

1) A Medium of Exchange
2) A Unit of Account
3) A Standard of Deferred Payment
4) A Store of Value
5) A transfer of value

Characteristics of Money

1) Generally acceptable
2) Durable ( long lasting)
3) Effortlessly recognizable
4) Difficult to Counterfeit ( not easily reproducible by people)
5) Relatively Scarce
6) Portable and Easily Transported
7) Possessing Uniformity
8) Divisible in to smaller parts without losing value.

Fiat money
Fiat money is a type of currency that has no intrinsic value and is not backed by a
physical commodity like gold or silver. Instead, its value comes from the trust and
confidence that people have in the issuing government and its ability to maintain the
currency's value.

DEMAND FOR MONEY

The desire of person to hold money in hand is called demand for

money ( liquidity Preference). According to J.M. Keynes, ' The demand for
money is the sum of the money required for transaction motive, Precautionary
Motive and Speculative Motive’
THEORIES OF DEMAND FOR MONEY

1) Classical Approach: The Quantity Theory of Money (QTM)

• Fisher's Equation of Exchange: Proposed by Irving Fisher, this theory suggests a

strong relationship between the money supply and price level. The equation
 MV=PTMV = PTMV=PT states that the money supply (M) times its velocity (V)
equals the price level (P) times transactions (T).
• Expanded Equation: MV+M′V′=PTMV + M'V' = PTMV+M′V′=PT includes
demand deposits (M') and their velocity (V'), indicating the total money flow equals
the value of transactions.

2) Neoclassical Approach: The Cambridge Approach

• Cash Balance Approach: Proposed by Cambridge economists, it emphasizes

money's utility as a transaction medium and a hedge against uncertainty. The equation
Md=kPYMd = kPYMd=kPY indicates the demand for money (Md) is a proportion (k)
of nominal income (PY).

3) Keynesian Theory of Demand for Money

• Liquidity Preference Theory: John Maynard Keynes identified three motives for
holding money:
o Transactions Motive: For daily transactions, proportional to income.
o Precautionary Motive: To guard against unforeseen expenses, also income
elastic.
o Speculative Motive: To take advantage of interest rate changes, inversely
related to interest rates.
• Liquidity Trap: At very low-interest rates, people prefer holding cash over bonds,
making the speculative demand for money perfectly elastic.

Post-Keynesian Theories of Demand for Money

4) Inventory Approach to Transaction Balances

Baumol-Tobin Model: This model assumes people hold money and interest-bearing assets, balancing
the transaction costs between them. The demand for money is sensitive to interest rates, calculated
using the Square Root Rule C=2bY/r where C is the optimal cash withdrawal size.

5) Friedman's Restatement of the Quantity Theory

• Permanent Income Hypothesis: Milton Friedman argued that demand for money is
determined by permanent income rather than current income. Money demand depends
on wealth, price level, opportunity costs of holding money, and inflation.

6) Demand for Money as Behavior towards Risk

• Tobin's Portfolio Theory: Tobin suggested that risk-averse individuals hold a mix of
money and interest-bearing assets. Money provides certainty, while bonds offer
potential returns but come with risk. The demand for money is negatively related to
interest rates.

• Tobin's Liquidity Preference Function builds on Keynesian economics by

examining how individuals choose between holding money and other assets, such
as bonds, based on interest rates.
 • UNIT 2:
• CONCEPT OF MONEY SUPPLY
Money Supply

The term "money supply" refers to the total quantity of money available to people in an
economy at any given time. It is a stock variable, meaning it represents the amount of money
at a specific point in time.

Key Aspects of Money Supply:

1. Definition: Money supply includes the stock of money available to the public as a
means of payment and store of value. It does not include interbank deposits.
2. Exclusion: The term "public" includes all economic units such as households, firms,
and institutions, excluding the producers of money (i.e., the government and the
banking system).

I) Rationale of Measuring Money Supply

1. Understanding Growth: To study the causes of money growth in the economy.

2. Evaluating Consistency: Provides a framework to evaluate whether the money stock
aligns with standards for price stability and to understand deviations from this
standard.

II) Sources of Money Supply

The supply of money in an economy is influenced by:

1. Central Bank Decisions: The central bank's policies and actions determine the
monetary base.
2. Commercial Bank Credit: The extent of credit creation by commercial banks
contributes to the money supply. This credit money is created through the lending
activities of banks.

III) Measurement of Money Supply

Monetary aggregates are used to measure the money supply, including:

• M1: Currency notes and coins with the public + demand deposits of banks (current
and savings accounts) + other deposits with the RBI.
• M2: M1 + savings deposits with post office savings banks.
• M3: M1 + net time deposits with the banking system.
• M4: M3 + total deposits with the Post Office Savings Organization (excluding
National Savings Certificates).

IV) Determinants of Money Supply

Money supply is determined by:

• Exogenous Factors: Central bank policies and actions.

• Endogenous Factors: Changes in economic activities, such as people's desire to hold
currency relative to deposits, interest rates, etc.

Money Multiplier Approach to Money Supply

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.
Money Multiplier (m)= Money supply
Monetary base
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 excess reserves to deposites, e = {ER/D} and

(c) the ratio of currency to depoists, c ={C/D}

This approach holds that total supply of nominal money in the economy is
determined by the joint behaviour of the central bank, behaviour of the commercial
banks and the behaviour of the general public respectively.

Behavior of the Central Bank

• High-Powered Money: If the behavior of the public and commercial banks remains
constant, the total supply of nominal money varies directly with the amount of high-
powered money issued by the central bank. The central bank influences the monetary
base through its monetary policy actions.

Behavior of Commercial Banks

• Reserve Ratio: This is the ratio of a bank's cash reserves to its deposits. An increase
in the required reserve ratio causes banks to contract loans, decreasing deposits and
the money supply.
• Excess Reserves: Money injected by the central bank that is held as excess reserves
by banks will not affect deposits or the money supply unless those reserves are used
to make loans.
• Opportunity Cost: The cost of holding excess reserves is the interest foregone on
loans or securities. As interest rates rise, the opportunity cost increases, leading banks
to hold fewer excess reserves. Hence, the excess reserves ratio is negatively related to
the market interest rate.
• Expected Deposit Outflows: If banks anticipate higher deposit outflows, they will
increase excess reserves to safeguard against potential losses.
Behavior of the Public

• Currency Ratio (c): The ratio of currency held by the public to deposits. When
people hold more currency and less in banks, the currency ratio increases, leading to a
lower money multiplier because banks can create less credit money.
• Time Deposit-Demand Deposit Ratio: An increase in this ratio suggests more time
deposits relative to demand deposits, leading to greater reserve availability and a
larger potential for deposit expansion.

Money Multiplier

The money multiplier is determined by:

1+𝑐
Money Multiplier (m)=
𝑟+𝑒+𝑐

1+𝑐
Money Supply (M)= xH
𝑟+𝑒+𝑐

Where:

r = required reserve ratio at the central bank

e = the excess reserve ratio of commercial banks

c = the currency ratio of the public Given:

m=1+0.50.15+0.001+0.5=1.50.651≈2.304m = \frac{1 + 0.5}{0.15 + 0.001 + 0.5} =

\frac{1.5}{0.651} \approx 2.304m=0.15+0.001+0.51+0.5=0.6511.5≈2.304

V) Effect of Government Expenditure on Money Supply

• Ways and Means Advances (WMA) / Overdraft (OD): When government balances
are low, they can use WMA/OD facilities, which creates excess reserves in the
banking system as government spending credits receiver accounts in commercial
banks. This can increase the money supply through the money multiplier effect.

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 credit multiplier is the reciprocal of the required reserve ratio. If reserve
ratio is 20%, then credit multiplier = 1/0.20 = 5.
Credit Multiplier= 1/Required Reserve Ratio
 UNIT 3: MONETARYPOLICY

Monetary Policy Overview

• Definition: Monetary policy refers to the actions taken by the central bank to control
and regulate the demand and supply of money and the flow of credit to achieve
macroeconomic goals.
• Components:
1. Objectives of Monetary Policy: Traditionally aimed at price stability; now
includes multiple objectives like economic growth, employment, debt
management, and exchange rate stability.
2. Analytics of Monetary Policy: Focuses on the transmission mechanisms.
3. Operating Procedure: Focuses on operating targets and instruments.

Objectives of Monetary Policy

• Price Stability: Controlling inflation is a key goal.
• Economic Growth and Employment: Achieving high levels of economic growth
and full employment.
• Other Objectives: Debt management, moderate long-term interest rates, exchange
rate stability, and balance of payments equilibrium.
• Trade-offs: Balancing conflicting objectives like inflation control and
unemployment.

Transmission of Monetary Policy

• Interest Rates: Changes to policy affect interest rates, influencing economic activity
and inflation.
• Channels:
1. Saving and Investment Channel: Lower interest rates reduce savings
incentives, increase borrowing, and encourage spending and investment.
2. Cash-flow Channel: Changes in interest rates affect disposable income,
influencing spending.
3. Asset Prices and Wealth Channel: Affects consumption and investment by
influencing asset prices and wealth.
4. Exchange Rate Channel: Impacts economic activity and inflation through
changes in the exchange rate.

Operating Procedures and Instruments

• Quantitative Tools:
1. Cash Reserve Ratio (CRR): Affects liquidity in the system.
2. Statutory Liquidity Ratio (SLR): Influences banks' credit creation capacity.
3. Liquidity Adjustment Facility (LAF): Provides financial accommodation to
banks.
4. Marginal Standing Facility (MSF): Lender of last resort for banks.
5. Market Stabilisation Scheme (MSS): Absorbs excess liquidity.
6. Bank Rate: Standard rate for RBI transactions with banks.
 7. Open Market Operations (OMO): Adjusts rupee liquidity through securities
transactions.
• Qualitative Tools:
1. Margin Requirements: Affect borrowing habits.
2. Moral Suasion: Persuades banks to adopt certain behaviors.
3. Selective Credit Control: Restricts credit to specific sectors.

Organizational Structure for Monetary Policy Decisions

• Monetary Policy Framework Agreement: Sets the inflation target for RBI.
• Monetary Policy Committee (MPC): Consists of 6 members, including the RBI
Governor, who determine the policy rate to achieve the inflation target.
• RBI's Role: The Monetary Policy Department assists the MPC, and the Financial
Markets Operations Department operationalizes the policy.

CHAPTER 9:
INTERNATIONAL TRADE
UNIT 1: THEORIES OF INTERNATIONAL TRADE
International Trade refers to the exchange of goods, services, and resources across
international borders. It allows countries to specialize in the production of goods and services
they can produce most efficiently while importing others, thereby improving global resource
allocation and increasing economic welfare.

Benefits of International Trade

1. Economic Growth and Efficiency:

o Stimulates economic efficiency and growth by encouraging the division of
labor and specialization.
o Leads to efficient allocation and use of resources, improving productivity and
reducing monopolistic tendencies.
2. Market Expansion and Innovation:
o Provides access to new markets and materials, resulting in innovative products
at lower prices.
o Enables sourcing inputs and components at competitive prices, widening
consumer choices.
3. Technological Advancement:
o Necessitates automation and technological change, promoting investment in
research and development.
4. Diverse Services Development:
o Encourages the growth of innovative services in sectors like banking,
insurance, and logistics.
5. Upgrading Emerging Economies:
o Helps emerging economies improve product quality, enhancing their position
in the global value chain.
 6. Broadening Production and Diversification:
o Opens new markets, broadening the productive base and facilitating export
diversification.
7. Human Resource Development:
o Promotes research and knowledge exchange, aiding human resource
development.
8. Strengthening International Bonds:
o Encourages cooperation and harmony through mutually beneficial exchanges.

Criticisms of International Trade

1. Unequal Benefits:
o Trade benefits are not equally distributed, potentially increasing disparities
between nations.
2. Economic Exploitation:
o Underprivileged countries risk exploitation by powerful transnational
corporations.
3. Environmental Impact:
o Can lead to environmental degradation and resource depletion.
4. Transmission of Economic Crises:
o Trade cycles can rapidly transmit economic crises between countries.
5. Dependence and Sovereignty:
o Over-reliance on foreign trade can impair economic autonomy and political
sovereignty.
6. Investment Distortion:
o Excessive export orientation may misalign investments from genuine domestic
needs.
7. Trade Policy Risks:
o Lack of transparency and predictability in trade policies can create
uncertainty.

Important Theories of International Trade

I) The Mercantilists’ View of International Trade

• Mercantilism: This theory advocated maximizing exports and minimizing imports to

accumulate precious metals. It viewed trade as a zero-sum game, where one country's
gain is another's loss.

II) The Theory of Absolute Advantage

• Adam Smith’s Absolute Cost Advantage: This theory suggests that a country
should specialize in producing and exporting goods in which it has an absolute cost
advantage. Trade occurs when each country can produce a good more efficiently than
the other.

III) The Theory of Comparative Advantage

• David Ricardo's Comparative Advantage: Ricardo's theory posits that countries

should specialize in producing goods in which they have a comparative advantage,
 even if they have an absolute disadvantage in producing all goods. This leads to
mutually beneficial trade.

IV) The Heckscher-Ohlin Theory of Trade

• Factor-Endowment Theory: This theory states that comparative advantage is

determined by differences in factor endowments. Countries export goods that use their
abundant resources intensively and import goods that require their scarce resources.
• Factor-Price Equalization Theorem: International trade leads to the equalization of
factor prices across countries, resulting in convergence of wages and returns on
capital.

Globalization and New International Trade Theory

• Paul Krugman’s Contributions: Krugman challenged traditional models by

highlighting that much trade occurs between countries with similar factor
endowments. He introduced concepts like economies of scale and network effects,
which explain why countries trade similar goods.
• Economies of Scale: As firms produce more, their cost per unit decreases, leading to
higher profits when serving both domestic and international markets.
• Network Effects: The value of a product or service increases as more people use it,
creating a bandwagon effect. Examples include mobile apps like WhatsApp and
software like Microsoft Windows.

UNIT 2-THE INSTRUMENTS OF TRADE POLICY

Recent Developments in India's International Trade Strategy

• Increased Engagement in Free Trade Agreements (FTAs): India has recently

shifted its approach from avoiding FTAs to actively pursuing them. Recent
agreements include:
o Mauritius (April 1, 2021)
o UAE (Comprehensive Economic Partnership Agreement, CEPA, effective
May 1, 2022)
o Australia (Economic Cooperation and Trade Agreement, ECTA, effective
April 2, 2022)
o Upcoming agreements with the UK, Canada, EU, GCC, and Israel.

Key Trade Policy Concepts

• Free Trade vs. Protectionism:

o Free Trade: Minimal state interference; market forces determine prices.
o Protectionism: Uses tariffs, quotas, and other instruments to shield domestic
industries from foreign competition.
• Trade Liberalization: Reducing trade barriers to open domestic markets to
international goods and services.
Trade Policy Instruments

1. Tariffs:
o Definition: Taxes on imports/exports.
o Forms:
▪ Specific Tariff: Fixed amount per unit.
▪ Ad Valorem Tariff: Percentage of the value of the good.
▪ Mixed Tariffs: Combination of specific and ad valorem.
▪ Compound Tariff: Combination of specific and ad valorem duties.
▪ Technical/Other Tariffs: Based on specific contents.
▪ Tariff Rate Quotas (TRQs): Lower tariff rates within quotas; higher
rates beyond quotas.
▪ Most-Favoured Nation (MFN) Tariffs: Standard tariffs for WTO
members.
▪ Preferential Tariffs: Lower rates for specific agreements or
developing countries.
▪ Bound Tariffs: Maximum tariff levels agreed upon in WTO.
▪ Applied Tariffs: Actual tariffs charged, which can be lower than
bound tariffs.
▪ Escalated Tariff Structure: Higher tariffs on processed goods
compared to raw materials.
▪ Prohibitive Tariffs: Set so high that no imports are feasible.
▪ Import Subsidies: Payments to reduce import costs (negative tariffs).
▪ Anti-Dumping Duties: Tariffs on goods sold below fair market value.
▪ Countervailing Duties: Offset subsidies from foreign governments.
2. Effects of Tariffs:
o On Trade: Decrease in international trade volume and market access.
o On Consumers: Higher prices and reduced consumer surplus.
o On Domestic Producers: Increased protection and potential growth in
domestic industry.
o On Efficiency: Distortion of comparative advantage and inefficient
production.
o On Government Revenue: Increased revenue from tariffs.

Non-Tariff Measures (NTMs)

• With the reduction of tariff barriers, NTMs have become more prevalent and often
have significant restrictive and distortionary effects on international trade

• Definition: NTMs are policy measures other than tariffs that affect international trade
by altering quantities traded, prices, or both. They can be protective or facilitative.
• Examples: Technical standards, health and safety regulations, import and export
quotas, licensing requirements, and administrative procedures.

Non-Tariff Barriers (NTBs)

• Definition: NTBs are a subset of NTMs with a protectionist or discriminatory intent,

used to favor domestic over foreign suppliers.
• Difference from NTMs: While NTMs encompass all measures affecting trade, NTBs
specifically refer to discriminatory measures intended to protect domestic industries.
Categories of NTMs

1. Technical Measures
o Sanitary and Phytosanitary (SPS) Measures: Protect human, animal, and
plant life from risks related to additives, pests, and diseases.
o Technical Barriers to Trade (TBT): Include standards and regulations
regarding product characteristics, labeling, and testing.
2. Non-Technical Measures
o Import Quotas: Limit the quantity of goods imported during a specified
period. Types include absolute quotas, tariff-rate quotas, seasonal quotas, and
temporary quotas.
o Price Control Measures: Include para-tariff measures that affect import
prices, such as minimum import prices.
o Non-Automatic Licensing and Prohibitions: Restrict quantities of imports
through licenses or complete prohibitions.
o Financial Measures: Involve regulations on foreign exchange and payment
terms.
o Measures Affecting Competition: Grant exclusive rights or preferences to
specific economic operators.
o Government Procurement Policies: Mandate purchasing from domestic
firms despite higher prices.
o Trade-Related Investment Measures: Include local content requirements
and restrictions related to exports.
o Distribution Restrictions: Limit distribution through additional licensing or
certification requirements.
o Restriction on Post-Sales Services: Reserve after-sales services to local
companies.
o Administrative Procedures: Involve costly and time-consuming procedures
that increase transaction costs.
o Rules of Origin: Criteria to determine the national source of a product.
o Safeguard Measures: Temporarily restrict imports to protect domestic
industries from surges.
o Embargos: Total bans on imports or exports to/from specific countries or
regions.

Export-Related Measures

1. Ban on Exports: Restrict exports during shortages to ensure domestic supply.

2. Export Taxes: Taxes on exported goods to reduce exports and increase domestic
supply.
3. Export Subsidies and Incentives: Financial support to encourage exports.
4. Voluntary Export Restraints (VERs): Informal quotas where exporting countries
voluntarily limit exports to avoid retaliatory measures.

Impact and Trends

• Global Trade Patterns: The increasing importance of developing countries and

regional trade agreements are reshaping global trade dynamics.
• Protective Strategies: Countries continue to devise new policies to protect their
economic interests.
 UNIT:3 TRADE NEGOTIATIONS
Regional Trade Agreements (RTAs) and the Evolution of International Trade
Institutions

Regional Trade Agreements (RTAs) are treaties between two or more countries aimed at
reducing trade barriers among member nations. These agreements come in various forms:

1. Unilateral Trade Agreements: One country offers trade incentives to another to

boost its economy. Example: Generalized System of Preferences (GSP).
2. Bilateral Agreements: Trade rules are set between two countries or blocs. Example:
EU-South Africa Free Trade Agreement.
3. Regional Preferential Trade Agreements: Members reduce trade barriers on a
reciprocal basis. Example: Global System of Trade Preferences among Developing
Countries (GSTP).
4. Trading Blocs: Groups of countries with a free trade agreement and common external
tariffs. Examples: Arab League, European Free Trade Association (EFTA).
5. Free-Trade Areas: Eliminate tariffs among members but maintain independent
external tariffs. Example: ASEAN–India Free Trade Area (AIFTA).
6. Customs Unions: Eliminate tariffs among members and apply a common external
tariff. Examples: EU, Gulf Cooperation Council (GCC).
7. Common Markets: Include free movement of goods, labor, and capital, along with a
common external tariff. Examples: EU, ASEAN.
8. Economic and Monetary Unions: Share a common currency and harmonize
macroeconomic policies. Example: European Union.

The General Agreement on Tariffs and Trade (GATT) initially governed international trade
in goods but became obsolete by the 1980s due to its limitations in addressing global trade
issues and its lack of coverage for services and intellectual property rights.

The Uruguay Round of negotiations, concluded in 1993, addressed these limitations and led
to the establishment of the World Trade Organization (WTO) in 1995. The WTO
encompasses the GATT and extends its scope to include trade in services, intellectual
property rights, and investment, marking a significant evolution in international trade
governance.

Overview of the World Trade Organization (WTO)

Introduction The World Trade Organization (WTO) is the primary global institution
overseeing international trade rules. It was established to facilitate smooth, predictable, and
fair trade among nations.

Objectives The WTO has six key objectives:

1. Rule Setting and Enforcement: Establish and enforce international trade rules.
2. Negotiation Forum: Provide a platform for trade liberalization discussions.
3. Dispute Resolution: Address and resolve trade disputes between members.
 4. Transparency: Enhance clarity in decision-making processes.
5. Global Cooperation: Collaborate with other international economic institutions.
6. Support for Developing Countries: Assist developing nations to fully benefit from
global trade.

Structure

• Secretariat: Based in Geneva, led by a Director General.

• Ministerial Conference: Highest decision-making body, meets biennially.
• General Council: Operates several times a year and oversees the Trade Policy
Review Body and Dispute Settlement Body.
• Specialized Councils: Oversee agreements in goods, services, and intellectual
property.
• Membership: Includes 164 members, with 117 being developing countries.

Guiding Principles

1. Non-Discrimination:
o Most-Favoured-Nation (MFN): Countries must extend equal trade
advantages to all WTO members.
o National Treatment: Foreign and local products/services must be treated
equally after market entry.
2. Trade Liberalization: Promotes gradual reduction of trade barriers.
3. Predictability: Ensures market stability through binding commitments.
4. Fair Competition: Aims for fair trading conditions and addresses unfair practices
like dumping.
5. Development Support: Provides flexibility and support for developing and least-
developed countries.

WTO Agreements

• Goods: Includes agreements on agriculture, sanitary measures, textiles, technical

barriers, and anti-dumping.
• Services: The General Agreement on Trade in Services (GATS) covers trade in
services and market access.
• Intellectual Property: The Agreement on Trade-Related Aspects of Intellectual
Property Rights (TRIPS) sets standards for IP protection.
• Plurilateral Agreements: Involves agreements signed by some members but not all.

The Doha Round Launched in 2001, the Doha Development Agenda aims to reform
international trade through lower barriers and revised rules, focusing on issues such as
agriculture and services.

G20 and Trade Facilitation The G20 economies have introduced both trade-restrictive and
trade-facilitating measures. While export restrictions remain, there have been efforts to
maintain open and predictable markets, particularly in response to crises like COVID-19 and
geopolitical tensions.
Conclusion The WTO plays a crucial role in managing global trade relations, promoting fair
competition, and supporting economic development, while continuously adapting to the
evolving global trade landscape.

UNIT :4 EXCHANGE RATE AND ITS ECONOMIC

EFFECTS
Exchange Rate Basics

• Exchange Rate Definition: The rate at which one currency can be exchanged for
another.
• Direct Quote (European Quotation): The domestic currency needed to buy one unit
of foreign currency (e.g., $1 = 60 INR).
• Indirect Quote (American Quotation): The foreign currency needed to buy one unit
of domestic currency (e.g., $0.0166 per INR).

Concepts

1. Base and Counter Currency:

o Direct Quote: Foreign currency is the base currency; domestic currency is the
counter currency.
o Indirect Quote: Domestic currency is the base currency; foreign currency is
the counter currency.
2. Cross Rate: Exchange rate derived from two different currency pairs involving a
common currency.
3. Selling Rate vs. Buying Rate: Selling rate is typically higher, reflecting the dealer's
margin.

Exchange Rate Regimes

1. Floating Exchange Rate: Determined by market forces of supply and demand.

2. Fixed Exchange Rate: Pegged by the central bank or government.
3. Managed Floating: A hybrid where the rate is mostly determined by market forces
but with some government intervention.

Exchange Rate Calculations

1. Nominal vs. Real Exchange Rate:

o Nominal Exchange Rate: Current exchange rate without adjustments for
inflation.
o Real Exchange Rate: Adjusted for price levels; reflects true purchasing
power.
2. NEER vs. REER:
o NEER (Nominal Effective Exchange Rate): Measures the value of a
currency against a basket of other currencies.
o REER (Real Effective Exchange Rate): Adjusted for inflation; indicates
competitiveness.
Foreign Exchange Market

• Spot Market: Immediate exchange of currencies.

• Forward Market: Contracts for future exchange of currencies.
• Vehicle Currency: USD is often used as a standard medium in foreign exchange
transactions.

Determination of Nominal Exchange Rate

• Determined by supply and demand factors including trade, investment, and financial
flows.
• Equilibrium Exchange Rate: Where supply and demand for foreign currency are
equal.

Exchange Rate Changes

• Depreciation vs. Devaluation:

o Depreciation: Market-driven decrease in currency value.
o Devaluation: Officially decreed reduction in currency value.
• Appreciation vs. Revaluation:
o Appreciation: Market-driven increase in currency value.
o Revaluation: Officially decreed increase in currency value.

Impacts of Exchange Rate Fluctuations

1. Economic Activity: Depreciation can boost exports and economic activity but may
increase import costs.
2. Inflation: Depreciation can lead to higher consumer prices.
3. Trade Balance: A depreciated currency can improve the current account balance.
4. Debt Burden: Depreciation increases the cost of repaying foreign-denominated debt.
5. Hedging Costs: Exchange rate fluctuations increase the need for financial hedging.

UNIT :5. INTERNATIONAL CAPITAL MOVEMENTS

Types of Foreign Capital

1. Foreign Aid/Assistance:
o Bilateral Aid: Direct government-to-government transfers.
o Multilateral Aid: Pooling of funds by multiple governments through
organizations like the World Bank.
o Tied Aid: Aid with conditions on its use versus Untied Aid: No conditions.
o Grants: Voluntary transfers by governments or organizations.
2. Borrowings:
o Direct Inter-Government Loans
o International Institutions Loans (e.g., IMF, World Bank)
 o Soft Loans: From institutions like IDA.
o External Commercial Borrowing
o Trade Credit Facilities
3. Deposits from Non-Resident Indians (NRI)
4. Investments:
o Foreign Portfolio Investment (FPI): Investments in financial assets like
stocks and bonds.
o Foreign Direct Investment (FDI): Investments in real assets like factories
and companies.

Foreign Direct Investment (FDI)

• Definition: Investments that reflect a lasting interest and control in a foreign

enterprise, usually involving more than 10% ownership.
• Components: Equity capital, reinvested earnings, and intra-company loans.
• Forms of FDI: Opening of subsidiaries, joint ventures, and acquisitions.

Types of FDI:

1. Horizontal Investment: Same business activity abroad as at home (e.g., a U.S. cell
phone company operating in India).
2. Vertical Investment: Investment in a different, but related activity (e.g., an auto
manufacturer investing in a parts supplier).
3. Conglomerate Investment: Investment in unrelated business activities (e.g., an
investor entering a new industry).

Two-Way Direct Foreign Investments: Reciprocal investments between countries, often

reflecting comparative advantages.

Foreign Portfolio Investment (FPI)

• Characteristics:
o Financial Capital: Investment in financial assets (stocks, bonds).
o Short-Term Nature: Often speculative and easily withdrawable.
o No Control: Investors do not manage or control the companies they invest in.
o Impact: Affects financial markets and exchange rates rather than production.

Comparison with FDI:

FDI FPI
Invests in physical assets Invests in financial assets
Long-term interest Short-term interest
Difficult to withdraw Easy to withdraw
Non-speculative Speculative
Accompanied by technology transfer No technology transfer
Direct impact on employment No direct impact on employment
Significant management influence No significant management influence
Reasons for Foreign Direct Investment (FDI)

• Higher Returns: Seeking better returns abroad.

• Market Expansion: Entering new markets with growth potential.
• Economies of Scale: Achieving cost savings through large-scale operations.
• Resource Access: Gaining access to raw materials or technology.
• Risk Diversification: Reducing exposure to economic fluctuations in the home
country.
• Strategic Motives: Avoiding competition, securing resources, or accessing new
technologies.

Host Country Determinants of FDI

• Economic Factors: Market size, growth, income levels.

• Policy Framework: Stability, regulatory environment, tax policies.
• Infrastructure: Quality of infrastructure and ease of doing business.
• Political Environment: Stability and openness to foreign investment.

Discouraging Factors:

• Poor infrastructure, high inflation, political instability, bureaucratic red tape,

corruption, and other barriers that make the investment climate less attractive.

This overview captures the essence of foreign capital movements, FDI, and FPI, including
their motives, impacts, and the factors influencing investment decisions. If you need any
more details or further clarification, feel free to ask!

Modes of Foreign Direct Investment:

1. Opening a Subsidiary or Associate Company: Establishing a new business entity in

a foreign country.
2. Equity Injection: Investing capital directly into an existing foreign company.
3. Acquisition of Controlling Interest: Purchasing a significant share to gain control
over a foreign company.
4. Mergers and Acquisitions (M&A): Combining with or acquiring foreign companies
to expand business operations.
5. Joint Ventures: Partnering with a foreign company to create a new, jointly owned
entity.
6. Greenfield Investment: Building new facilities from scratch in a foreign country.
7. Brownfield Investment: Utilizing existing infrastructure through mergers,
acquisitions, or leasing.

Benefits of FDI:

1. Increased Competition: Foreign enterprises enhance competition, leading to better

quality products and lower prices.
2. Enhanced Capital Flow: FDI brings in capital that can boost economic output and
development.
 3. Technological and Skill Transfer: Foreign firms introduce advanced technologies
and management practices.
4. Political and Structural Reforms: Competition for FDI encourages improvements in
legal and economic systems.
5. Employment Generation: Direct and indirect jobs are created, especially in
developing countries.
6. Higher Wages and Skills Development: FDI promotes better wages for skilled jobs
and overall skill enhancement.
7. Market Access: Foreign firms often open up new markets and strengthen bilateral
relations.
8. Export Promotion: Foreign firms can boost the host country's exports.
9. Increased Tax Revenue: Effective tax measures on FDI can contribute to
government revenue.
10. Economies of Scale: FDI can lead to lower production costs and consumer prices.

Potential Problems Associated with FDI:

1. Job Creation Issues: FDI may favor capital-intensive methods, limiting job creation
in labor-abundant countries.
2. Regional Disparities: FDI can exacerbate regional inequalities by concentrating
investments in well-endowed areas.
3. Crowding-Out Effect: Foreign investments might drive up local interest rates and
crowd out domestic investments.
4. Balance of Payments Instability: Increased imports and profit repatriation can strain
the host country's balance of payments.
5. Limited Skill Transfer: High-skilled jobs often remain in the home country, leaving
lower-skilled positions in the host country.
6. Market Distortion: Aggressive practices by foreign firms can distort local markets.
7. Environmental Concerns: FDI may lead to exploitation of natural resources and
environmental damage.
8. Dual Economy Formation: Large foreign investments can create a dual economy
with a developed foreign sector and an underdeveloped domestic sector.
9. Loss of Sovereignty: Excessive foreign control can impact a host country’s policy-
making and economic sovereignty.

FDI in India:

FDI has been a crucial driver of India’s economic growth, contributing to technological
advancement, job creation, and overall economic development. Recent policies have eased
FDI regulations, resulting in record inflows and significant investments in sectors like
technology, telecommunications, and automobile. Indian companies are also expanding their
global presence, investing abroad to gain access to new technologies and markets. Despite the
benefits, the challenges of balancing foreign influence and ensuring sustainable development
remain critical areas of focus.

In summary, while FDI offers numerous benefits such as capital inflow, job creation, and
technological advancement, it also presents challenges that need careful management to
maximize positive outcomes and mitigate potential drawbacks
 CHAPTER 10: INDIAN ECONOMY
I. Status of Indian economy: pre-independence period
(1850-1947)
II. Indian economy: post-independence (1947-1991
III. Economic reforms of 1991
IV. NITI Aayog: a bold step for transforming India
V. Overview of the Indian economy

Status of Indian Economy: Pre-Independence Period

(1850-1947)
Economic Overview (1st to 17th Century AD)
 • Prosperity and Self-Reliance: India was one of the largest economies in the ancient
and medieval world, controlling a significant portion of global wealth.
• Economic Structure: Comprised self-sufficient villages and commercial cities,
fostering diverse economic activities.
• Division of Labor: Based on race, class, and gender, which structured economic and
social differentiation.
• Agriculture: The dominant occupation, complemented by skilled artisans producing
high-quality manufactures, handicrafts, and textiles for the global market.

Ancient Economic Philosophy

• Arthashastra: A treatise by Kautilya (Chanakya) (321–296 BCE) emphasizing

statecraft, economic policy, and military strategy.
o Focus: Material well-being (artha), including wealth and land.
o Agriculture: Essential for state revenue and prosperity.
o Taxation: Fair and easily understood.
o Kingship: Prioritized the welfare of the subjects.

British Colonial Impact

East India Company Rule (1757-1858)

• Industrial Revolution: Britain’s need for raw materials and markets for finished
goods reversed India’s trade pattern.
• Tariff Policies: Discriminatory tariffs favored British imports over Indian exports,
harming Indian competitiveness.
• Destruction of Indian Handicrafts: Due to hostile policies and competition from
machine-made goods.
• Economic and Social Consequences:
1. Unemployment: Shift to agriculture due to lack of alternate employment.
2. Land Pressure: Subdivision and fragmentation of land holdings, reducing
agricultural productivity.
3. Consumer Preferences: Shift towards imported goods weakened domestic
industries.
4. Zamindari System: Created a class focused on perpetuating British rule.
5. Tenancy Issues: Excessive rents and absentee landlordism.
6. Agricultural Collapse: High indebtedness, exploitative money lenders, and
neglect of productivity measures.

British Government Rule (1858-1947)

• Industrial Development:
o Cotton Mills: Grew steadily, becoming internationally competitive by the
1930s.
o Jute Mills: Expanded around Calcutta, dominating the global market by the
late 19th century.
o Other Industries: Brewing, paper-milling, leather-making, matches, and rice-
milling also developed.
o Heavy Industries: Iron industry established by British capital, ranking eighth
in the world by 1930.
 o Global Standards: India ranked as the twelfth largest industrialized country
by the early 20th century.
• Limited Industrial Growth: Producer goods industries did not expand significantly
due to English producers' influence on policy to discourage competition.
• Economic Transformation: Insufficient industrial growth to transform the economic
structure. Manufacturing sector's share in net domestic product (NDP) was only 7% in
1946, with factory employment comprising 1.4% of the population by 1941.

Conclusion

The pre-independence Indian economy experienced significant transformation under British

rule, shifting from a prosperous, self-reliant economy with a strong manufacturing base to an
exporter of raw materials with a weakened industrial sector. This transition had profound
economic and social implications, setting the stage for the challenges faced by India post-
independence.

Indian Economy: Post-Independence (1947-1991)

Initial Conditions at Independence

• Rural and Poor Population: Predominantly rural, mostly illiterate, and exceedingly
poor population.
• Low Human Capital: Literacy rate at 18% and life expectancy at 32 years in 1951.
• Deep Stratification: Society characterized by extreme heterogeneity.

Nehruvian Model of Economic Policy

• Centralized Planning: Focused on social and economic redistribution and state-

directed industrialization.
• Planning Commission: Established to plan economic development through five-year
plans.

Industrialization Strategy

• Government's Role: Central government designed economic strategies and

investments, coordinating with the private sector.
• Industrial Policy Resolution (1948): Expanded public sector role and regulated
private sector licensing.
• State Monopoly: Strategic areas like atomic energy, arms, ammunition, and railways
reserved for the state.
• Dual Economic Philosophy:
1. Nehru's Vision: Socialistic society with emphasis on heavy industry.
2. Gandhian Philosophy: Small scale and cottage industries, and village
republics.

Policies and Challenges in the 1950s and 1960s

• Public Sector Expansion: Priority on public sector dampened private investment.

 • Balance of Payments Crisis (1958): Led to tightening of trade and investment
policies.
• Hindu Growth Rate: Average GDP growth rate of 3.5% from 1950-80.
• Agricultural Neglect: Initial focus on capital goods over agriculture led to inadequate
agricultural development.

Green Revolution

• Agricultural Crisis: Severe droughts in 1966 and 1967 led to negative growth in
agriculture and food shortages.
• Policy Shift: Focus shifted to increasing agricultural productivity through the Green
Revolution.
• Innovations: High-yielding seed varieties, intensive use of water, fertilizers, and
pesticides boosted food grain production.

Nationalization and Interventionist Policies

• Bank Nationalization: 14 banks nationalized in 1969, followed by 6 more in 1980.

• License-Raj: Extensive administrative controls on trade and industrial licensing.
• Economic Stagnation (1965-81): Decline in productivity and growth due to
interventionist policies, wars, droughts, and oil shocks.

Policies and Their Impact

• Equity vs. Growth: Policies aimed at income redistribution hampered wealth

creation.
• MRTP Act (1969): Restricted expansion of large firms, limiting growth in capital-
intensive sectors.
• Small Scale Sector Reservation (1967): Promoted small scale industries but
hindered competitiveness in labor-intensive industries.
• Stringent Labor Laws: Discouraged labor-intensive industries in the organized
sector.

Realization and Need for Change

• Counterproductive Regime: Realization that strict controls and regulations were

counterproductive.
• Need for Incentives and Openness: Recognition of the need for adequate incentives
and openness for sustained rapid growth.

Conclusion

The period from 1947 to 1991 saw India grappling with the challenges of building a self -
sustaining economy through centralized planning and state-directed industrialization. While
there were successes, particularly in heavy industry and agriculture (through the Green
Revolution), the overall economic growth was stifled by excessive regulation and lack of
incentives for private sector participation. The realization of these issues set the stage for
significant economic reforms in the early 1990s.

The Era of Reforms (1980s-1991)

Early Liberalization (1980s)

• Context: Early liberalization efforts began in the 1980s, especially after 1985, aiming
to restore price stability through tight monetary policy, fiscal moderation, and
structural reforms.
• Nature: Often termed as "reforms by stealth" due to their ad hoc and unpublicized
nature.
• Economic Impact: These reforms led to higher growth rates, with GDP growing at an
average annual rate of 5.7% during the Sixth Plan (1980-1985) and 5.8% during the
Seventh Plan (1985-1990).

Key Reforms

Industrial Reforms

• Delicensing: In 1985, 25 broad categories of industries were delicensed, later

extended to others.
• Broad-banding: Allowed firms flexibility in changing their product mix without
needing new licenses.
• MRTP Act Amendments: Raised the asset limit from ₹20 crore to ₹100 crore to
relax constraints on larger firms.

Taxation and Financial Reforms

• MODVAT Introduction: Converted multipoint excise duties into a modified value-

added tax, reducing input taxation and associated distortions.
• SEBI Establishment: Established as a non-statutory body in 1988 to regulate the
securities market.

Trade and Exchange Rate Management

• Open General License (OGL): Steadily expanded the OGL list, including 1,329
capital goods items by April 1990.
• Export Incentives: Introduced and expanded several export incentives.
• Exchange Rate Adjustments: Set the exchange rate at a realistic level, depreciating
the rupee by about 30% from 1985-1986 to 1989-1990.
• Price and Distribution Controls: Abolished controls on cement and aluminum.
• Tariff and Import Policies: Budget for 1986 introduced policies cutting taxes,
liberalizing imports, and reducing tariffs.

Structural Inadequacies and Growth Constraints

 • Licensing Policies: Convoluted licensing policies inhibited private sector
investments.
• Public Sector Reservations: Excessive government controls and bureaucratic
procedures plagued the public sector, leading to inefficiency and low returns on
investment.
• MRTP Act: Restrictive conditions under the MRTP Act created barriers for large
industrial houses.
• Import Controls: Tariffs, quotas, and quantitative restrictions protected domestic
industries from foreign competition, limiting growth.

Outcomes and Legacy

• Limited Scope of Reforms: Reforms in the 1980s were not comprehensive but laid
the groundwork for more extensive reforms in the 1990s.
• Change in Perception: Built confidence among politicians and policymakers about
the efficacy of policy changes in fostering sustained economic growth.
• Market-Oriented Approach: Fostered the belief that competitive markets can ensure
economic growth and increase welfare, shifting the focus from government
intervention to market-driven approaches.

Conclusion

The early reforms of the 1980s, though limited in scope and ad hoc in nature, were
instrumental in setting the stage for the more comprehensive economic reforms of the 1990s.
These initial efforts demonstrated the potential of policy changes to drive economic growth
and shifted the mindset towards a more market-oriented approach, paving the way for the
New Economic Policy of 1991.

.The Economic Reforms of 1991

Background and Causes for Reforms

In 1991, India initiated a series of bold economic reforms under the leadership of Prime
Minister Narasimha Rao. These reforms were driven by several critical factors:

1. Fiscal Imbalance: During the 1980s, government revenue expenditure consistently

exceeded revenue receipts, leading to large fiscal deficits financed by both domestic
and external debt.
2. Public Debt: Persistent deficits resulted in swelling public debt, with a significant
portion of government revenues allocated to interest payments.
3. Oil Price Shock: The Gulf War in 1990 led to a surge in oil prices, placing severe strain
on India's balance of payments.
4. Foreign Exchange Crisis: Foreign exchange reserves dwindled to a mere $1.2 billion,
enough to cover only two weeks of imports, precipitating the need for urgent economic
reforms.
5. Industrial Decline: Tightened import restrictions to conserve forex led to a reduction
in industrial output.
6. External Borrowing: Dependence on the International Monetary Fund (IMF) for
external borrowing came with stringent policy conditions.
 7. Political and Economic Crisis: A fragile political situation compounded by economic
crises led to a loss of confidence in the Indian economy.

Objectives of the Reforms

The 1991 reforms marked a significant shift from a centrally planned economy to a more
market-oriented one. The main objectives were:

1. Market Orientation: Transitioning from a centrally directed economy to a market-

friendly one.
2. Macroeconomic Stabilization: Achieving fiscal discipline by significantly reducing
the fiscal deficit.

Key Reform Measures

The reform package of 1991 comprised mutually supportive measures to address the balance
of payments crisis and structural rigidities. The measures can be broadly categorized into fiscal
reforms, monetary and financial sector reforms, capital market reforms, industrial policy
reforms, and trade policy reforms.

Fiscal Reforms

1. Stable and Transparent Tax Structure: Introduction of a more stable and transparent
tax system.
2. Better Tax Compliance: Ensuring better compliance with tax regulations.
3. Reducing Government Expenditure: Focus on curbing excessive government
spending.
4. Reduction and Elimination of Subsidies: Cutting down on unnecessary subsidies.
5. Disinvestment: Selling off government equity in select public sector undertakings.
6. Encouraging Private Sector Participation: Promoting greater involvement of the
private sector.

Monetary and Financial Sector Reforms

1. Interest Rate Liberalization: Deregulation of interest rates by the Reserve Bank of

India (RBI).
2. Banking Competition: Opening new private sector banks and fostering competition
among public, private, and foreign banks.
3. Reduction in Reserve Requirements: Lowering the statutory liquidity ratio (SLR) and
cash reserve ratio (CRR) as per the Narasimham Committee's recommendations.
4. Liberalization of Branch Licensing: Allowing banks greater freedom in branch
operations.
5. Prudential Norms: Implementing stricter accounting norms for asset classification,
income disclosure, and bad debt provisions.

Capital Market Reforms

1. Statutory Recognition of SEBI: Strengthening the Securities and Exchange Board of

India (SEBI) as an independent regulator to ensure a transparent capital market
environment.
Industrial Policy Reforms

1. End of License Raj: Removing licensing restrictions for most industries, except those
related to security, safety, and environmental concerns.
2. Public Sector Limitation: Restricting the public sector to strategic areas and
encouraging private sector participation.
3. MRTP Act Restructuring: Simplifying regulations related to mergers,
amalgamations, and takeovers.
4. Deregulation of Small-Scale Industries: Allowing large-scale industries to enter
previously reserved sectors.
5. Liberalization of Foreign Investment: Introducing automatic approval for foreign
direct investments (FDI) in most sectors.
6. Trade Liberalization: Shifting from a positive list approach to a negative list approach
for import licensing, reducing tariffs, and making the rupee convertible on the current
account.
7. Disinvestment: Selling government holdings in public sector enterprises to enhance
autonomy and efficiency.

Trade Policy Reforms

1. Removal of Quantitative Restrictions: Dismantling import and export restrictions.

2. Reduction and Simplification of Tariffs: Phased reduction of tariffs to encourage
outward orientation.
3. Export Incentives: Continuing and initiating new incentives to boost exports.
4. Exchange Rate Liberalization: Moving from a fixed exchange rate to a managed
floating system, allowing the rupee to float freely.

Impact of Reforms

The reforms of 1991 led to significant changes in the Indian economy:

• Global Integration: India increasingly integrated with the global economy.

• Market Orientation: Shift towards a market-oriented economy with reduced
government intervention.
• Private Sector Growth: Unprecedented growth in private sector investment and
initiatives.
• International Competitiveness: Sectors like auto components, telecommunications,
software, pharmaceuticals, biotechnology, and professional services achieved high
levels of international competitiveness.
• Access to Foreign Technology and Finance: Easing of trade controls facilitated
access to foreign technology, inputs, know-how, and finance.
• Stable FDI Inflows: Consistent foreign direct investment inflows and substantial
foreign portfolio investments.
• Foreign Exchange Reserves: India now holds one of the largest international reserves,
providing a cushion for imports.
• Service Sector Growth: Robust demand for IT and financial services, maintaining a
high services trade surplus.
• Economic Stability: Increased incomes, a large domestic market, and high aggregate
demand sustain the economy.
• Reduced Poverty: Significant reduction in poverty levels.
 • Enhanced Competition: Reforms led to increased competition in banking, insurance,
and other financial services, benefiting customers.
• Infrastructure Growth: Phenomenal growth in infrastructure sectors.
• Agriculture's Decline: A steady decline in the value-added share of agriculture and
allied activities.
• Financial Sector Deepening: Greater financial sector liberalization and depth.

Challenges

Despite the successes, India still faces challenges such as high fiscal deficits, inflation, and a
high level of debt, which was 86% of GDP in FY21/22, higher than the average for emerging
market and developing economies (EMDEs).

GDP Growth Rates Post 1991 Reforms

The table and graph below present India's GDP growth rates from 1991 to 2021, highlighting
the economic performance following the reforms:

Year GDP Growth (Annual %) Year GDP Growth (Annual %)

1991 1.056831 2006 8.060733
1992 5.482396 2007 7.660815
1993 4.750776 2008 3.086698
1994 6.658924 2009 7.861889
1995 7.574492 2010 8.497585
1996 7.549522 2011 5.241315
1997 4.049821 2012 5.456389
1998 6.184416 2013 6.386106
1999 8.845756 2014 7.410228
2000 3.840991 2015 7.996254
2001 4.823966 2016 8.256306
2002 3.803975 2017 6.795383
2003 7.860381 2018 6.453851
2004 7.922937 2019 3.737919
2005 7.923431 2020 -6.59608
2021 8.681229

Conclusion
In conclusion, the economic reforms of 1991 transformed India's economic landscape, paving
the way for sustained growth, increased global integration, and greater market orientation.
While challenges remain, the reforms have undeniably positioned India as a significant player
in the global economy.
NITI AAYOG: A BOLD STEP FOR TRANSFORMING INDIA
For nearly sixty-four years, the Planning Commission of India, a staunch advocate of public
investment-led development, was one of the most important institutions within India's central
government. The rise of neoliberal ideologies, which emphasized market orientation and a
reduced role of government, coupled with the collapse of the traditional planning system,
necessitated a change in governance institutions.

On January 1, 2015, the Planning Commission was replaced by the National Institution for
Transforming India (NITI) Aayog. This shift aimed to spur innovative thinking by engaging
objective experts and to promote cooperative federalism by enhancing the influence of the
states. NITI Aayog serves as a think tank for the government, functioning as a directional and
policy dynamo.

Objectives of NITI Aayog:

1. National Development Priorities: To evolve a shared vision of national development

priorities with active involvement from states.
2. Cooperative Federalism: To foster cooperative federalism through structured support
initiatives and mechanisms with the states.
3. Village-Level Planning: To develop mechanisms to formulate credible plans at the
village level and progressively aggregate these plans at higher levels of government.
4. National Security: To ensure that national security interests are incorporated in
economic strategy and policy.
5. Inclusive Growth: To pay special attention to sections of society at risk of not
benefiting adequately from economic progress.
6. Strategic Policy Frameworks: To design strategic and long-term policy frameworks
and monitor their progress and efficacy.
7. Stakeholder Partnerships: To provide advice and encourage partnerships between
stakeholders and think tanks, educational institutions, and policy research institutions.
8. Knowledge and Innovation: To create a support system for knowledge, innovation,
and entrepreneurship through a collaborative community of experts and partners.
9. Inter-sectoral Issues: To offer a platform for resolving inter-sectoral and inter-
departmental issues to accelerate the development agenda.
10. Resource Centre: To maintain a state-of-the-art resource centre and be a repository of
research on good governance and sustainable development.
11. Monitoring and Evaluation: To actively monitor and evaluate the implementation of
programs and initiatives, identifying needed resources to strengthen success and
delivery.
12. Technology and Capacity Building: To focus on technology upgradation and capacity
building for program implementation.
13. Further Activities: To undertake other necessary activities to further the national
development agenda.

Key Initiatives of NITI Aayog:

1. Life: Envisions replacing the prevalent 'use-and-dispose' economy.

2. National Data and Analytics Platform (NDAP): Facilitates and improves access to
Indian government data.
 3. Shoonya Campaign: Aims to improve air quality in India by accelerating the
deployment of electric vehicles.
4. E-Amrit: A one-stop destination for all information on electric vehicles.
5. India Policy Insights (IPI):
6. Methanol Economy Programme: Aimed at reducing India's oil import bill,
greenhouse gas emissions, and converting coal reserves and municipal solid waste into
methanol.
7. Transforming India’s Gold Market: Constituted to recommend measures for tapping
into the potential of the gold sector to stimulate exports and economic growth.

Criticisms of NITI Aayog:

Experts argue that NITI Aayog has a limited role as it does not produce national plans, control
expenditures, or review state plans. A significant shortcoming is its exclusion from the
budgeting process. It also lacks autonomy and balance of power within the central
government's policy-making apparatus. The termination of the Planning Commission has
strengthened the Ministry of Finance, which is fixated on near-term macroeconomic stability
and naturally inclined to limit expenditure. However, NITI Aayog lacks the independence and
power to act as a counterweight and a "voice of development" concerned with inequities

Overview of the Indian Economy

India's economy is diversified and comprises three main sectors: primary, secondary, and
tertiary.

Primary Sector

Historical Context and Current Status

Agriculture, along with its allied sectors, is the largest source of livelihood in India.
Historically, until the end of the 1960s, India was a food -deficient nation reliant on imports.
However, India has since emerged as the world’s largest producer of milk, pulses, jute, and
spices and has the largest area planted under wheat, rice, and cotton. It is also the second -largest
producer of fruits, vegetables, tea, farmed fish, cotton, sugarcane, and rice. The Indian food
and grocery market is the world's sixth largest, with retail contributing 70% of the sales.

Key Statistics and Contributions

• Employment: Approximately 47% of India’s population is directly dependent on

agriculture for their livelihood.
• Economic Contribution: The Gross Value Added (GVA) by agriculture and allied
sectors was 18.8% of the GDP in 2021-22.
• Production: Food grains production reached 315.7 million tonnes in 2021-22, and
private investment in agriculture increased to 9.3% in 2020-21.

Growth and Government Initiatives

The agricultural sector recorded a growth of 3.5% in 2022-23, driven by robust rabi sowing
and allied activities. The government has implemented various measures to support agriculture,
such as:

• Minimum Support Price (MSP): Fixed at 1.5 times the all-India weighted average
cost of production for all 23 mandated crops.
• Investment and Infrastructure: Promotion of crop diversification, improvement of
market infrastructure, and investment in agriculture through the Agriculture
Infrastructure Fund.
• Export Promotion: India is among the top ten exporters of agricultural products, with
significant increases in export value in recent years. The Agricultural and Processed
Food Export Development Authority (APEDA) oversees export promotion.

Major Initiatives and Policies

Several recent measures to support agriculture include:

• PM KISAN: Income support to farmers.

• Institutional Credit: Availability of credit at concessional rates.
• National Mission for Edible Oils: Aimed at increasing domestic production.
• Pradhan Mantri Fasal Bima Yojana (PMFBY): Crop insurance scheme.
• Mission for Integrated Development of Horticulture (MIDH): Focused on the
holistic growth of the horticulture sector.
• Soil Health Cards: Provided to farmers to promote sustainable farming practices.
• Paramparagat Krishi Vikas Yojana (PKVY): Supporting organic farming.
• Per Drop More Crop: Scheme to increase water use efficiency.
• Micro Irrigation Fund: Support for micro-irrigation projects.
• E-NAM: A national electronic trading portal for agricultural commodities.
• Kisan Rail: Improved logistics for farm produce.

Challenges Facing Indian Agriculture

Despite the growth and numerous initiatives, Indian agriculture faces several challenges:

1. Fragmented Landholdings: Predominantly small and medium-sized farms lead to low

productivity and marketable surplus.
2. Resource Intensity: Agriculture is cereal-centric and regionally biased, stressing water
resources and soil fertility.
3. Infrastructure Deficiencies: Inadequate agro-processing infrastructure and
competitive value chains.
4. Technological Adoption: Slow adoption of environmentally sustainable and climate-
resilient technologies.
5. Marketing and Credit: Ineffective marketing practices and credit delivery systems.
6. Climate Change: Complex adaptation challenges to climate disturbances.
7. Price Volatility: High volatility in food prices.
8. Monsoon Dependency: Heavy reliance on monsoons, leading to crop and livelihood
losses.
9. Export Potential: Inability to fully tap the export potential of both primary and value-
added products.
10. Post-Harvest Management: Inadequate infrastructure and management practices.
 11. Poverty and Malnutrition: Continued high incidence of poverty and malnutrition
among the agricultural population.

In summary, while Indian agriculture has made significant strides and continues to be a critical
sector, it faces multifaceted challenges that require continued and enhanced policy
interventions and technological advancements.

The Secondary Sector

Economic Significance and Structure

The industrial sector in India is crucial to the economy, contributing about 30% of the total
gross value added (GVA) and employing over 12.1 crore people. This sector includes a wide
range of industries such as manufacturing, heavy industries, fertilizers, pharmaceuticals,
chemicals and petrochemicals, oil and natural gas, food processing, mining, defense products,
textiles, retail, micro, small and medium enterprises (MSMEs), cottage industries, and tourism.
The informal sector accounts for more than 50% of the GVA.

Industrial Production and Growth

Manufacturing is the dominant component of the industrial sector, accounting for 78% of total
production. The manufacturing GVA at current prices was estimated at USD 77.47 billion in
Q3 of FY 2021-22, contributing around 16.3% to the nominal GVA over the past decade. The
combined index of eight core industries stood at 142.8 in 2022-23, driven by coal, refinery
products, fertilizers, steel, electricity, and cement. As of January 2023, the Manufacturing
Purchasing Managers’ Index (PMI) was 55.4. India's ranking in the Global Innovation Index
improved to 40th in 2022 from 81st in 2015.

Government Policies and Initiatives

The Department for Promotion of Industry and Internal Trade (DPIIT) plays a key role in
formulating and implementing industrial policy. The government has introduced several
policies to boost industrial performance, including:

• Goods and Services Tax (GST): Launched on July 1, 2017, as a single domestic
indirect tax law replacing various taxes like excise duty, VAT, and service tax.
• Corporate Tax Reduction: Domestic companies can opt to pay income tax at 22%,
provided they do not avail any exemptions/incentives.
• Make in India: Initiated in 2014 to foster investment, innovation, and infrastructure
development. "Make in India 2.0" focuses on 27 sectors.
• Ease of Doing Business: Simplifying procedures, digitizing government processes, and
decriminalizing minor defaults. India ranks 63rd in the World Bank’s Doing Business
Report 2020.
• National Single Window System: A one-stop shop for investor approvals and services.
• PM Gati Shakti National Master Plan: Facilitates data-based decisions for integrated
infrastructure planning.
• National Logistics Policy (NLP): Aims to lower logistics costs to match those of
developed countries.
 • Production Linked Incentive (PLI) Scheme: Enhances manufacturing capabilities
and export competitiveness across 14 key sectors.
• Industrial Corridor Development Programme: Develops greenfield industrial
regions with sustainable infrastructure.
• FAME-India Scheme: Promotes manufacturing of electric and hybrid vehicles.
• Udyami Bharat: Empowers MSMEs.
• PM Mega Integrated Textile Region and Apparel (PM MITRA): Attracts cutting-
edge technology and investment in textiles.
• Opening Up for Global Investments: Implemented transformative FDI reforms across
various sectors.
• Foreign Investment Facilitation Portal (FIFP): Simplifies the process for granting
FDI approvals.
• Remission of Duties and Taxes on Export Products (RoDTEP): Boosts exports by
providing rebates on unrefunded duties/taxes.
• Start-up India Programme: Facilitates innovation and entrepreneurship.
• Public Procurement Order, 2017: Prefers locally manufactured goods/services in
public procurement.
• Emergency Credit Line Guarantee Scheme (ECLGS): Provides guaranteed credit to
monitor lending institutions.

Foreign Direct Investment (FDI)

India remains an attractive destination for foreign investments in manufacturing. FDI equity
inflows have been rising, with total inflows of USD 58.77 billion in 2021-22.

Challenges Facing the Industrial Sector

Despite numerous policies and initiatives, the industrial sector faces several challenges:

• Infrastructure and Manpower: Shortages leading to reduced productivity.

• Import Reliance: Volatility in exchange rates and associated costs.
• MSME Credit: Limited availability of credit for MSMEs.
• Industrial Location: Unsustainable cost structures due to poorly planned locations.
• Public Sector Issues: Inefficiencies and low productivity in public sector industries.
• Labor Relations: Strained relations and loss of man-hours.
• Export Competitiveness: Lower competitiveness and external demand.
• Global Supply Chains: Disruptions and uncertainties.
• Economic Factors: Inflation, input cost escalations, and lower demand.
• Global Slowdown: Negative sentiments affecting investment.
• Monetary Policy: Increased credit costs due to aggressive tightening.
• Fuel Prices: High and rising costs.
• Informal Sector: Significant presence affecting formal sector growth.

Future Prospects

India is gearing up for the fourth industrial revolution (Industry 4.0) with initiatives to integrate
technologies like cloud computing, IoT, machine learning, and AI. The National
Manufacturing Policy aims to increase manufacturing's share in GDP to 25% by 2025.
In conclusion, while the secondary sector in India has shown robust growth and potential,
addressing the challenges and leveraging new technologies will be critical for sustained
industrial development.

The Tertiary Sector: India's Growth Engine

Overview and Economic Significance

The tertiary sector, or the services sector, has played a pivotal role in India's post -reform
economy, driving growth in income and employment. Unlike the typical development
trajectory where countries transition from agriculture to industry, India's growth has largely
skipped the secondary sector, moving directly from agriculture to services. This sector, which
produces intangible goods such as services, is now the largest in India, accounting for 53.89%
of the country's Gross Value Added (GVA). In 2020-21, the GVA for the services sector was
estimated at ₹96.54 lakh crore.

Growth and Productivity

The services sector is the fastest-growing sector in India and boasts the highest labor
productivity. Both domestic and global factors have fueled its growth, with knowledge-based
services like professional and technical services expanding rapidly. Information-intensive
activities such as computing, accounting, inventory management, quality control, personnel
administration, marketing, advertising, and legal services have seen significant growth due to
advanced information technology applications. Additionally, growth in the services sector can
complement and stimulate the manufacturing sector, as evidenced by the remarkable rise of
service-oriented startups in recent years.

Global Standing and Trade

India is among the top 10 World Trade Organization (WTO) members in service exports and
imports. In November 2022, India's services exports reached USD 27.0 billion, driven by
software, business, and travel services. Even during the Covid -19 pandemic, while other
sectors faced setbacks, India's services exports remained resilient due to the increased demand
for digital support and the need for digital infrastructure modernization.

Foreign Direct Investment (FDI)

The services sector is the largest recipient of FDI inflows in India, accounting for over 60% of
total FDI equity inflows. According to the World Investment Report 2022 by UNCTAD, India
was the seventh-largest recipient of FDI in 2021. In the fiscal year 2021-22, India received its
highest-ever FDI inflows, totaling USD 84.8 billion, with USD 7.1 billion in the services sector
alone.

Government Policies and Initiatives

To liberalize investment and boost the services sector, the Indian government has implemented
several measures, including:
 • 100% Foreign Participation: Allowed in telecommunication services through the
Automatic Route, covering all services and infrastructure providers.
• Insurance Sector: The FDI ceiling was raised from 49% to 74%.
• National Single-Window System: Launched to simplify and streamline the investment
approval process.
• Enhanced FDI Ceiling: Through the automatic route, facilitating easier and more
attractive investment opportunities.

Conclusion

India's tertiary sector has become the backbone of its economy, driving substantial growth and
attracting significant foreign investment. With continued government support and strategic
policies, the services sector is poised to maintain its robust growth trajectory, further cementing
India's position as a global leader in service exports and innovation.