CA Foundation

Part- 1
Paper-4: Business Economics

Section B: Micro Economics

Jatin Dembla
 Table Of Content

Chapter Name Pg No.

Chapter 1: Nature & Scope of Business Economics

Unit 1: Introduction 1
Unit 2: Basic Problems of an Economy & Role of Price Mechanism 3

Chapter 2: Theory of Demand and Supply

Unit 1: Law of Demand and Elasticity of Demand 5
Unit 2: Theory of Consumer Behaviour 9
Unit 3: Supply 12

Chapter 3: Theory of Production and Cost

Unit 1: Theory of Production 14
Unit 2: Theory of Cost 17

Chapter 4: Price Determination in Different Markets

Unit 1: Meaning and Types of Markets 20
Unit 2: Determination of Prices 22
Unit 3: Price Output Determination under Different Market Forms 23

Chapter 5: Business Cycles 26

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Chapter 1 Nature & Scope of Business Economics
Unit - 1: Introduction
Nature of Business Economics
Definition In Micro Economics we study about-
• Science is a systematized body of
Science knowledge which establishes cause and
▪ Business Economics may be defined as the use Product Pricing effect relationships.
of economic analysis to make business decisions
involving the best use of an organizations scare • Business Economics is based largely on
Consumer Behaviour Micro-Economics. A business manager is
resources. usually concerned about achievement of
Micro
the predetermined objectives of his
Meaning of Economics Factor Pricing Economics
organisation so as to ensure the long-
term survival and profitable functioning
▪ Economics is the study of processes by which
of the organisation.
the relatively scarce resources are allocated to Economic condition of a section of people
• A business unit is influenced by the
satisfy the competing unlimited wants of human
external economy environment, including
beings in a society. Behaviour of Firms Macro
price levels, income, employment, and
Analysis
government policies like taxation, interest
rates, and monopoly regulation.
Location of Industry
Human wants are
unlimited • as it involves practical application of rules
An economy exists Art and principles for the attainment of set
In Macro Economics we study about- objectives.
because of two facts

Resources are scarce National Income and National Output Use of

• largely uses the theory of markets and
Theory of
private enterprise. It uses the theory of
Markets and
the firm and resource allocation in the
The General Price Level and Interest Rates Private
backdrop of a private enterprise economy.
Subject -matter of Economics Enterprises

Balance of Trade and Balance of Payments • in its approach as it tackles practical

Micro Economics Macro Economics Pragmatic in
problems which the firms face in the real
Approach
world.
is the study of the is the study of External value of Currency
overall • it incorporates tools from other disciplines
behaviour of such as Mathematics, Operations
different individuals economic Interdisciplin
Research, Management Theory,
phenomena or the The overall Level of Savings and Investment ary
Accounting, marketing, Finance, Statistics
and organizations
within an economic economy as a whole. and Econometrics .
The Level of Employment and Rate of Economic • It suggests the application of economic
system. principles with regard to policy
Growth Normative
formulation, decision-making and future
planning.

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Scope Of Business Economics
Micro Economics applied to
Operational or Internal Issues.

• Business Economics makes use of

microeconomic analysis such as, demand
analysis and forecasting, production and
cost analysis, inventory management,
market structure and pricing policies,
resource allocation, theory of capital and
investment decisions, profit analysis and
risk and uncertainty analysis.

Macro Economics applied to

Environmental or External
Issues.

• Business Economics also considers

macroeconomics related to economic
systems, business cycles, national income,
employment, prices, saving and investment,
Government’s economic policies and
working of financial sector and capital
market.

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Chapter 1 Nature & Scope of Business Economics
Unit - 2: Basic Problems Of An Economy And Role Of Price Mechanism
Basic Problems Of An Economy Capitalist Economy Demerits

Every economic system, be it capitalist, socialist or Is an economic system in which all means of
►Economic inequalities lead to wide differences
mixed, has to deal with this central problem of production are owned and controlled by private in economic opportunities and perpetuate
scarcity of resources relative to the wants for them. individuals for profit. An economy is called unfairness in the society.
This is generally called ‘the central economic
capitalist or a free market economy or laissez- ►The capitalist system ignores human welfare
problem’. The central economic problem is further
faire economy. because, under a capitalist set up, the aim is
divided into four basic economic problems.
profit and not the welfare of the people.
Characteristics ► Less of merit goods like education and health
What to Produce ? care will be produced.
Right to Freedom of ►Due to unplanned production, economic
• Since the resources are limited, every society Freedom of
has to decide which goods and services should be
private
enterprise
economic instability in terms of over production, economic
property choice
produced and how many units of each good (or depression, unemployment etc., is very common
service) should be produced under capitalism. These result in a lot of human
Consumer
Profit motive
Sovereignty
Competition misery.
How to Produce ?
►There is enormous waste of productive
• It has to decide whether to use labour intensive resources as firms spend huge amounts of money
Absence of Government Interference
techniques or capital - intensive techniques. The on advertisement and sales promotion activities.
choice would depend on the availability of ► Excessive materialism as well as conspicuous
different factors of production and their Merits and unethical consumption lead to environmental
relative prices. degradation.
►There is usually high degree of operative
For whom to Produce ? Socialist Economy
efficiency under the capitalist system.

• How the goods (and services) should be ►Cost of production is minimized as every
The material means of production i.e. factories,
distributed among the members of the society producer tries to maximize his profit by employing capital, mines etc. are owned by the whole
methods of production which are cost-effective. community represented by the State. A socialist
What Provisions are to be made for Economic ►Capitalist system offers incentives for efficient economy is also called as “Command Economy” or
Growth?
economic decisions and their implementation. a “Centrally Planned Economy”.
• A society has to decide how much saving and ►Consumers are benefitted as competition forces
investment (i.e. how much sacrifice of current
consumption) should be made for future producers to bring in a large variety of good quality
progress. products at reasonable prices.

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Characteristics Merits

Absence of
Collective Economic
Consumer ►Economic freedom and existence of private property
Ownership planning
Choice
which ensures incentive to work and capital formation.
►Price mechanism and competition forces operating in
Minimum role
of Price Relatively the private sector promoting efficient decisions and
Absence of
Mechanism Equal Income better resource allocation.
Competition
or Market Distribution
forces ►Consumers are benefitted through consumers’
sovereignty and freedom of choice.
►Appropriate incentives for innovation and technological
Mixed Economy
progress.
System depends on both markets and ►Encourages enterprise and risk taking.
governments for allocation of resources. In fact, ►Advantages of economic planning and rapid economic
every economy in the real world makes use of development on the basis of plan priorities.
both markets and governments and therefore is ►Comparatively greater economic and social equality and
mixed economy in its nature.
freedom from exploitation due to greater state
participation and direction of economic activities.
Features Mixed Economy
►Disadvantages of cut-throat competition averted
through government’s legislative measures such as
Co-existence of private and public sector: The
first important feature of a mixed economy is environment and labour regulations.
the co-existence of both private and public
enterprise.

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Chapter 2 Theory of Demand and Supply
Unit - 1: Law Of Demand And Elasticity Of Demand
Meaning Of Demand Demand Function Demand Schedule
► Demand means desire or wish to buy and ► A demand schedule is a table that shows
It states the relationship between the demand for
consume a commodity or service backed by a product and its determinants. It may be various prices and the corresponding quantities
adequate ability to pay and willingness to pay. expressed as follows- demanded. The demand schedules are of two
types; individual demand schedule and market
Effective demand for a thing depends on
Dx = f (PX, M, PY, PC, T, A) demand schedule.
(i) desire • Dx is the quantity demanded of product X
• PX is the price of the commodity Demand Curve
(ii) means to purchase and
• M is the money income of the consumer ► The slope of a demand curve is - ∆P/∆Q (i.e
(iii) willingness to use those means for that • PY is the price of its substitutes
the change along the vertical axis divided by the
purchase • PC is the price of its complementary goods
• T is consumer tastes, and preferences change along the horizontal axis). The negative
Determinants of Demand • A is advertisement expenditure. sign of this slope is consistent with the law of
► Demand for a product depends on a number of demand.
Law Of Demand
determinants / variables. The study of relationship
►According to the law of demand, other things
between demand and its determinants is essential
being equal, if the price of a commodity falls, the Individual demand curve
for a business firm. It helps in estimating market
quantity demanded of it will rise and if the price of
demand for its product. a commodity rises, its quantity demanded will
decline. Thus, there is an inverse relationship
between price and quantity demanded, ceteris
Price of
Price of the
Related
Income of the paribus.
Commodity Consumer
Commodities
►Prof. Alfred Marshall defined the Law thus:
“The greater the amount to be sold, the smaller
must be the price at which it is offered in order
Taste and Consumer's
Other Factors that it may find purchasers or in other words the
Preferences Expectation
amount demanded increases with a fall in price and
diminishes with a rise in price”.

Market demand curve

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Rationale of the Law of Demand Exceptions to the Law of Demand Movement along the Demand Curve
Law of diminishing marginal utility
• According to Marshall, the consumer has
diminishing utility for each additional unit of a
commodity and therefore, he will be willing to
pay only less for each additional unit.
Conspicuous Speculative
• The operation of diminishing marginal utility Giffen goods
goods goods
and the act of the consumer to equalize the
utility of the commodity with its price result in
a downward sloping demand curve.
rightward shift (Inc. in demand)
Price effect
• The total fall in quantity demanded due to an • demand curve (when more is demanded at
Conspicuous Future expectations Demand for each price) can be caused by a rise in
increase in price is termed as Price effect. The necessities about prices necessaries income, a rise in the price of a substitute, a
law of demand can be dubbed as “Negative
fall in the price of a complement, a change in
Price Effect” with some exceptions. The law has been derived assuming consumers to be tastes in favour of this commodity, an
The substitution The income effect rational and knowledgeable about marketconditions. increase in population, and a redistribution
effect occurs when occurs when a of income to groups who favour this
commodity's price
a commodity's price
falls, increasing a
Movement along the Demand Curve commodity.
falls, causing
consumers to consumer's real
Income effect
Substitution effect

substitute it for income, leading to leftward shift (Dec. in demand)

more expensive increased demand
alternatives, for the commodity.
resulting in an • demand curve (when less is demanded at
increase in total each price) can be caused by a fall in income,
demand for the a fall in the price of a substitute, a rise in
commodity. the price of a complement, a change in
tastes against this commodity, a decrease in
population, and a redistribution of income
Arrival of new consumers away from groups who favour this
commodity.
• When the price of a commodity falls, more
consumers start buying it because some of those Contraction of Demand Expansion of Demand
Elasticity of Demand
who could not afford to buy it earlier may now • Other things being • When the price falls
be able to buy it. equal, when the price and the quantity ► Elasticity of demand is defined as the responsiveness
rises and as a response, demanded increases of the quantity demanded of a good to changes in one of
Different uses the quantity demanded it is an extension of
the variables on which demand depends. More precisely,
• Commodities with multiple uses experience a decreases, it is a demand or a
contraction of demand downward movement elasticity of demand is the percentage change in
downward slope in demand curve, with or an upward movement on the same demand quantity demanded divided by the percentage change in
decreased prices resulting in increased demand along the same demand curve. one of the variables on which demand depends.
for varied purposes and increased demand for curve.
limited uses.
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Price Elasticity of Demand Price Elasticity of Demand Total Revenue

►As demand curve slopes downwards to the right, the sign ► Total revenue (TR) = Price × Quantity sold
of price elasticity is negative. Except in the rare case of a good with perfectly
► Ep= % change in quantity demanded / % change in elastic or perfectly inelastic demand, when a
price.
seller raises the price of a good, there are two
∆𝒒 𝒑 ∆𝒒 𝒑
𝑬𝑷 = × =
𝒒 ∆𝒑 ∆𝒑 𝒒
× effects which act in opposite directions on
revenue.
►In point elasticity, we measure elasticity at a Price effect: After a price increase (decrease),
given point on a demand curve. When the price each unit sold sells at a higher (lower) price,
change is somewhat larger or when price elasticity which tends to raise (lower) the revenue.
is to be found between two prices or two points on Quantity effect: After a price increase
the demand curve, we use arc elasticity. (decrease), fewer (more) units are sold, which
tends to lower (increase) the revenue.
−𝒅𝒒 𝒑
Ep = ×
𝒅𝒑 𝒒

The Relationship between Price elasticity &

Arc-Elasticity
Total Revenue (TR)

Demand
Elastic Unitary Elastic Inelastic
Price TR Decreases TR remains same TR Increases
increase
e=0, Perfectly Quantity demanded does not change as Price TR Increases TR remains same TR
Inelastic price changes decrease Decreases
e<1, Inelastic Quantity demanded changes by a Determinants of Price Elasticity of Demand
smaller percentage than does price Position of a Nature of the
e=1, Unit Elastic Quantity demanded changes by exactly Availability of commodity in a need that a
►The arc elasticity will always lie somewhere (but substitutes consumer’s commodity
the same percentage as does price budget satisfies
not necessarily in the middle) between the point
e>1, Elastic Quantity demanded changes by a
larger percentage than does price elasticities calculated at the lower and the higher Number of uses
to which a Consumer
e=∞, Perfectly Purchasers are prepared to buy all they prices. commodity can
Time period
habits
𝑸𝟐 −𝑸𝟏 𝑷𝟐 +𝑷𝟏 be put
Elastic can obtain at some price and none at all Ep = ×
𝑸𝟐 +𝑸𝟏 𝑷𝟐 −𝑷𝟏
at an even slightly higher price

Tied demand Price range

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Income Elasticity of Demand Cross Elasticity of Demand
►Advertising elasticity of demand is typically
► Income elasticity of demand is the degree of ►The cross elasticity of demand is the positive. Higher the value of advertising elasticity
responsiveness of quantity demanded of a good to percentage change in the quantity demanded of greater will be the responsiveness of demand to
changes in the income of consumers. In symbolic commodity X as a result of a percentage change in change in advertisement.
form, percentage change in demand / percentage the price of some related commodity Y. ►Advertisement elasticity varies between zero
change in income. and infinity.
► For all normal goods, income elasticity is ►It is measured by % change in demand divided
positive, on the other hand, goods having negative by % change in spending on advertising.
income elasticity are known as inferior goods
► If the income elasticity for a good is greater Advertisement Elasticity
than one, such goods are called luxury goods. On
► Forecasting of demand is the art and science
the other hand, if the income elasticity is less than
Cross Elasticity between of predicting the product or a service at some
one, it is a necessity. Cross elasticity between two complementary goods
future date on the basis of certain past
△𝑸 𝒀 two substitute goods is is negative.
Ei = ×
△𝒀 𝑸 positive behaviour patterns of some related events and
the prevailing trends in the present.
The relationship between the two is described in the ∆𝐪𝐱 ∆𝐩𝐲
following three propositions: 𝐄𝐂 = ÷
𝐪𝐱 𝐩𝐲 Various methods for Demand Forecasting
∆𝐐𝐱 𝐩𝐲
𝐄𝐂 = ×
∆𝐩𝐲 𝐪𝐱 Survey of Collective
If the proportion of income spent on a good remains the
same as income increases, then income elasticity for the buyers' opinion
good is equal to one Advertisement Elasticity intentions method
►Advertisement elasticity of sales or promotional
If the proportion of income spent on a good increase as Expert
elasticity of demand is the responsiveness of a Barometric
income increases, then the income elasticity for the good is opinion
greater than one. good's demand to changes in firm's spending on method
method
advertising.
If the proportion of income spent on a good decrease as ►The advertising elasticity of demand measures the Controlled
Statistical
income rises, then income elasticity for the good is less percentage change in demand that occurs given a one experiment
than one. methods
percent change in advertising expenditure. s

►Advertising elasticity measures the effectiveness

of an advertisement campaign in bringing about new
sales.

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Chapter 7 Theory of Demand and Supply
Unit - 2: Theory Of Consumer Behavior
Meaning of Utility Law Of Diminishing Marginal Utility Law Of Diminishing Marginal Utility
►It refers to the want satisfying power of goods It states that as a consumer increases the ► Marshall defined the concept of consumer’s
and services. It is not absolute but relative. It is a consumption of a commodity, every successive unit
surplus as the “excess of the price which a
subjective concept and it depends upon the mental of the commodity gives lesser and lesser
consumer would be willing to pay rather than go
satisfaction to the consumer.
attitude of people. without a thing over that which he actually does
Marshall: “The additional benefit which a person pay”, is called consumer’s surplus.”
Two types of market failure namely; derives from a given increase in the stock of a
thing diminishes with every increase in the stock what a
the sum total of the additional utility that he already has.” consumer is
utilities derived derived from the
from the consumption of an ready to pay
The law states that the consumer is said to be at
consumption of all additional unit of the
the units of a commodity.
equilibrium, when the following condition is met: consumer’s
(MUX/PX) = (MUY/PY) surplus
Marginal Utility
Total Utility

commodity MU = TUn - TUn-1

consumed by a or
consumer at a given Or
(MUx / MUY) = (Px /PY) what he
time. MU = ∆TU /∆N
TU = σ MU actually pays
Assumptions of Marginal Utility Analysis

Limitations:
Relationship Between TU & MU The different units consumed should be identical in all
respects. The habit, taste, treatment and income of the Consumer’s surplus cannot be measured precisely -
Total utility rises as long as MU is positive, but at a diminishing
consumer also remain unchanged. because it is difficult to measure the marginal utilities
rate because MU is diminishing
of different units of a commodity consumed by a person.
Marginal utility diminishes throughout There should be no time gap or interval between the
consumption of one unit and another unit i.e. there should In the case of necessaries, the marginal utilities of the
be continuous consumption. earlier units are infinitely large. In such case the
When marginal utility is zero, total utility is maximum. It is a
consumer’s surplus is always infinite.
saturation point

The law may not apply to articles like gold, cash where a
When marginal utility is negative, total utility is diminishing The consumer’s surplus derived from a commodity is
greater quantity may increase the lust for it.
affected by the availability of substitutes.

MU is the rate of change of TU or the slope of TU

The shape of the utility curve may be affected by the
presence or absence of articles which are substitutes or There is no simple rule for deriving the utility scale of
MU can be positive, zero or negative. complements. articles which are used for their prestige value.

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Consumer’s surplus cannot be measured in terms of Indifference Map
money because the marginal utility of money changes as
purchases are made and the consumer’s stock of money
diminishes.

The concept can be accepted only if it is assumed that

utility can be measured in terms of money or otherwise.
Many modern economists believe that this cannot be
done.

Indifference Curve
►Is a curve which represents all those ►represents a collection of many indifference There are two reasons for this
combinations of two goods which give same curves where each curve represents a certain
satisfaction to the consumer. Since all the level of satisfaction. The want for a particular good is satiable so
combinations on an indifference curve give that when a consumer has more of it, his
Properties of indifference curve intensity of want for it decreases.
equal satisfaction to the consumer, the
consumer is indifferent among them.
Indifference curve slopes downwards to the Most goods are imperfect substitutes of one
right another. MRS would remain constant if they
could substitute one another perfectly
It is always convex to the origin
Budget Line/ Price Line
Two ICs never intersect each other
►Budget line or price line shows all those
combinations of two goods which the consumer
It will never touch the axes
can buy spending his given money income on the
Higher the indifference curve higher is the two goods at their given prices.
level of satisfaction.

Marginal Rate of Substitution

► The marginal rate of substitution of X for Y

𝑴𝑼𝑿
(MRSxy) is equal to
𝑴𝑼𝒀

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Consumer's Equilibrium

►A consumer is said to be in equilibrium when

he is deriving maximum possible satisfaction
from the goods and is in no position to
rearrange his purchase of goods.
The consumer attains equilibrium at the point
where the budget line is tangent to the
indifference curve and
MUx / Px =MUy /Py = MUz /Pz

Q is the point of equilibrium

where MRSXY =MUX / MUY

Assumptions:

The consumer has a given indifference map which shows his

scale of preferences for various combinations of two goods
X and Y.

He has a fixed money income which he has to spend wholly

on goods X and Y.

Prices of goods X and Y are given and are fixed.

All goods are homogeneous and divisible, and

The consumer acts ‘rationally’ and maximizes his satisfaction.

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Chapter 2 Theory of Demand and Supply
Unit - 3: Supply
Shift in Supply Curve
Definition
▪The amount of a good or service that the
producers are willing and able to offer to the
market at various prices during a given period of
time.

Determinants Of Supply
Price of the Prices of factors
good of production
It is an upward sloping curve showing a
▪When the supply curve bodily shifts towards the
Prices of positive relationship between price and
related goods
right as a result of a change in one of the factors
quantity supplied.
that influence the quantity supplied other than
State of Nature of competition Movements on the Supply Curve the commodity’s own price, we say there is an
technology and size of industry increase in supply.
When these factors cause the supply curve to
Governmen shift to the left, we call it decrease in supply
t Policy

Elasticity Of Supply
Law Of Supply
▪ The elasticity of supply is defined as the
▪It states that when the price of the good rises,
responsiveness of the quantity supplied of a good
the corresponding quantity supplied increases and
to a change in its price.
when the price reduces, the quantity supplied also When the quantity supplied of a good 𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐬𝐮𝐩𝐩𝐥𝐢𝐞𝐝
reduces. 𝐄𝐈 =
increase as a result of an increase in its 𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐏𝐫𝐢𝐜𝐞
▪There is a direct relationship between price and price then there is an upward movement on 𝐨𝐫
𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐬𝐮𝐩𝐩𝐥𝐢𝐞𝐝 ∆𝐪
quantity supplied. the supply curve. The reverse is the case 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐬𝐮𝐩𝐩𝐥𝐢𝐞𝐝 𝐪 ∆𝐪 𝐩
when there is a fall in the price of the good. 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐩𝐫𝐢𝐜𝐞 or ∆𝐩 = ∆𝐩 = 𝐪
𝐩𝐫𝐢𝐜𝐞 𝐩

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Type of Supply Elasticity
Measurement of supply-elasticity

The elasticity of supply can be considered with reference to a given point on the
supply curve or between two points on the supply curve. When elasticity is measured
at a given point on the supply curve, it is called point elasticity.
𝒅𝒒 𝒑
𝑬𝜹 ×
𝒅𝒑 𝒒

Equilibrium Price
Equilibrium price is one at which the wishes
of both the buyers and the sellers are
satisfied. At this price, the amount that
buyers want to buy and sellers want to sell
will be equal.
E is equilibrium point where quantity
demanded is equal to quantity supplied

e=0, Perfectly a change in price, the quantity supplied of a Market Equilibrium and Social Efficiency
inelastic supply good remains unchanged
e<1, Relatively less- a change in the price of a good its supply At equilibrium price, when the market is in
elastic supply changes less than proportionately, equilibrium, social efficiency is achieved
e=1, Unit-elastic the relative change in the quantity supplied is with maximum social surplus to both
exactly equal to the relative change in the producers and consumers enjoying
price maximum possible surplus.
e>1, Relatively The quantity supplied of a good change
greater-elastic supply substantially in response to a small change in
the price of the good
e=∞, Perfectly elastic nothing is supplied at a lower price, but a small
supply increase in price causes supply to rise from
zero

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Chapter 3 Theory Of Production And Cost
Unit - 1: Theory Of Production
Meaning of Production Labour Capital

Production is the outcome of the combined activity Labor refers to mental or physical exertion for Capital has been rightly defined as ‘produced
of the four factors of production viz, land, labour, producing goods or services, aiming to secure means of production’ or ‘man-made instruments
capital and organization. In simple terms production, income beyond pleasure directly derived from the of production’.
means ‘creation of utility’. i.e. Utility of form, utility work.
Stages of capital formation:
of place, utility of time and personal utility. Characteristics of labour:
1. Savings
Factors Of Production Land is a free gift of nature • Individual income significantly impacts
Land their ability to save, with higher incomes
Human Effort often leading to increased savings due to
In Economics, 'land' refers to all natural resources, decreased consumption propensity.
including soil fertility, water, air, light, and heat,
Labour is perishable
not just soil or earth's surface. 2. Mobilisation of savings
• Availability of appropriate financial
Characteristics of land: Labour is an active factor products and institutions is a necessary
precondition for mobilisation of savings.
Land is a free gift of nature
Labour is inseparable from the labourer
3. Investment
Supply of land is fixed
Labour power differs from labourer to labourer • Capital formation is achieved when real
savings are converted into real capital
Land is permanent and has indestructible powers assets, and an economy should have an
All labour may not be productive
entrepreneurial class willing to invest in
Land is a passive factor productive ventures.
Labour has poor bargaining power

Land is immobile
Labour is mobile

Land has multiple uses There is no rapid adjustment of supply of labour to

the demand for it
Land is heterogeneous
Choice between hours of labour and hours of
leisure
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Entrepreneur: Objectives of an enterprise Cobb-Douglas Production Function

An entrepreneur, also known as the organizer, Organic Economic Social Paul H. Douglas and C.W. Cobb of the U.S.A.
manager, or risk taker, is responsible for objectives objectives objectives studied the production function of the American
mobilizing and combining factors, initiating
manufacturing industries.
production processes, and bearing associated
Human objectives National objectives It stated as Q= KLa C(1-a)
risks.
where Q is output, L the quantity of labour, C
Functions of Entrepreneur Production Function quantity of capital, K and a are positive constants.

Initiating business enterprise ▪The production function is a statement of the Law of Variable Proportions
and resource co-ordination relationship between a firm's scarce resources (i.e.
its inputs) and the output that results from the use The law of variable proportion or the law of
• An entrepreneur initiates a business by
of these resources. diminishing returns is relevant when some factors
identifying opportunities, conceiving
project ideas, deciding on scale,
▪The production function can be algebraically are kept fixed and others are varied. It is
products, and processes, and then owns expressed in the form of an equation in which the
applicable to the short-run.
and manages the enterprise. output is the dependent variable and inputs are the
independent variables. Total product
Risk bearing or uncertainty ▪The equation is: • is the total output resulting from the
bearing Q = f (a, b, c, d ....... n) efforts of all the factors of production
• Entrepreneurs bear ultimate ▪Where 'Q' stands for the rate of output of given combined together at any time.
responsibility for business success and commodity and a, b, c, d ....... n, are the different
survival, as plans may not be realized due factors (inputs) and services used per unit of time. Average product
to the dynamic economy and daily
Short-Run Vs Long-Run Production Function • is the total product per unit of the
changes.
variable factor.
Short-Run 𝑻𝒐𝒕𝒂𝒍 𝑷𝒓𝒐𝒅𝒖𝒄𝒕
Innovations • AP=
𝑵𝒐.𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑭𝒂𝒄𝒕𝒐𝒓𝒔
•1. The short-run is a period of time in which at least one of the
• Schumpeter argues that entrepreneurs' inputs used remains unchanged during that period.
primary role is to introduce innovations, •2. In the short run, a firm cannot install a new capital Marginal product
equipment to increase production.
which include improved products,
processes, raw materials, technology, •3. The behaviour of production is the subject matter of the • is the change in total product per unit
law of variable proportion. change in the quantity of variable factor.
novel business models, and expansion into
Long-Run
unexplored markets. • 𝑴𝑷𝒏 = 𝑻𝑷 𝒏 − 𝑻𝑷 𝒏−𝟏 .
•1. The long run is a period of time in which all factors of
production are variable.
• 2. It is a time period when the firm will be able to install new
machines and capital equipments apart from increasing the
variable factors of production.
•3. The behaviour of production is the subject matter of the
law of returns to scale.
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Relationship between Average Product Returns to Scale Isoquants

and Marginal Product
▪It describes the relationship between inputs and It show various combinations of two factors
when average product rises as a result of an increase in output in the long run when all inputs are changed in which the firm can buy with given expenditure or
the quantity of variable input, marginal product is more the same proportion. outlay.
than the average product.
Figure shows various iso-cost lines representing
Constant It occurs when the inputs increase by some different combinations of factors with different
Returns to proportion and the output also increases by the
when average product is maximum, marginal product is Scale outlays. AB, CD and EF are Iso-cost lines.
same proportion. It is also called linear homogeneous
equal to average product. In other words, the marginal
production function
product curve cuts the average product curve at its
maximum. Increasing It occurs when the inputs increase by some
Returns to proportion and the output increases more than
Scale proportionately.

when average product falls, marginal product is less than

Decreasing It occurs when the inputs increase by some
the average product.
Returns to proportion and the output increases less than
Scale proportionately.

Isoquants
Least Cost Combination
▪Isoquants or product indifference curves show all
those combinations of different factors of For producing a given output, the tangency point of
production which give the same output to the the relevant isoquant (representing the output)
producer. with an iso-cost line represents the least cost
IQ is Isoquant curve. combination of factors.
C is the tangency point of the given isoquant with
an iso-cost line represents the least cost
the total product increases at an increasing rate upto
a point (in figure upto point F), marginal product also combination of factors for producing a given
Stage 1 rises and is maximum at the point corresponding to output.
the point of inflexion and average product goes on
rising.

•the total product continues to increase at a

diminishing rate until it reaches its maximum at point
Stage 2 H, where the second stage ends. In this stage, both
marginal product and average product of the variable
factor are diminishing but are positive

total product declines, MP is negative, average

product is diminishing. This stage is called the stage
Stage 3
of negative returns since the marginal product of the
variable factor is negative during this stage.

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Chapter 3 Theory Of Production And Cost
Unit - 2: Theory Of Cost
Cost Analysis Indirect costs Cost Function
► It refers to the study of behaviour of cost in • are those which cannot be easily and ► the mathematical relation between cost and
definitely identifiable in relation to a plant,
relation to one or more production criteria. It the various determinants of cost. It expresses
product, process or department. They not
concerned with the financial aspects of production. visibly traceable to any specific goods, the relationship between cost and output.
services, processes, departments or Economists are generally interested in two types
Types of Cost operations. of cost functions; the short run cost function
and the long run cost function.
Outlay costs and Opportunity costs Incremental cost

• Outlay costs involve actual expenditure • refers to the additional cost incurred by a Cost Function is divided into two-
of funds. firm as a result of a business decision.
Short-run cost Long-run cost
• Opportunity cost is concerned with the function function
cost of the next best alternative Sunk costs
Fixed or Long run cost of
opportunity which was foregone in order
• are already incurred once and for all, and constant costs production is
to pursue a certain action.
cannot be recovered. which are not a the least
function of possible cost of
Accounting costs
Historical cost output. These producing any
• explicit costs and includes all the are inescapable given level of
payments and charges made by the • refers to the cost incurred in the past on
or output when all
entrepreneur to the suppliers of various the acquisition of a productive asset.
uncontrollable. individual
productive factors. factors are
Replacement cost
variable.
Economic costs • is the money expenditure that has to be
• take into account explicit costs as well as incurred for replacing an old asset.
implicit costs. A firm has to cover its
economic cost if it wants to earn normal Private costs
profits.
• are costs actually incurred or provided for
by firms and are either explicit or implicit.
Direct costs

• are those which have direct relationship Social cost

with a component of operation. They are
readily identified and are traceable to a • refers to the total cost borne by the
particular product, operation or plant. society on account of a business activity
and includes private cost and external cost.

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Average Fixed cost

• AFC is obtained by dividing the total fixed

cost by the number of units of output
produced.
𝑻𝑭𝑪
• AFC=
𝑸

Average variable cost

Stair-step costs
Fixed Cost • is found out by dividing the total variable
• remain fixed over certain range of output; cost by the number of units of output
• Fixed or constant costs which are not a
but suddenly jump to a new higher level when produced.
function of output. These are inescapable or
output goes beyond a given limit.
uncontrollable. • AVC=
𝑻𝑽𝑪
𝑸

Average total cost

• is the sum of average fixed cost and average
variable cost.
𝑻𝑪
• ATC= or ATC = AFC + AVC
𝑸

Marginal cost
• is the addition made to the total cost by the
Variable costs production of an additional unit of output.
Total cost ∆𝑻𝑪
• MC= or MCn = TCn – TCn-1
• Variable costs are a function of output in • a business is defined as the actual cost that ∆𝑸
the production period. must be incurred for producing a given Relationship between Average Cost and
quantity of output. Marginal Cost

When average cost falls as a result of an

increase in output, marginal cost is less than
average cost.

When average cost rises as a result of an

increase in output, marginal cost is more than
Semi-variable costs average cost.

• are neither perfectly variable, nor

absolutely fixed in relation to the changes
When average cost is minimum, marginal cost
in the size of output.
is equal to the average cost.

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Kinds of Internal Economies and Diseconomies

Technical Managerial Commercial Financial Risk bearing

economies and economies and economies and economies and economies and
diseconomies diseconomies diseconomies diseconomies diseconomies

Kinds of External Economies and Diseconomies

Long run Average Cost Curve(LAC) Cheaper raw Technological

Development of Growth of ancillary
material and external
skilled Labour industries
• The long run average cost curve, often called capital equipments economies.
a planning curve, is so drawn as to be tangent
to each of the short run average cost
curves.
Better
• The LAC curve is tangent to each of the transportation and Economies of
short run average cost curves. Every point marketing Information.
on the long run average cost curve will be a facilities
tangency point with some short run AC curve

Economies of Scale and Diseconomies

of Scale

► When increase in scale is upto optimum level,

then it is economies of scale. On the other
hand, increase in scale beyond the optimum
level, results in diseconomies of scale.

►Economies of scale is of two types-

• Internal economies of scale which accrue to a
firm when it engages in large scale production.
• External economies of scale accrue to a firm
due to factors which are external to a firm.

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Chapter 4 Price Determination In Different Markets
Unit - 1: Meaning & Types of Markets
Meaning of Market On the basis of time On the basis of Regulation
►Market is the whole set of arrangements for
Very short period market: a period of time in Regulated Market: In this market, transactions
buying and selling of a commodity or service.
which supply is fixed and cannot be increased or are statutorily regulated so as to put an end to
The elements of a market are:
decreased. unfair practices. Eg. Stock exchange.
➢ Buyers and sellers;
➢ A product or service; Short-period Market: the supply of output may Unregulated Market: It is also called a free
➢ Bargaining for a price;
be increased by increasing the employment of market as there are no stipulations on the
➢ Knowledge about market conditions; and
variable factors with the given fixed factors and transactions.
➢ One price for a product or service at a given
time. state of technology.
On the basis of volume of Business
Long-period Market: all factors become variable
Classification of Market
and the supply of commodities may be changed by Wholesale Market: The wholesale market is the
On the basis of geographical area altering the scale of production. market where the commodities are bought and

Very long-period or secular period is one when sold in bulk or large quantities.
Local Markets: When buyers and sellers are
limited to a local area or region, the market is secular movements are recorded in certain Retail Market: When the commodities are sold
called a local market. factors over a period of time. in small quantities, it is called retail market.

Regional Markets: Regional markets cover a On the basis Nature of Transactions

wider area such as a few adjacent cities, parts of On the basis of competition
states, or cluster of states. Spot or cash Market: those markets where
Perfectly competitive market and
goods are exchanged for money payable either
National Markets: The trade policy of the
immediately or within a short span of time. Imperfectly competitive market.
government may restrict the trading of a
commodity to within the country. Forward or Future Market: transactions involve
contracts with a promise to pay and deliver goods
at some future date.

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Types of Market Total Revenue refers to the amount of money which a firm realizes by selling certain units of a commodity.

TR=P× Q
Perfect Competition
Average Revenue refers to the revenue earned per unit of output.
• Very large number of sellers. AR=TR/Q
• No product differentiation.
• Price elasticity of demand of a firm is infinite. Marginal Revenue refers to the change in total revenue resulting from the sale of an additional units of a
commodity.
• No degree of control over price.
MR=∆TR/∆Q

Monopolistic Competition

TR & Price Elasticity of Demand

• Large number of Sellers.

Relationship Between A R, MR,

• Slight product differentiation.
• Price elasticity of a firm is large. MR= 𝐴𝑅 ×
𝑒−1
, Where e = price elasticity of demand
𝑒
• Some degree of control over price. 1−1
Thus if e = 1, MR = 𝐴𝑅 × = 0.
1

Oligopoly and if e >1, MR will be positive

• Small numbers of sellers. and if e <1, MR will be negative

• Price elasticity of demand of a firm is small.
• Some degree of control over price.
• Product differentiation is none to substantial.

Monopoly

Behavioural principles
• Only single seller.
• Extreme product differentiation.
• Price elasticity of a firm is small.
The firm will maximize profits at the point at
• Degree of control over price is very
considerable. which marginal revenue is equal to marginal
cost

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Chapter 4 Price Determination in Different Markets
Unit - 2: Determination Of Prices

Equilibrium Price Changes In Demand & Supply Simultaneous Changes in Demand & Supply

Increase in demand,
causing an increase in
equilibrium price and
quantity

The supply and demand curves shift in the same direction

as follows:
It is the price at which the quantity demanded of Decrease in demand
▪When both demand and supply increase, the equilibrium
a commodity equals the quantity supplied of the resulting in a quantity increases but the change in equilibrium price is

commodity there is no unsold stock or no decrease in price and uncertain.

unsupplied demand. quantity demanded ▪When both demand and supply decrease, the equilibrium
quantity decreases but the change in equilibrium price is
uncertain.

Increase in supply,
resulting in decrease
in equilibrium price
and increase in
quantity supplied

The supply and demand curves shift in the opposite

Decrease in supply
directions as follows:
causing an increase in When demand increases and supply decreases, the
Stable Equilibrium
the equilibrium price equilibrium price rises but nothing certain can be said
A state where the quantity that firms sell is equal
and a fall in quantity about the change in equilibrium quantity.
to the quantity that the consumers desire to buy.
demanded When demand decreases and supply increases, the
equilibrium price falls but nothing certain can be said
about the change in equilibrium quantity.

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Chapter 4 Price Determination in Different Markets
Unit - 3: Price-Output Determination Under Different Market Forms
Perfect Competition Short run supply curve of the firm in a competitive ▪ Losses:
market A firm in equilibrium
✓ There are large number of buyers and sellers can minimize losses
who compete among themselves. while maintaining
output at MR = MC,
✓ All goods must sell at a single market price. meeting variable and
✓ Every firm is free to enter the market or to go fixed costs, and
out of it. attempting to continue
short-run production.
✓ There is perfect knowledge of the market
conditions on the part of buyers and sellers.
✓ Perfectly competitive markets have very low
▪ One interesting thing about the MC curve of a firm
transaction costs.
in a perfectly competitive industry is that it depicts
✓ All firms individually are price takers. the firm’s supply curve.
Marginal cost and supply curves for a price-taking
Price Determination
firm
Equilibrium of the
Industry Can a competitive firm earn profits? ✓ The output is produced at the minimum
An industry in economic
feasible cost.
terminology consists of
a large number of ▪ Supernormal Profits: ✓ Consumers pay the minimum possible price
independent firms. A firm's average revenue which just covers the marginal cost i.e. MC =
equals its average total cost, AR. (P = MC).
Equilibrium of the Firm indicating normal or zero ✓ Plants are used to full capacity in the long
The firm is said to be in economic profits. Supernormal
run, so that there is no wastage of resources
equilibrium when it profits occur when average
i.e. MC = AC.
maximizes its profit. revenues exceed total cost.
✓ Firms earn only normal profits i.e. AC = AR.
The output which gives
✓ Firms maximize profits (i.e. MC = MR), but
maximum profit to the ▪ Normal profits:
the level of profits will be just normal.
firm is called When a firm just meets its
average total cost, it earns ✓ There is optimum number of firms in the
equilibrium output.
normal profits. Here AR = ATC. industry.
✓ In other words, in the long run, LAR = LMR =
P = LMC = LAC and there will be optimum
allocation of resources.

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Monopoly ▪ AR and MR are both negatively by sloped (downward

sloping) curves.
The word ‘Monopoly’ means “alone to sell”.
▪The slope of the MR curve is twice that of the AR
Monopoly is a situation in which there is a single
curve. MR curve lies half-way between the AR curve
seller of a product which has no close
and the Y axis. i.e. it cuts the horizontal line between
substitute. Pure monopoly is never found in Y axis and AR into two equal parts.
practice.
▪AR cannot be zero, but MR can be zero or even
negative.
Features Conditions for the Equilibrium of an individual
firm:
Single seller of the product: In a monopoly Long run (i) MC = MR
market, there is only one firm producing or
equilibrium of (ii) MC curve must cut MR curve from below.
a monopolist
supplying a product.

Barriers to Entry: there are strong barriers to

entry. The barriers to entry could be economic,
institutional, legal or artificial.

No close-substitutes: A monopoly firm controls

market supply, sets prices, sells no substitutes, Short run equilibrium of a The long-term
Imperfect Competition-Monopolistic Competition firm under Monopolistic equilibrium of a firm in
and faces a steep downward demand curve. Competition – With losses monopolistic competition
Large number of sellers: In a monopolistically competitive
Market power: A monopoly firm has market market, there are large number of independent firms who Oligopoly
power i.e. it has the ability to charge a price individually have a small share in the market.
above marginal cost and earn a positive profit. Oligopoly is an important form of imperfect
Product differentiation: the products of different sellers
competition. Oligopoly is often described as
are differentiated on the basis of brands. Because competing
Relationship between AR and MR products are close substitutes, demand is relatively elastic, ‘competition among the few’. Prof. Stigler
but not perfectly elastic as in perfect competition. defines oligopoly as that “situation in which a
Freedom of entry and exit: Barriers to entry are firm bases its market policy, in part, on the
comparatively low and new firms are free to enter the expected behavior of a few close rivals”.
market if they find profit prospects and existing firms are
free to quit.

Non-price competition: firms are often in fierce competition

with other firms offering a similar product or service, and
therefore try to compete on bases other than price,

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Types of Oligopoly: Kinked Demand Curve

Pure oligopoly or perfect oligopoly occurs when

the product is homogeneous in nature.

Open and closed oligopoly: In an open oligopoly

market new firms can enter the market and
compete with the existing firms. But, in closed
oligopoly entry is restricted.

Collusive and Competitive oligopoly: When few

firms of the oligopoly market come to a common ▪ Paul A. Sweezy propounded the kinked demand curve
model of oligopoly. The price will be kept unchanged
understanding or act in collusion with each
for a long time due to fear of retaliation and price
other either in fixing price or output or both, it
tend to be sticky and inflexible.
is collusive oligopoly.
Other important market forms
Partial or full oligopoly: The dominating firm
will be the price leader. In full oligopoly, the ▪Duopoly, a subset of oligopoly, a market situation in which there
market will be conspicuous by the absence of are only two firms in the market.
price leadership.
▪Monopsony is a market characterized by a single buyer of a
Syndicated and organized oligopoly: product. Or service and is mostly applicable to factor markets in
Syndicated oligopoly refers to that situation which a single firm is the only buyer of a factor.

where the firms sell their products through a

▪Oligopsony is a market characterized by a small number of large
centralized syndicate. Organized oligopoly
buyers and is mostly relevant to factor markets.
refers to the situation where the firms
organize themselves ▪Bilateral monopoly is a market structure in which there is only a
single buyer and a single seller i.e. it is a combination of
monopoly market and a monopsony market.

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Chapter 5 Business Cycles

Meaning Of Business Cycles Trough and Depression Features Of Business Cycles

► These rhythmic fluctuations in aggregate
• Depression is the severe form of recession and is
economic activity that an economy experiences Business cycles occur periodically although they do not
characterized by extremely sluggish economic
exhibit the same regularity. The duration of these
over a period of time are called business cycles activities. Demand for products and services
cycles varies. The intensity of fluctuations also varies.
or trade cycles. decreases, prices are at their lowest and decline rapidly
forcing firms to shut down several production facilities.
Since companies are unable to sustain their work force,
Phases Of Business Cycle there is mounting unemployment which leaves the
Business cycles have distinct phases of expansion, peak,
consumers with very little disposable income.
contraction and trough. These phases seldom display
►The business cycles or the periodic booms and smoothness and regularity. The length of each phase is
slumps in economic activities reflect the upward also not definite.
Recovery
and downward movements in economic variables.
A typical business cycle has four distinct phases.
• The economy cannot continue to contract endlessly. It
These are: reaches the lowest level of economic activity called Business cycles generally originate in free market
trough and then starts recovering. economies. They are pervasive as well. Disturbances in
one or more sectors get easily transmitted to all other
Expansion (also called Boom or Upswing) sectors.

• state continues till there is full employment of The broken line (marked ‘trend’) represents the
resources and production is at its maximum steady growth line or the growth of the economy when
possible level using the available productive there are no business cycles Repercussions of business cycles get simultaneously felt
on nearly all economic variables viz. output, employment,
Peak investment, consumption, interest, trade and price
levels.
• The term peak refers to the top or the highest
point of the business cycle. This is the end of
expansion and it occurs when economic growth
has reached a point where it will stabilize for a
Business cycles have serious consequences on the well-
short time and then move in the reverse
being of the society
direction.

Contraction

• During contraction, there is fall in the levels of

investment and employment. The consequence is
a discrepancy or mismatch between demand and
supply. Supply far exceeds demand. Initially,
this happens only in few sectors and at a slow
pace, but rapidly spreads to all sectors

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Causes Of Business Cycles

Money Supply Relevance Of Business Cycles in
Internal Causes: The Internal causes or endogenous
factors which may lead to boom or bust are: Business Decision Making
• According to Hawtrey, trade cycle is a purely
monetary phenomenon. Unplanned changes in
supply of money may cause business
► Business cycles affect all aspects of an economy.
Fluctuations in Effective Demand fluctuation in an economy. Business cycles have tremendous influence on
business decisions. The stage of the business cycle is
• According to Keynes, fluctuations in economic crucial while making managerial decisions regarding
activities are due to fluctuations in aggregate Psychological factors expansion or down-sizing. However, it should be kept
effective demand (Effective demand refers to the
willingness and ability of consumers to purchase
in mind that business cycles do not affect all sectors
goods at different prices). • According to Pigou, modern business uniformly. Some businesses are more vulnerable to
activities are based on the anticipations of changes in the business cycle than others. Businesses
business community and are affected by
waves of optimism or pessimism. Business whose fortunes are closely linked to the rate of
Fluctuations in Investment fluctuations are the outcome of these economic growth are referred to as "cyclical"
psychological states of mind of businessmen. businesses.
• According to some economists, fluctuations in
investments are the prime cause of business cycles. External Causes: The External causes or exogenous
Investment spending is considered to be the most
volatile component of the aggregate demand. factors which may lead to boom or bust are:

Variations in government spending

Post War
Wars
Reconstruction
• Fluctuations in government spending with its impact
on aggregate economic activity result in business
fluctuations. Government spending, especially during
and after wars, has destabilizing effects on the
economy.

Technology
Natural Factors
shocks
Macroeconomic policies

• Macroeconomic policies (monetary and fiscal

policies) also cause business cycles. Expansionary
policies, such as increased government spending Population
and/or tax cuts, are the most common method of growth
boosting aggregate demand.

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 CA Foundation
Part- 2
Paper-4: Business Economics

Section B: Macro Economics

Jatin Dembla
 Table Of Content
Chapter Name Pg No.

Chapter 6: Determination of National Income

Unit 1: National Income Accounting 1
Unit 2: The Keynesian Theory of Determination of National Income 4

Chapter 7: Public Finance

Unit 1: Fiscal Functions: An Overview, Centre and State Finance 9
Unit 2: Market Failure/ Government intervention to correct Market Failure 11
Unit 3: The Process of Budget Making: Sources of Revenue, Expenditure Management and Management of Public Debt 15
Unit 4: Fiscal Policy 17

Chapter 8: Money Market

Unit 1: The Concept of Money Demand: Important Theories 20
Unit 2: The Concept of Money Supply 23
Unit 3: Monetary Policy 25

Chapter 9: International Trade

Unit 1: Theories of International Trade 27
Unit 2: The Instruments of Trade Policy 28
Unit 3: Trade Negotiations 30
Unit 4: Exchange Rate and Its Economic Effects 32
Unit 5: International Capital Movements 35

Chapter 10: Indian Economy 37

Kinshuk Institute
Chapter 6 Determination of National Income
Unit - 1: National Income Accounting
National Income Accounting
Usefulness and Significance of National Income Estimates

Defined as the net value of all economic National income is the sum total of Income distribution,
For analyzing and Knowing the
goods and services produced within the factor incomes generated by the economic forecasting
evaluating the composition and
domestic territory of a country in an normal residents of a country in the and for choosing
performance of an structure of the
economic policies and
accounting year plus the net factor form of wages, rent, interest and economy, national income,
evaluating them.
income from abroad. profit in an accounting year.

Usefulness and Significance of National Income Estimates

Gross Domestic Product Net Domestic Product Gross National Product (GNP)

Nominal The value of all final goods and services produced in the Equal to GDP minus depreciation. GNPMP = GDPMP + Factor income earned by the domestic
GDP or country within a given period. Total value of production minus the value of factors of production employed in the rest of the world -
GDPMP capital used up in producing that output. Factor income earned by the factors of production of the
Output of each of these is valued at its market price, and the
NDPMP = GDPMP - Depreciation rest of the world employed in the domestic territory.
values are added together to get GDPMP.
Distinction between 'gross' and 'net' is
Real GDP Nominal GDP increases over time for two reasons: The total income earned by a nation's permanent residents (called
depreciation or consumption of fixed capital.
1. The production of most of goods increases over time nationals).
Gross = Net + Depreciation or
2. The prices of most goods also increase over time.
Net = Gross – Depreciation GNPMP = GDPMP + Net Factor Income from Abroad
Real GDP is constructed as the sum of the quantities of final
GDPMP = GNPMP - Net Factor Income from Abroad (NFIA)
goods times constant (rather than current prices)
GDP Calculation of real GDP gives us a useful measure of inflation
Net Factor Income from Abroad is positive,
Deflator known as GDP deflator. Net National Product at Market NFIA=
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 Net compensation of then GNPMP would be greater than GDPMP.
=
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷
× 𝟏𝟎𝟎
Prices (NNPMP) employees + Net Distinction between ‘national’ and
The GDP deflator is a price index used to convert nominal GDP income from property
‘domestic’ is net factor income from
to real GDP. NNPMP = GNPMP - Depreciation and entrepreneurship
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 NNPMP = NDPMP + Net Factor Income from + Net retained abroad.
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 = × 𝟏𝟎𝟎
𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓
Abroad earnings National = Domestic + Net Factor
The deflator for the base year is always 100. NNPMP = GDPMP + Net Factor Income from Income from Abroad
The GDP deflator, the inflation rate between two consecutive Abroad - Depreciation
years can be compute using the following procedure:
𝑮𝑫𝑷 𝒅𝒆𝒇𝒍𝒂𝒕𝒐𝒓 𝒊𝒏 𝒚𝒆𝒂𝒓 𝟐 − 𝑮𝑫𝑷 𝒅𝒆𝒇𝒍𝒂𝒕𝒐𝒓 𝒊𝒏 𝒚𝒆𝒂𝒓 𝟏
= × 𝟏𝟎𝟎
𝑮𝑫𝑷 𝒅𝒆𝒇𝒍𝒂𝒕𝒐𝒓 𝒊𝒏 𝒚𝒆𝒂𝒓 𝟏

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Gross Domestic Product at Factor Cost Net Domestic Product at Factor Cost Net National Product at Factor Cost (NNPFC) or
(GDPFC) (NDPFC) National Income

= GDPMP - Indirect Taxes + Subsidies

It is sum of domestic factor incomes or domestic
OR NNPFC = National Income = FID (factor income earned in
income net of depreciation.
= Compensation of employees + Operating Surplus (rent + domestic territory) + NFIA.
NDPFC = NDPMP - Net Indirect Taxes OR
interest+ profit) + Mixed Income of Self-employed + If NFIA is positive, then national income will be greater than
= Compensation of employees
Depreciation domestic factor incomes.
+ Operating Surplus (rent + interest+ profit) +
Market Price = Factor Cost + Net Indirect Taxes OR
Mixed Income of Self-employed
= Factor Cost + Indirect Taxes - Subsidies
Factor Cost = Market Price - Net Indirect Taxes OR
= Market Price - Indirect Taxes + Subsidies
Disposable Personal Income (DI)

Per Capita Income Disposable Personal Income (DI) that is available for their consumption or savings DI = PI - Personal Income Taxes

GDP per capita is a measure of a country's economic output

per person. Net National Disposable Income Gross National Disposable Income Domestic Income may be categorized
Obtained by dividing the country's gross domestic product, (NNDI) (GNDI) into
adjusted by inflation, by the total population.
Net National Income + other net NNDI + CFC = GNI + other net Public sector= income from property and
current transfers from the rest of current transfers from the rest of entrepreneurship accruing to government
Personal Income the world (Receipts less payments) the world (Receipts less payments) administrative departments and savings of
non-departmental enterprises.
Personal income is a measure of the actual current income
receipt of persons from all sources.
NNI + net taxes on income and (Other Current Transfers refer to
PI = NI + income received but not earned - income wealth receivable from abroad + current transfers other than the Private sector= NDPFC - Income from
earned but not received net social contributions and primary incomes) property and entrepreneurship accruing to
benefits receivable from abroad. government administrative departments -
PI = NI - Undistributed profits - Net interest payments Savings of non-departmental enterprises.
made by households Corporate Tax +Transfer Payments
Price vs Market Price

to the households from firms & government.

Factor Cost vs Basic

The basic price is the

Relationship between Factor Relationship between Basic
Private Income subsidised price without tax.
Cost and Basic Price Price and Market Price
Basic price = factor cost +
• Factor cost + production • Basic Price + Product tax -
Factor income from net domestic product accruing to the Production taxes - tax - production subsidies = Product Subsidy = Market
private sector + Net factor income from abroad + Production subsidy Basic prices. Price.
National debt interest + Current transfers from
government + Other net transfers from the rest of the
world.

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The Circular Flow of Income Limitations and Challenges of National
Income Method
The continuous circulation of production, income Income Computation
generation and expenditure involving different
Whatever is produced by a producing unit is distributed (a) lack of an agreed definition of national income,
sectors of the economy. among the factors of production for their services.
There are three different interlinked phases: NNPFC or National Income= Compensation of employees +
Operating Surplus (rent + interest + profit) + Mixed (b) issue of transfer payments,
Disposition Consumption/
Investment
Income of Self-employed + Net Factor Income from
Abroad (c) services of durable goods,
(Note: Interest paid by the government on public debt,
interest on consumption loans and interest paid by one firm
to another are excluded. Profit =Corporate taxes+ dividend (d) valuation of a new good at constant prices, and
retained + earnings)
capital gains, windfall profits, transfer incomes and income
Production of goods Distribution as factor (e) valuation of government services
and services incomes (Rent, Wages, from sale of second-hand goods and financial assets and
Interest, Profit) payments out of past savings are not included.

Three methods of measuring National Income: Expenditure Method

Value Added Method or Product Method

Also called Income Disposal Approach, national income is the
aggregate final expenditure in an economy during an accounting year.
The sum total of net value added at factor cost across all producing units
GDPMP = ∑ 𝑭𝒊𝒏𝒂𝒍 Expenditure
of the economy. This method involves the following steps:
GDPMP = C+ GDFC + NX
Identifying the Estimating the gross value added GNPMP = GDPMP + NFIA
Step 1

Step 2

producing (GVAMP) by each producing

GNPFC = GNPMP -NIT
enterprises and enterprise
classifying them into NNPFC = GNPFC - Depreciation
= Value of output –
different sectors Intermediate consumption OR
according to the
nature of their = (Sales + change in stock) –
activities. Intermediate consumption

Estimation of National income.

Step 3

For each individual unit

Σ(GVAMP) - Depreciation = Net value added (NVAMP)
For the economy as a whole
Net value added (NVAMP) - Net Indirect taxes =
Net Domestic Product (NVAFC)
Net Domestic Product (NVAFC) + (NFIA) = National
Income (NNPFC)

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Chapter 6 Determination of National Income
Unit - 2: The Keynesian Theory of Determination of National Income
Important Note Aggregate Demand Function
The circular broken lines with arrows show factor
John Maynard Keynes in his masterpiece 'The General Theory AD = C + I
of Employment Interest and Money' published in 1936 put forth and product flows and present ‘real flows’ and the
AD = C + ̅𝑰
a comprehensive theory to explain the determination of continuous line with arrows show ‘money flows’
equilibrium aggregate income and output in an economy. C = Aggregate demand of consumer goods
which are generated by real flows.
I = Aggregate demand for investment goods
The equilibrium analysis is best understood with a hypothetical ̅𝑰= constant investment.
simple a two-sector economy which has only households and firms Real flows refer to Money flows refer to the
with all prices (including factor prices), supply of capital and
the flow of the actual payments for the services Consumption Function
technology constant; the total income produced Y, accrues to the
goods or services (wages) or consumption payments.
households and equals their disposable personal income. Consumption function expresses the functional
relationship between aggregate consumption
The equilibrium output occur when the desired amount of output expenditure and aggregate disposable income,
demanded by all the agents in the economy exactly equals the There are no injections into or leakages from the
amount produced in a given time period. system. expressed as: C = f (Y)
Factor Payments = Household Income = C = a + bY
Circular Flow in a Simple Two-Sector Model Household Expenditure = Total Receipts of C = Aggregate consumption expenditure
Firms = Value of Output. a = Constant term which denotes the value of
consumption at zero level of disposable income
b = Marginal propensity to consume [MPC =∆𝑪÷∆𝒀= b]
Two sector model assumption: Y = Total disposable income

(a) Only two sector in the economy viz household and firms Keynesian Consumption Function
(b) No government sector: No tax, No govt. expenditure, No
transfer payment The Keynesian assumption
is that consumption
(c) No foreign trade increases with an increase
(d) Factor price, product price, supply of capital and in disposable income. But
technology, all are constant increase in consumption will
be less than the increase in
In the two-sector economy, Aggregate Demand
(e) No retained earning disposable income i.e. 0 < b
(AD) or aggregate expenditure consists of only < 1. This fundamental
(f) No any injection into or leakage from the system
two components: aggregate demand for consumer relationship between
goods and aggregate demand for investment goods (e) High rate of unemployment income and consumption
plays a crucial role in the
/ being determined exogenously and constant in Keynesian theory of income
the short run. determination.

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Marginal Propensity to Consume (B) Consumption & Saving Function Two-Sector Model of National Income
The value of the increment to consumer Determination
Y1 income level, consumption is more than income.
expenditure per unit of increment to income.
Saving is negative. Y1 income level, consumption is
MPC =∆𝑪 / ∆𝒀
less than income and saving is positive. At Y1
∆C = Change in consumption
income level, consumption and income is equal and
∆ Y = Change in income
saving is zero.
The MPC is not necessarily constant for all
As level of income increase, Average propensity to
changes in income (in fact, the MPC tends to
consume decrease and Average propensity to
decline at higher income levels), most analysis of
saving increase.
consumption generally works with a constant MPC.

Average Propensity To Consume

The ratio of total consumption to total income.

APC =C/Y
The proportion of income spent on consumption
decreases as income increases.

Saving Function The equilibrium level of national income is a

situation in which aggregate demand (C+ I) is equal
National income Y = C + S which shows that
to aggregate supply (C + S) OR I = S.
disposable income is, by definition, consumption
plus saving. Therefore, S = Y – C.
If C+I > C+S
Marginal Propensity to Save • an increase in aggregate spending makes the
This increment to saving per unit increase in aggregate demand schedule shift upward.
disposable income (1 - b). • As a result, the equilibrium point would shift
∆S /∆ Y or 1-b upward causing an increase in the national
Aggregate Supply income.
Saving is an increasing function of the level of
income i.e. saving increase as income increases. If C+I < C+S
Ex-ante or planned aggregate supply is the total
supply of goods and services which firms in a • an decrease in aggregate spending makes the
Average Propensity to Save
national economy plan on selling during a specific aggregate demand schedule shift downward.
The ratio of total saving to total income is called time period. It is equal to the national income of • As a result, the equilibrium point would shift
average propensity to save (APS). the economy, which is either consumed or saved. downward causing an decrease in the national
𝐓𝐨𝐭𝐚𝐥 𝐒𝐚𝐯𝐢𝐧𝐠 𝐒
AS = C + S income.
APS = =
𝐓𝐨𝐭𝐚𝐥 𝐈𝐧𝐜𝐨𝐦𝐞 𝐘

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Equilibrium with Unemployment or Inflation Investment Multiplier MPC is one, investment multiplier is infinite
MPC is zero, investment multiplier is one
Aggregate expenditure line intersects the 45- Investment multiplier explains how many times
the aggregate income increases as a result of an MPC is low, investment multiplier is low
degree line at the level of potential GDP, then
there is full employment equilibrium. increase in investment. When the level of MPC is high, investment multiplier is high
investment increases by an amount says ∆I, the Circular Flow Three-Sector Model
equilibrium level of income will increase by some
multiple amounts, ∆Y. The ratio of ∆Y to ∆I is
called the investment multiplier, k.
k = ∆Y/∆I

Effect of Changes in Autonomous Investment

If the aggregate demand is for an amount of output

less than the full employment level of output, then we
say there is deficient demand. Deficient demand
gives rise to a ‘deflationary gap’ or ‘recessionary gap’

Y = C + I +G
The three-market circular flow model which accounts
for government intervention highlights the role played
by the government sector.
i) Taxes on households and business sector to fund
Multiplier expresses the relationship between an
government purchases
initial increment in investment and the resulting
ii) Transfer payments to household sector and subsidy
increase in aggregate income. As per investment
payments to the business sector
If the aggregate demand is for an amount of output greater multiplier, when there is an increase in
iii) Government purchases goods and services from
than the full employment level of output, then we say there investment, change in income is more than change
is excess demand. Excess demand gives rise to ‘inflationary business sector and factors of production from
in investment. It is due to marginal propensity to
gap’ which is the amount by which actual aggregate demand household sector, and
consume.
exceeds the level of aggregate demand required to establish iv) Government borrowing in financial markets to
Higher the marginal propensity to consume,
the full employment equilibrium. finance the deficits occurring when taxes fall short
• This is the sort of gap that tends to occur during a higher the investment multiplier and vice versa.
of government purchases
business-cycle expansion and sets in motion forces that will k = 1/1-MPC or 1/MPC
cause demand pull inflation.

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Three-Sector Model of National Government Sector and Income Determination Circular Flow Four-Sector Model
Income Determination
1. Income Determination with Lump Sum Tax
C = a + b Yd
Yd = Y –T (disposable income), T = lump sum tax
Y= a + b (Y - T) + I + G
Y = 1/1-b (a-bT+I+G)

2. Income Determination with tax as a function

of Income
Consumption function is C = a + b Yd
Yd= Y- T+ TR [T is a lump sum tax and TR is
autonomous transfer payments]
C = a+ b (Y - T + TR)
Y= C+ I+ G
Y= a+ b (Y - T + TR) + I + G
Y= a +bY – bT +bTR + I + G
Y – bY= a – bT +bTR + I + G
Y(1-b)= a – bT +bTR + I + G
𝟏
Y= (a – bT +bTR + I + G)
𝟏−𝒃
Aggregate demand function = C+I+G • The four-sector model includes all four
supply function = C + S + T 3. Income Determination with tax as a function macroeconomic sectors, the household sector, the
G= Government expenditure; T = Tax of Income business sector, the government sector, and the
Equilibrium is identified as the intersection Tax function: Tax function T = T̅+ t Y foreign sector and in equilibrium,
between the C+I+G line and the 45- degree line. T̅= autonomous constant tax; t = income tax rate Y = C + I + G + (X-M)
T = total tax
The equilibrium income is Y1. • The domestic economy trades goods with the
Consumption function: C = a + b Yd
If C+I+ G > C+S+T Where Yd = Y- T or Y -T̅ - t Y foreign sector through exports and imports.
• An increase in aggregate spending makes the C= a+ b(Y- T̅ - t Y)
aggregate demand schedule shift upward. • Imports are subtracted from exports to derive net
Equilibrium level Y= C + I+ G
• Result: The equilibrium point would shift upward exports, which is the foreign sector's contribution
Y=a+bYd+I+G; Y=a+b(Y-T̅-tY) +I+G
causing an increase in the national income. to aggregate expenditures. If net exports are
Y = a +bY - bT̅ - b t
If C+I+G< C+S+T positive (X > M), there is net injection and national
Y + I + G Y- bY + btY = a -bT̅+ I +G income increases. Conversely, if X<M, there is net
• An decrease in aggregate spending makes the
aggregate demand schedule shift downward. Y (1- b+ bt) = a -bT̅+ I +G; Y = 1/1-b(1-t) (a -bT̅+ I withdrawal and national income decreases.
• Result: The equilibrium point would shift downward +G)
causing an decrease in the national income. 1/1-b(1-t) (represent the tax multiplier)

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Four-Sector Model of National Income Determination

net exports are positive (X > M)

• there is net injection and national income increases.

if X<M,
• there is net withdrawal and national income
decreases.

The autonomous expenditure multiplier in a four-

sector model includes the effects of foreign
𝟏 𝟏
transactions and is stated as against in a
𝟏−(𝒃+𝒎) (𝟏−𝒃)
closed economy.

The greater the value of y, the lower will be the

autonomous expenditure multiplier.

An increase in the demand for exports of a country is

an increase in aggregate demand for domestically
produced output and will increase equilibrium income
just as would an increase in government spending or an
autonomous increase in investment.

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Chapter 7 Public Finance
Unit - 1: Fiscal Functions: An Overview, Centre & State Finance
Public Finance Allocation Function Redistribution Function
►Since the 1930s, the traditional functions of the 1. Meaning of Resource Allocation The distribution function aims at redistribution of
state have been supplemented with the economic Resource allocation is the allocation of available income so as to ensure equity and fairness to
functions (also called the fiscal functions or the resources in an economy, determining the promote the wellbeing of all sections of people and
public finance function) production of goods and services, as resources are
is achieved through taxation public expenditure,
limited and have multiple uses.
regulation and preferential treatment of target
►Richard Musgrave (1959) introduced the three-
populations.
branch taxonomy of the role of government in a
2. Reason of Resource Allocation
market economy namely, resource allocation,
Allocation of resources is based on demand and
income redistribution and macroeconomic The distribution function of the government aims at:
supply in market. In the absence of govt.
stabilisation. intervention, market failure may occur. It means
resources are misallocated by too much production redistribution of income to achieve an equitable
distribution of societal output among
Role of Government in an Economic of certain goods and too little production of certain
other goods. The main purpose of allocation
System households ensuring increased overall social
function is maximizing social welfare.
welfare
The allocation and distribution function are
microeconomic function and stabilization is
advancing the well-being of those members of the
macroeconomic function. The allocation function Market failures which hinder efficient allocation society who suffer from deprivations of different
of resources occur mainly due to the following types
aims to correct the sources of inefficiency in the
reasons:
economic system while the distribution role
ensures that the distribution of wealth and income (a) Imperfect competition and presence of monopoly in the
providing equality of income, wealth and
market which reduce welfare of consumers
is fair. opportunities
(b) Failure of market to provide collective goods which is
Monetary and fiscal policy, the problems of consumed commonly by all the people.
providing security (in terms of fulfillment of basic
macroeconomic stability, maintenance of high (c) Externalities exist needs) for people who have hardships, and ensuring
levels of employment and price stability etc fall (d) Factor immobility which causes unemployment and that everyone enjoys a minimum standard of living
under the stabilization function. inefficiency

(e) Imperfect information

(f) Inequalities in the distribution of income and wealth.

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Stabilization Function Fiscal policy

♦ One of the key functions of fiscal policy and
Government expenditure policy and taxation policy
aims at eliminating macroeconomic fluctuations
to affect economic activities like production,
arising from suboptimal allocation.
investment, saving, inflation, income, demand etc.
♦ Concerned with the performance of the Expansionary fiscal policy is adopted to end
aggregate economy in terms of labour recession and contractionary fiscal policy is
employment and capital utilization, overall output resorted to for controlling inflation.
and income, general price levels, economic
growth and balance of international payments.
Centre and State Finance
♦Fiscal federalism deals with the division of
♦ Government’s stabilization intervention may be
governmental functions and financial relations
through monetary policy as well as fiscal policy.
among the different levels of government.
Monetary policy has a singular objective of
controlling the size of money supply and interest ♦The central government should be responsible for
rate in the economy, while fiscal policy aims at the economic stabilization and income
changing aggregate demand by suitable changes redistribution, but the allocation of resources
in government spending and taxes. should be the responsibility of state and local
governments.
The stabilization function is concerned with the
performance of the aggregate economy in terms of:
♦Articles 268 to 281 of the constitution contain
specific provisions in respect of distribution of
Labour employment and capital utilization
finances among states.

Overall output and income

General price level

Balance of international payments

The rate of economic growth

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Chapter 7 Public Finance
Unit - 2: Market Failure
the money cost of Social cost are private
Public Finance 2. Externalities production incurred cost borne by
by the firm individuals directly
►"Market failure" refers to a market that is not Externalities, also referred to as 'spillover involved in a transaction
functioning properly, but rather, it does not wages, raw materials, together with the
effects', 'neighbourhood effects' 'third-party heating and lighting external cost borne by
function as it should. effects' or 'side-effects', occur when the actions the third parties not
supply curve here directly involved in the
►Market failure occurs when the free market of either consumers or producers result in costs or corresponds to only transaction.

Private cost

Social costs
benefits that do not reflect as part of the market the private marginal
leads to misallocation of resources, resulting in costs. Social Cost = Private
over or underproduction of goods and services, therefore are external to the market. Cost + External Cost
leading to less-than-optimal outcomes.
External costs are not
Positive and Negative externalities
included in firms'
Two types of market failure namely; income statements or
• A negative externality initiated in consumers' decisions.
Negative production which imposes an external

Complete market failure Partial market failure

production
externalities
cost on others may be received by
another in consumption or in
3. Public Goods
occurs when the market occurs when the market production.
fails to supply products functions but produces the Paul A. Samuelson who introduced the concept of
and services despite their wrong quantity or price, ‘collective consumption goods’ in his path breaking
high demand, resulting in leading to economic • A positive production externality 1954 paper ‘The Pure Theory of Public
"missing markets." welfare loss. Positive initiated in production that confers Expenditure’
production external benefits on others may be
externalities received in production or in
consumption. Public goods do not conform to the settings of
Reasons of Market Failure market exchange and left to the market, they will
1. Market Power • Negative consumption externalities not be produced at all or will be underproduced.
initiated in consumption which produce Negative
external costs on others may be consumption
This is because the price becomes zero.
"Market power or monopoly power is the ability of received in consumption or in externalities
a firm to profitably raise the market price of a production. Quasi-Public Goods
good or service over its marginal cost. Firms that The quasi-public goods or services, also called a
have market power are price makers and • A positive consumption externality near public good (for e.g. education, health
initiated in consumption that confers Positive
therefore, can charge a price that gives them external benefits on others may be consumption services) possess nearly all of the qualities of the
positive economic profits. received in consumption or in externalities private goods and some of the benefits of public
production.
good.

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Classification of Public Goods 4. Incomplete Information Government Interventions to

Minimise Market Failure
Excludable Non-excludable Complete information is an important element of
Rivalrous Private goods: Common resources: competitive market. Perfect information implies ►Because of the social costs imposed by
-Less likely to -A special class of that both buyers and sellers have complete monopoly, governments intervene by establishing
have the free impure public goods. information about anything that may influence rules and regulations designed to promote
rider problem. -Generally available
their decision making. competition and prohibit actions that are likely to
free of charge.
-Additional restrain competition.
-Price mechanism
resource costs are
does not apply. Asymmetric Information ►Example: Competition Act, 2002 (as amended
involved for
-Overuse of them by the Competition (Amendment) Act, 2007).
providing to cause their depletion Asymmetric information occurs when there is an
another individual. and degradation. imbalance in information between the buyer and the ►Natural monopolies can produce the entire
-Example:Food, -Example:Fish seller i.e., when the buyer knows more than the output of the market at a cost that is lower than
clothing, cars etc. stocks, forest seller, or the seller knows more than the buyer. This what it would be if there were several firms.
resources, coal etc. can distort choices. Examples of such natural monopoly are
Non- Club goods: Pure public goods:
rivalrous - Are some goods -No direct payment electricity, gas and water supplies
• Adverse selection generally refers to any
situation in which one party to a contract
which is neither by the consumer. or negotiation, such as a seller, possesses Government Interventions to
pure private goods -The good is information relevant to the contract or
Adverse
Correct Externalities
nor pure public provided, one negotiation that the corresponding party,
goods. individual cannot Selection such as a buyer, does not have; this
asymmetric information leads the party ►One method of ensuring internalization of
-Also called deny other lacking relevant knowledge to make negative externalities is imposing pollution taxes.
impure individuals’ suboptimal decisions and suffer adverse
effects.
Pigouvian taxes by 'making the polluter pay', seek
public goods. consumption.
-Example: National to internalize external costs into the price of a
-Example:
Cinemas, private defence product or activity.
• opportunism characterissed by an ►Pollution taxes are difficult to determine and
parks, satellite
Moral informed person's taking advantage of a
television etc. Hazard less-informed person through an administer due to difficulty to discover the right
unobserved action. level of taxation, problems associated with
inelastic nature of demand for the good and the
problem of possible capital flight.

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Subsidy is market-based policy and involves the

government paying part of the cost to the firms in
order to promote the production of goods having
positive externalities.
Two of the most common types of individual
subsidies are welfare payments and unemployment
benefits.

Government Intervention in the case

►When merit goods are directly provided free of
of Merit Goods
cost by government, there will be substantial
►The second approach Tradable emissions permits, Merit goods such as education, health care etc are demand for the same. If provided free at zero
also known as cap-and-trade, are marketable socially desirable and have substantial positive prices, the demand OD far exceeds supply.
externalities. Left to the market, merit goods are
licenses for polluters to emit limited quantities of likely to be underproduced and under-consumed so Government Intervention in the case
pollutants, allowing for different pollution levels that social welfare will not be maximized.
across regulated entities. of Demerit Goods
The possible government responses to under- Demerit goods are goods which impose significant
►Permit allocation aims for maximum emissions,
provision of merit goods are regulation, legislation, negative externalities on the society as a whole
creating a shortage and creating a positive price for subsidies, direct government provision and a and are believed to be socially undesirable.
pollution. High polluters pay more, while low combination of government provision and market
provision. The production and consumption of demerit goods
polluters profit from surplus permits.
are likely to be more than optimal under free
markets. The government should therefore
Effect of Subsidy on Output intervene in the marketplace to discourage their
production and consumption.

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Government Intervention in the Case Government Intervention for

of Public Goods Correcting Information Failure
►In the case of non-excludable pure public goods Makes it mandatory to have accurate labeling and
where entry fees cannot be charged, direct content disclosures by producers.
provision by governments through the use of Public dissemination of information.
general government tax revenues is the only option.

►A very commonly followed method in the case of Regulation of advertising and setting of advertising
standards.
excludable public good is to grant licenses to
private firms to build a facility and then the
Government Intervention for
government regulates the level of the entry fee Market Outcome of Price Ceiling
chargeable from the public.
Equitable Distribution
When prices of certain essential commodities rise
excessively government may resort to controls in ►Government failure occurs when intervention is
Price Intervention: Non-Market the form of price ceilings (also called maximum ineffective causing wastage of resources expended
Pricing price) for making a resource or commodity available for the intervention and/or when intervention
to all at reasonable prices.
Price controls may take the form of either a price produces fresh and more serious problems. This
floor (a minimum price buyers are required to pay) creates inefficiency and leads to a misallocation of
or a price ceiling (a maximum price sellers are
scare resources.
allowed to charge for a good or service).

With the objective of ensuring stability in prices

and distribution, governments often intervene in
grain markets through building and maintenance of
buffer stocks.

Market Outcome of Minimum Support Price

Government usually intervenes in many primary
markets which are subject to extreme as well as
unpredictable fluctuations in price

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Chapter 7 Public Finance
Unit - 3: The Process of Budget Making: Sources of Revenue,
Expenditure Management and Management of Public Debt
Budget Statement Sources of Revenue Public Expenditure Management
▪ A budget is a statement that presents the details Department of Revenue exercises control in respect ▪ Public expenditure management is the process
of ‘where the money comes from’ and ‘where the of matters relating to all the direct and indirect that allows governments to be fiscally responsible.
money goes to’. union taxes through two statutory boards: Public expenditure programmes or projects should
1. the Central Board of Direct Taxes (CBDT) and
be designed and implemented to provide given
▪The budget is prepared by the Ministry of Finance 2. the Central Board of Indirect Taxes and Customs
levels of outputs or achieve specific objectives at
in consultation with NITI Aayog and other relevant (CBIC).
minimum cost.
ministries. The budget must be presented and
Government receipts
approved by both houses of parliament before the Public Debt Management
beginning of the fiscal year (April 1 to March 31). Government debt from internal and external
Revenue receipts Capital receipts
sources contracted in the Consolidated Fund of
The Process of Budget Making India is defined as Public Debt.
Tax Revenue Non-Debt
▪ The budgetary procedures are - • Corporation tax; Taxes on • (a) Recoveries of loans and Public debt management refers to the task of
income; Wealth tax; advances determining, by the fiscal and monetary
(i) Preparation of the budget Customs duties; Union
• (b) Miscellaneous capital authorities, the size and composition of debt, the
(ii) Presentation and enactment of the budget and excise duties; Goods and
receipts (disinvestments and maturity pattern, interest rates, redemption of
services tax including GST
(iii) Execution of the budget. compensation cess; Taxes on
others) debt etc. It is the process of setting up and
union territories Debt implementing the strategy for managing public
▪ Annual Financial Statement shows the receipts • (a) Market loans for debt in order to raise the required amount of
• Centre’s net tax revenue
and expenditure of the government in three and the National Calamity different purposes funding at the desired risk and cost levels.
Contingent duty (NCCD) • (b) Short term /Treasury
separate parts: Institutions responsible for public debt management are:
transferred to the National bill borrowings
1. Consolidated Fund of India Calamity Contingency.
• (c) Securities issued against
Reserve Domestic marketable debt i.e., dated securities,
Bank of treasury bills and cash management bills
2. Contingency Fund of India, and the Non-Tax Revenues small savings,
India
3. Public Account. • Interest receipts, Dividends • (d) State provident fund
Ministry of external debt
and profits from public (Net)
Finance
sector enterprises and • (e) Net external debts (MOF)
surplus transfers from • (f) Other receipts (Net)
Reserve Bank of India; Ministry of Other liabilities such as small savings,
Finance; Budget deposits, reserve funds etc
Other Non-tax revenues
Division and
and Receipts of union Reserve Bank of
territories India

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Type of budgets Capital Receipts & Revenue Receipts Fiscal Deficit

-Those receipts that -Those receipts Total Receipts excluding borrowing = Revenue
Balanced budget lead to a reduction in which neither create Receipts + Capital Receipts excluding borrowing
the assets or an any liability nor cause or (Non debt creating capital receipts).
A budget in which revenues are equal to increase in the any reduction in the
Non debt creating capital receipts include
expenditures liabilities of the assets of the

Capital Receipts

Revenue Receipts
recoveries of loans advanced by the government
government government
Revenue does not fall short of expenditure. and sale proceeds of government assets, including
i.e., revenue is equal to expenditure -Recoveries of loans, -Two sources of those released from divestment of government
earnings from revenue receipts: tax equity in public sector undertakings (PSUs).
disinvestment and revenues and non-tax
(Revenue = Expenditure)
debt. revenues Primary Deficit
▪Primary deficit thus gives an estimate of
Unbalanced budget Revenue Expenditure & Capital Expenditure borrowings on account of current expenditure
exceeding current revenues. The goal of measuring
Revenue Capital
Surplus budget primary deficit is to focus on present fiscal
Expenditure Expenditure
imbalances.
when estimated govt receipts are Expenditure incurred Expenditures of the
more than the estimated govt for purposes other government which ▪Primary deficit = Fiscal deficit – Net Interest
expenditure it is termed as than creation of result in creation of liabilities
surplus budget. physical or financial physical or financial ▪Net interest liabilities interest payments minus
public revenue exceeds public assets of the central assets or reduction
interest receipts by the government on domestic
expenditure (R>E) government. in financial liabilities.
lending.
A government spends
more than it collects Outcome budget
Deficit budget by way of revenue, it
incurs a budget ▪ a direct link between budgetary allocations of
• when estimated govt receipts deficit. schemes and its annual performance targets
are less than the govnt Revenue Deficit measured through output and outcome indicators.
expenditure, it is termed as a
deficit budget.
The excess of government’s revenue expenditure over Guillotine
• public expenditure exceeds
revenue receipts.
public revenue (E>R) ▪ Parliament's limited time allows for limited
The shortfall of the government's current receipts over
expenditure demands examination. After
current expenditure.
discussion period, Lok Sabha speaker puts
Revenue deficit = Revenue expenditure – Revenue
outstanding grants demands to vote, known as
receipts
'Guillotine'.

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Chapter 7 Public Finance
Unit - 4: Fiscal Policy

Meaning Types Of Fiscal Policy Instruments of Fiscal Policy

•Fiscal policy involves the use of government 1. Government Expenditure
spending, taxation and borrowing to influence both
the pattern of economic activity and level of ►Public expenditures generate income through
growth of aggregate demand, output, and various government activities like capital
employment. expenditure on public works, relief expenditures,
•The significance of fiscal policy as a strategy for subsidy payments, transfer payments, and social
achieving certain socio-economic objectives was security benefits.
not recognised or widely acknowledged before ►Government Expenditure includes:
Expansionary fiscal policy is designed to stimulate the
1930 due to the faith in the limited role of
economy during the contractionary phase of a business current expenditures to meet the day to day
government advocated by the then prevailing cycle and is accomplished by increasing aggregate running of the government,
laissez- faire approach. expenditures and aggregate demand through an increase
in all types of government spending and/or a decrease in Capital expenditures refer to government
•Fiscal policy is in the nature of a demand-side
taxes. investments in capital equipment and infrastructure.
policy
An expansionary fiscal policy is used to address
recession and the problem of general unemployment on Transfer payments, government spending, do not
Objective of Fiscal Policy account of business cycles. contribute to GDP as they transfer income between
groups without direct contribution from receivers.
Maintenance of price stability

Pump priming
achievement and maintenance of full employment,

•Pump priming involves a one-shot injection of

acceleration of the rate of economic Contractionary fiscal policy is designed to restrain the government expenditure into a depressed economy
development, and levels of economic activity of the economy during an
with the aim of boosting business confidence and
inflationary phase by decreasing the aggregate
expenditures and aggregate demand through a decrease encouraging larger private investment. It is a
in all types of government spending and/ or an increase temporary fiscal stimulus in order to set off the
equitable distribution of income and wealth. in taxes.
multiplier process.
Discretionary fiscal policy involves the government's
deliberate actions to alter expenditure and taxes to
influence national output, employment, and prices.

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2. Taxes • Repayment of loan - Supply of money Fiscal Policy for Long Run Economic
recession & increase in market - Demand increase -
depression Production increase - Industrial growth Growth
►Tax is a fiscal policy tool that involves increase
•Fiscal policies supporting infrastructure
adjustments in government revenues or tax rates
spending, public goods like education,
to stimulate or limit private consumption and Inflation
• Borrowing - Supply of money decrease -
demand decrease - Price level decrease research, and development, and well-
investment expenditures.
designed tax policies that reward innovation
and entrepreneurship promote long-term
• Low corporate taxes boost business 4. Budget
profits and investment, with tax economic growth.
recession &
reduction or government spending
depression ►The budget is simply a statement of revenues earned
needed based on recessionary gap size
and multiplier magnitude. from taxes and other sources and expenditures made
by a nation’s government in a year.
• New taxes can be levied and the rates
of existing taxes are raised to reduce ►A government’s budget can either be balanced, Fiscal Policy for Reduction in
disposable incomes and to wipe off the surplus or deficit Inequalities of Income and Wealth
surplus purchasing power.
Inflation
• However, excessive taxation usually
decrease new investments and •Income tax differentiation. High tax on
Surplus budget Deficit budget Balanced budget
therefore the government has to be rich people and low tax on poor people
cautious about a policy of tax increase.
• the government • the government • When
collects more expenditure in a expenditures in •Indirect taxes differentiation. High tax on
3. Public Debt than what it year is greater a year equal its luxuries goods and low tax on goods which is
spends. It than the tax revenues for
When the market loan, the reduces demand revenue it that yea. No largely used by low-income group.
government borrows government issues and collects. It effect on
from its own people in treasury bills and increases
• control inflation. demand. •Government spending on welfare
the country, it is government demand, output,
It decreases
called internal debt. securities of varying employment and programme for poor people such as:
nation's debt.
denominations and
Market loan and Small saving

When the But it reduce industrial growth. (a) Poverty alleviation programmes
Internal and External debt

government borrows duration which are But it increase

indus
from outside sources, traded in debt nation's debt. (b) Infrastructure provision on a selective
markets.
the debt is called basis
external debt. The small savings
represent public
borrowings, which are
not negotiable and
are not bought and
sold in the debt
market e.g., NSC,
NDC etc.

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Fiscal Policy Limitations

♦ In respect of choice of appropriate policy
♦ Recognition lag
♦ Decision lag
♦ Implementation lag
♦ Impact lag
♦ inappropriate timing,
♦difficulties of forecasting due to uncertainties,
♦ possible conflicts between different objectives,
♦ possibility of generating disincentives,
♦ practical difficulty to reduce government expenditures and the possibility of
certain fiscal measures replacing private spending.

Fiscal Policy Limitations

♦ When spending of government increase during recession, sometimes it

decreases private spending which is known as Crowding Out.

♦An increase in the size of government spending during recessions will 'crowd-
out' private spending in an economy. In other words, when spending by
government in an economy replaces private spending, the latter is said to be
crowded out.

♦As a result of crowding out, the effectiveness of expansionary fiscal policy in

stimulating aggregate demand will be diminished to a great extent. This may
also possibly reduce the economy's prospects of long-run economic growth.

♦During deep recessions, crowding-out is less likely to happen as private sector

investment is already minimal and therefore there is only insignificant private
spending
to crowd out.

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Chapter 8 Money Market
Unit - 1: The concept of Money Demand: Important Theories
Meaning of Money Demand for Money The Cambridge approach
►Money refers to assets which are commonly used The demand for money is derived demand and is a ►In the early 1900s, Cambridge Economists
and accepted as a means of payment or as a medium decision about how much of one’s given stock of Alfred Marshall, A.C. Pigou, D.H. Robertson, and
wealth should be held in the form of money rather John Maynard Keynes (then associated with
of exchange or of transferring purchasing power.
than as other assets such as bonds.
Cambridge) put forward a fundamentally different
Fiat Money Classical Approach approach to quantity theory, known as cash balance

►Fiat money is used as a medium of exchange The Quantity Theory of Money (QTM) approach.

because the government has, by law, made them

♦ One of the oldest theories of Economics, was
“legal tender,” which means, they serve, by law, as
first propounded by Irving Fisher of Yale
means of payment. Money increases utility in the following two ways
University in his book ‘The Purchasing Power of
Money’ published in 1911.
Functions of Money • Enabling the possibility of split-up of sale and
♦ There is strong relationship between money and purchase to two diffeent points of time rather
Medium of Basis of
Exchange Credit price level and the quantity of money is the main than being simultaneous.
determinant of the price level or the value of • Being a hedge against uncertainty.
money.
Value of
MV = PT Md = k PY
Store
a unit or standard of
• M = the total amount of money in
deferred payment • Md = is the demand for money balances,
circulation (on an average) in an economy
• Y = real national income.
• V = transactions velocity of circulation
• P= average price level of currently
common measure of • P = average price level (P= MV/T)
produced goods and services
value • T = the total number of transactions.
• PY = nominal income
Characteristics of Money MV + M'V' = PT • k= = proportion of nominal income (PY) that
people want to hold as cash balances
Acceptable Relatively scarce, • Equation of Exachange to include demand
(bank) depostits (M') and Velocity in the
• Durable or long-lasting • Easily transported total supply of Money

Effortlessly recognizable. Possessing uniformity;

• Difficult to counterfeit • Divisible

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Keynesian Theory of Demand of Money Speculative motive Liquidity Liquidity trap is a situation where the
trap desire to hold bonds is very low and
►Keynes’ theory of demand for money is known as • The speculative motive reflects people's
approaches zero, and the demand to hold
‘Liquidity Preference Theory’. ‘Liquidity desire to hold cash in order to be equipped to
money in liquid form as an alternative
exploit any attractive investment opportunity
preference’, a term that was coined by John approaches infinity.
requiring cash expenditure.
Maynard Keynes in his masterpiece ‘The General People expect a rise in interest rate and
• The speculative demand for money and
Theory of Employment, Interest and Money’ interest are inversely related. the consequent fall in bond prices and the
(1936), denotes people’s desire to hold money resulting capital loss.
rather than securities or long-term interest-
bearing investments. The speculative demand becomes
perfectly elastic with respect to interest
rate and the speculative money demand
People hold money (M) in cash for three motives curve becomes parallel to the X axis.

Post-Keynesian Development in the

The transaction motive
Theory of Demand for Money
• The transactions motive for holding cash
relates to the need for cash for current ►Inventory Approach to Transation Balances
transactions for personal and business (Baumol)
exchange. The transaction demand for money Individual’s Speculative Demand for Money ►Baumol (1952) and Tobin (1956) developed a
is directly related to the level of income. It
can be calculated as follows: deterministic theory of transaction demand for
• Lr=kY 'real cash balance', known as Inventory Theoretic
• Lr = Transaction demand for money Approach, in which money is essentially viewed as
• k = ratio of earning which is kept for an inventory held for transaction purposes.
transaction purposes ►People hold an optimum combination of bonds and
• Y = earning cash balance, i.e., an amount that minimises the
opportunity cost.
The precautionary motive
►The optimal average money holding is: a positive
• Individuals as well as businesses keep a function of income Y, a positive function of the
portion of their income to finance
price level P, a positive function of transactions
unanticipated expenditures. It depends on the
size of income, prevailing economic as well as costs c, and a negative function of the nominal
political conditions and personal interest rate i.
Aggregate Speculative Demand for Money
characteristics of the individual etc.

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Friedman's Restatement of the

Quantity Theory
►Milton Friedman (1956) extending Keynes'
speculative money demand within the framework of
asset price theory holds that demand for money is
affected by the same factors as demand for any
other asset, namely, permanent income and relative
returns on assets.

►The nominal demand for money is positively

related to the price level, P; rises if bonds and
stock returns, r and r, respectively decline and vice
versa; is influenced by inflation; and is a function
of total wealth

Demand for Money as Behaviour

toward Risk
►The Demand for Money as Behaviour toward as
'aversion to risk' propounded by Tobin states that
money is a safe asset but an investor will be willing
to exercise a trade-off and sacrifice to some
extent the higher return from bonds for a
reduction in risk.

►According to Tobin, rational behaviour induces

individuals to hold an optimally structured wealth
portfolio which is comprised of both bonds and
money and the demand for money as a store of
wealth, depends negatively on the interest rate.

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Chapter 8 Money Market
Unit - 2: Concept of Money Supply
Meaning Measurement of Money Supply Money Multiplier Approach to
► Money supply means the stock of money. It ►The measures of money supply vary from country Supply of Money
refers to the stock of money available to the public to country, from time to time and from purpose to
► The money multiplier approach to money supply
as a means of payment and store of value. purpose.
propounded by Milton Friedman and Anna
► Public includes household, firms and institutions ► Measurement of money supply is essential as it
Schwartz, (1963) considers three factors as
enables a framework to evaluate whether the stock
except Government and the banking system. immediate determinants of money supply
of money in the economy is consistent with the
Demand deposit with bank is included in the a) the stock of high-powered money (H)
standards for price stability, to understand the
meaning of money supply. b) the ratio of deposit to reserve, e = {ER/D} and
nature of deviations from this standard and to
c) the ratio of deposit to currency, c ={C/D}
study the causes of money growth.
Rationale Of Measuring Money Supply ►In India, RBI has been publishing data on four 1. The behavior of the central bank
alternative measures of money supply denoted by
This tool aids in analyzing monetary developments
M1, M2, M3, M4 besides the reserve money. ►Central bank change money supply by two ways:
to gain a comprehensive understanding of the
factors driving money growth. ►M1= Currency and coins with the people + demand (1) Supply of high-powered money (2) Reserve ratio
deposits of banks (Current and Saving accounts) + ►The supply of nominal money in the economy will
other deposits with the RBI. directly vary with the supply of nominal high-
M2= M1 + savings deposits with post office savings powered money issued by the central bank if public
Supply of money is used for price stability. Supply banks. and commercial bank behaviour remains unchanged.
of money is compared with standard and if there M3= M1 + net time deposits with the banking
is deviation, it can be controlled. system. 2. The behavior of commercial bank
M4= M3 + total deposits with the Post Office
Savings Organization (excluding National Savings ►The additional units of high-powered money that
Sources of Money Supply Certificates). goes into ‘excess reserves’ of the commercial banks
do not lead to any additional loans and therefore,
The central banks of all countries are empowered to issue Concept of Money Multiplier these excess reserves do not lead to the creation
currency and therefore, the central bank is the primary
source of money supply in all countries. In effect, high of deposits.
M= m x MB
powered money is the source of all other forms of money. ►Higher excess reserve ratio› Low loan ›Low
• M= money supply, money supply
• m= money multiplier ►Lower excess reserve ratio › High loan › High
The supply responses of the commercial banking system
of the country to the changes in policy variables initiated • MB= monetary base or high-powered money. money supply
by the central bank to influence the total money supply in Money Supply ►Excess reserve ratio depends on: (a) Interest
the economy. In India, RBI is the Central Bank. Money Multiplier(m) =
Monetary Base rate (b) Expected deposit outflow

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3. The behavior of public Effect of Government Expenditure ►Reserve Money = Currency in circulation +

M = C+D H = C+ reserves on Money supply Bankers' deposits with the RBI + Other deposits
with the RBI
• C=currency ►When the Reserve Bank lends to the governments = Net RBI credit to the Government + RBI credit to
• D=deposits/demand deposits. under WMA /OD it results in the generation of the Commercial sector + RBI's Claims on banks +
excess reserves (i.e. excess balances of commercial RBI's net foreign assets + Government's Currency
►The public, banks and the central bank by three banks with the Reserve Bank). liabilities to the public - RBI's net non-monetary
variables namely, currency-deposit ratio c= C/D, Liabilities
reserve-ratio r= Reserves/D, and the stock of high- Credit Multiplier NM1 = Currency with the public + Demand deposits
powered money (H) with the banking system + 'Other' deposits with
►The Credit Multiplier also referred to as the
the RBI.
Money Supply M =
1+C
x H deposit multiplier or the deposit expansion
r+e+c
multiplier, describes the amount of additional money NM2= NM1 + Short-term time deposits of
• the currency ratio set by depositors c residents (Including and up to contractual maturity
created by commercial bank through the process of
which depends on the behaviour of the of one year).
public lending the available money it has in excess of the
• excess reserves ratio set by banks e, and central bank’s reserve requirements. NM3 = NM2 + Long-term time deposits of residents
• the required reserve ratio set by the ► Credit Multiplier= 1/Required Reserve Ratio + Call/Term funding from financial institutions
central bank r, which depends on
prescribed CRR and the balances necessary
New Monetary Aggregates Liquidity aggregates
to meet settlement obligations.
►Based on the recommendations of the Working ►L1 = NM3 + All deposits with the post office
savings banks (excluding National Savings
Monetary Policy & Money Supply Group on Money (1998), the RBI has started
Certificates).
publishing a set of four new monetary aggregates on
► The central bank of a country wants to stimulate
the basis of the balance sheet of the banking sector ►L2 = L1 +Term deposits with term lending
economic activity it does so by infusing liquidity
in conformity with the norms of progressive institutions and refinancing institutions (FIs) +
into the system.
𝟏 liquidity. The new monetary aggregates are: Term borrowing by FIs + Certificates of deposit
∆𝑴𝒐𝒏𝒆𝒚 𝒔𝒖𝒑𝒑𝒍𝒚 = × ∆𝑹𝒆𝒔𝒆𝒓𝒗𝒆𝒔
𝑹 issued by FI's.
Is it possible that the value of money multiplier Reserve money
is zero? ►L3 = L2+ Public deposits of non-banking financial
►also known as central bank money, base money or companies
• may happen when the interest rates are too low
high-powered money, determines the level of
and the banks prefer to hold the newly injected
reserves as excess reserves with no risk liquidity and price level in the economy.
attached to it.

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Chapter 8 Money Market
Unit - 3: Monetary Policy
Meaning Monetary Transmission Mechanism Operating Procedure & Instruments
▪ Monetary policy refers to the use of monetary The process or channels through which the evolution 1. Quantitative tools
policy instruments which are at the disposal of the of monetary aggregates affects the level of
central bank to regulate the availability, cost and production and price level is known as ‘monetary Cash Reserve Ratio
use of money and credit to promote economic transmission mechanism’ i.e how they impact real • The fraction of the total net demand and
growth, price stability, optimum levels of output variables such as aggregate output and employment. time liabilities (NDTL) of a scheduled
and employment, balance of payments equilibrium, commercial bank in India which it should
maintain as cash deposit with the
stable currency or any other goal of government’s Analytics of Monetary Policy Reserve Bank irrespective of its size or
economic policy. financial position.
Interest rate
Quantum channel
channel
Objectives Of Monetary Policy
High CRR Low liquidity
Stability in price or controlling inflation Exchange rate
Asset price channel
channel
• Full employment
High liquidity Lower CRR
Regulate the issue of bank notes A contractionary monetary policy-induced increase in
interest rates increases the cost of capital and the
• Ensure adequate flow of credit to the productive real cost of borrowing for firms and households who Statutory Liquidity Ratio (SLR)
sector respond by cutting back on their investment and
Maintenance of a judicious balance between price purchase expenditures respectively. • is what the scheduled commercial banks
stability and economic growth. The exchange rate channel works through expenditure in India are required to maintain as a
switching between domestic and foreign goods on stipulated percentage of their total
• Debt management Demand and Time Liabilities (DTL) / Net
account of appreciation / depreciation of the domestic
currency with its impact on net exports and DTL (NDTL) in Cash, Gold or approved
Moderate long term interest rate
consequently on domestic output and employment. investments in securities.
• External balance of payments equilibrium Two distinct credit channels- the bank lending channel
and the balance sheet channel- operate by altering Rise in the SLR which is resorted to during
access of firm and household to bank credit and by
periods of high liquidity, tends to lock up
the effect of monetary policy on the firm's balance
sheet respectively. • a rising fraction of a bank's assets in the form
Asset prices generate important wealth effects that of eligible instruments, and this reduces the
impact, through spending, output and employment. credit creation capacity of banks.

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Reduction in the SLR during periods of economic Moral suasion Reverse Repo rate
downturn
• By way of persuasion, the RBI convinces • The reverse of repo rate, i.e., this is the
• the opposite effect. The SLR requirement also banks to keep money in government rate RBI pays to banks in order to keep
facilitates a captive market for government securities, rather than certain sectors. additional funds in RBI.
securities.
• Reverse Repo Rate = Repo Rate - 1
Selective credit control
5. Marginal Standing Facility (MSF)
Statutory Liquidity Ratio

• Controlling credit by not lending to

Cash
Treasury bills of the selective industries or speculative
Government of India businesses. ▪ The penal rate at which the Central Bank lends
Gold money to banks, over the rate available under the
Dated Securities rep policy. Banks availing MSF Rate can use a
3. Market Stabilisation Scheme (MSS) maximum of 1% of SLR securities.
Investment
State Government MSF Rate = Repo Rate + 1MSF Rate = Repo
Loans The Government of India borrows from the RBI Rate + 1
(such borrowing being additional to its normal
Other insturments
as notified by RBI borrowing requirements) and issues treasury Monetary Policy Committee
bills/dated securities. ♦ The Monetary Policy Committee (MPC) consisting
6 Open Market Operations (OMO) of six members shall determine the policy rate to
Bank Rate
• OMOs is a general term used for achieve the inflation target through debate and
market operations conducted by the • "the standard rate at which the Reserve majority vote by a panel of experts.
Reserve Bank of India by way of sale/ Bank is prepared to buy or re-discount bills ♦ The Monetary Policy Framework Agreement is an
purchase of Government securities to/ of exchange or other commercial paper
agreement reached between the Government of
from the market with an objective to eligible for purchase under the Act.
adjust the rupee liquidity conditions in India and the Reserve Bank of India (RBI) on the
the market on a regular basis. maximum tolerable inflation rate as 4 per cent
3. Liquidity Adjustment Facility (LAF)
Consumer Price Index (CPI) inflation with a
2. Qualitative tools deviation of 2 percent.
Repo rate
♦ Choice of a monetary policy action is rather
Margin requirements • the rate at which banks borrow from RBI complicated in view of the surrounding
• RBI sets a margin against collateral, on a short-term basis against a repurchase
uncertainties and the need for exercising complex
which influences customer borrowing agreement. Banks are required to provide
government securities as collateral and judgment to balance growth and inflation concerns.
habits. Raising these margin
requirements reduces borrowing later buy them back after a pre-defined Additional complexities arise in the case of an
capacity. time. emerging market like India.

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Chapter 9 International Trade
Unit - 1: Theories Of International Trade

Arguments against International Trade Theory of Comparative

Meaning
Advantage : Ricardo
♦Negative labour market outcomes
•International trade is the exchange of goods and
♦Economic exploitation
services as well as resources between countries • Ricardo's theory of comparative advantage
♦Exhaustion of Natural Resources
and involves greater complexity compared to states that a nation should specialise in the
♦May result in consumerism
production and export of the commodity in
internal trade ♦Dependence
which its absolute disadvantage is smaller
♦May result in Inflation
(this is the commodity of its comparative
Important Theories of International Trade ♦Disregard for welfare of people
advantage) and import the commodity in
♦Quick transmission of trade cycles
♦Rivalries and risks in trade associated with changes in which its absolute disadvantage is greater
A powerful stimulus to economic efficiency and contributes (this is the commodity of its comparative
to economic growth and rising incomes. governments' policies of participating countries
disadvantage).
Important Theories of International Trade
Mercantilists View of
Efficient deployment of productive resources to their best International Trade Heckscher-Ohlin Theory of
use is a direct economic advantage of foreign trade. Trade
• Mercantilism advocated maximising exports
in order to bring in more precious metals • The Heckscher-Ohlin theory of trade, also
Trade provides access to new markets and new materials and and minimising imports through the state referred to as Factor-Endowment Theory
enables sourcing of inputs and components internationally at imposing very high tariffs on foreign goods. of Trade or Modern Theory of Trade,
competitive prices. states that comparative advantage in cost
Theory of Absolute Advantage: of production is explained exclusively by
Adam Smith the differences in factor endowments.
Trade also provides greater stimulus to innovative services in
banking, insurance, logistics, consultancy services etc. • According to Adam Smith's Absolute Cost New Trade Theory
Advantage theory, a country will specialise • New Trade Theory is the latest entrant to
in the production and export of a commodity explain the rising proportion of world
in which it has an absolute cost advantage. trade in the developed world and bigger
Emerging economies can enhance product value and move up
the global value chain by improving output quality, superior developing economies (such as BRICS)
products, finer labor, and environmental standards. Factor-Price Equalisation which trade in similar products. These
Theorem countries constitute more than 50% of
• that international trade equalises the factor prices
world trade. Accoring to this theory, two
Trade strengthens bonds between nations by bringing between the trading nations. Therefore, with free key concepts
citizens of different countries together in mutually trade, wages and returns on capital will converge • Economies of Scale and Network effects,
beneficial exchanges across the countries. affects international tarde in a major way

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Chapter 9 International Trade
Unit - 2: The Instruments of Trade Policy
Meaning of Trade Policy Other Forms of Import Tariffs Non-Tariff Measures
►Trade policy encompasses all instruments that Dumping occurs Countervailing ►Non-tariff measures (NTMs) are policy
governments may use to promote or restrict when manufacturers duties are tariffs measures, other than ordinary customs tariffs,

Countervailing Duties
sell goods in a to offset the

Anti-dumping Duties
imports and exports. that can potentially have an economic effect on
foreign country artificially low
below the sales prices charged by international trade in goods, changing quantities
►Trade policies are broadly classified into price-
prices in their exporters, who traded or prices or both.
related measures such as tariffs and non-price domestic market or enjoy export
measures or non-tariff measures (NTMs). below their full subsidies and tax Category of Non-Tariff Measures
average cost of the concessions offered
Meaning of Tariff product. It hurts by the governments Technical Measures
domestic producers in their home
►Tariff, also known as customs duty is defined as country.
1. Sanitary and Phytosanitary
a financial charge in the form of a tax, imposed at Effects of Tariff (SPS) measures
the border on goods going from one customs
territory to another. Tariffs are the most visible Tariff barriers increase are applied to protect human, animal or plant
and universally used trade measures. create obstacles to government life from risks arising from additives, pests,
trade, revenues.
contaminants, toxins or disease-causing
Forms of Import Tariffs
organisms and to protect biodiversity.
• A specific tariff is an import
duty that assigns a fixed reduce the 2. Technical Barriers to Trade
protect domestic
monetary tax per physical unit of prospect of market
Specific the goods imported, whereas an industries,
access,
Tariff ad valorem tariff is levied as a cover both food and non-food traded products
constant percentage of the refer to mandatory ‘Standards and Technical
monetary value of one unit of the Regulations’ that define the specific
imported good. make imported increase characteristics that a product should have,
goods more consumption of
such as its size, shape, design, labelling /
Ad • An ad valorem tariff is levied as expensive, domestic goods,
a constant percentage of the marking / packaging, functionality or
volorem
monetary value of one unit of the performance and production methods, excluding
tariff imported good.
measures covered by the SPS Agreement.

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Trade-Related Investment
Non- Technical Measures Export Related Measures
Measures
Imported quota Ban of Export
• The regulations stipulate that a specific
• direct restrictions on the physical percentage of a final product should be • Exports of certain items may be banned during
amount of goods allowed into a country produced domestically. shortages.
for a specific period, usually one year,
enforced by licenses. Export Taxes
Restriction on Post-sales
Services • An export tax is a tax collected on exported goods
Price Control Measures and may be either specific or ad valorem and an
• Producers may be limited from offering
• Additional taxes and charges are export subsidy includes financial contribution to
after sales services for exported goods
measures used to control or influence domestic producers in the form of grants, loans,
in the importing country, with these
the prices of imported goods, equity infusions also usually provide etc., or give
services being reserved for local service
supporting domestic prices when these some form of income or price support. Both distort
companies.
prices are lower. trade.

Safeguard Measures Export subsidies and Incentives

Non-automatic Licensing &
Prohibition • Countries temporarily restrict imports of • Given by government to boost exports.
a product if their domestic industry is
• Measures typically aim to restrict the
severely impacted or threatened by a Voluntary Export-Restraints
importation of goods from various
surge in imports.
sources or a single supplier.
• Voluntary Export Restraints (VERs) refer to a
type of informal quota administered by an
Financial Measures Embargos
exporting country voluntarily restraining the
quantity of goods that can be exported out of a
• The regulation of foreign exchange • a total ban imposes by government on
country during a specified period of time,
access and payment terms for imports, import or export of some or all
imposed based on negotiations to appease the
including advance payment requirements commodities to particular country or
importing country and to avoid the effects of
and controls, can increase import costs. regions for a specified or indefinite
possible trade restraints.
period.
Measures Affecting
Competition

• Economic privileges are granted to a

select group of economic operators,
often through government-imposed
channels or compulsory use of national
services.

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Chapter 9 International Trade
Unit - 3: Trade Negotiations
Meaning General Agreement on Tariffs & WTO Functions
► International trade negotiations, especially the Trade (GATT)
►The WTO does its functions by acting as a forum
ones aimed at formulation of international trade ►The General Agreement on Tariffs and Trade for trade negotiations among member governments,
rules, are complex interactive processes engaged (GATT) provided the rules for most of the world administering trade agreements, reviewing national
in by countries having competing objectives. trade for 47 years, from 1948 to 1994. trade policies, cooperating with other international
►Eight multilateral negotiations known as "trade organizations and assisting developing countries in
Taxonomy Of Regional Trade
rounds" held under the auspices GATT resulted in trade policy issues through technical assistance and
Agreements ( RTAs) substantial international trade liberalization. training programmes.
► As groupings of countries (not necessarily ►The eighth of the Uruguay Round of 1986-94, was
belonging to the same geographical region) which the last and most consequential of all rounds and WTO Activities
are formed with the objective of reducing barriers culminated in the birth of WTO and a new set of
to trade between member countries. agreements replacing the General Agreement on
►The WTO activities are supported by the
Tariffs and Trade (GATT).
Secretariat located in Geneva, headed by a
Different types of agreements
World Trade Organization (WTO) Director General. It has a three-tier system of
decision making. The top-level decision-making body
►The eighth of the Uruguay Round of 1986-94, was is the Ministerial Conference, followed by councils
Regional the last and most consequential of all rounds and
Unilateral trade Bilateral namely, the General Council and the Goods Council,
preferential culminated in the birth of WTO and a new set of
agreements. agreements
trade agreements Services Council and Intellectual Property (TRIPS)
agreements replacing the General Agreement on
Tariffs and Trade (GATT). Council.

Free-trade WTO Members

Customs union
area
Trading bloc Principal objective of the WTO
►The WTO currently has 164 members, of which
►Facilitate the flow of international trade 117 are developing countries or separate customs
smoothly, freely, fairly and predictably. territories accounting for about 95% of world
Common market and economic and monetary union
trade.

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Important Agreements under WTO ♦ Apparent north-south divide

♦ Exceptionally high tariffs
♦ Agriculture
♦ Tariff escalation, erosion of preferences and
♦ SPS measures difficulties with regard to adjustments.
♦ Textiles and clothing
♦ Technical barriers to trade (TBT)
Doha Round, formally the Doha
♦ Trade-related investment measures (TRIMs)
♦ Anti-dumping Development Agenda
♦ Customs valuation
♦ The ninth round since the Second World War was
♦ Pre-shipment inspection (PSI)
officially launched at the WTO’s Fourth Ministerial
♦ Rules of origin
Conference in Doha, Qatar, in November 2001.
♦ Import licensing procedures
♦ Subsidies and countervailing measures ♦ Sought to accomplish major modifications of the
♦ Safeguards, Trade in Services (GATS) international trading system through lower trade
♦ Intellectual Property Rights (TRIPS) barriers and revised trade rules
♦ Settlement of Disputes (DSU)
♦ Trade Policy Review Mechanism (TPRM) ♦ Include 20 areas of trade.
♦ Plurilateral trade agreements on trade in civil
aircraft and government procurement.

A Few concerns of WTO

♦ Slow progress of multilateral negotiations

♦ Uncertainties resulting from regional trade
agreements
♦ Inadequate or negligible trade liberalisation
♦ Those which are specific concerns to the
developing countries
♦ Protectionism and lack of willingness among
developed countries to provide market access
♦ Difficulties that they face in implementing the
present agreements

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Chapter 9 International Trade
Unit - 4: Exchange Rate and its Economic Effects
Exchange Rate Meaning Fixed Exchange Rate or Pegged Nominal Vs Real Exchange Rate
▪ Exchange rate is the rate at which the currency exchange rate ▪ Real Exchange Rate: The 'real exchange rate'
of one country exchanges for the currency of ►Under fixed exchange rate system country’s incorporates changes in prices and describes 'how
another country. government and central bank decides the rate and many' of a good or service in one country can be

direction of currencies. traded for 'one' of that good or service in a

foreign country.
Exchange Rate Regime ►Exchange rate is generally determined by the
market force. Time being it is called soft peg. ▪ Real exchange rate=
▪ An exchange rate regime is the system by which 𝑫𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒑𝒓𝒊𝒄𝒆 𝑰𝒏𝒅𝒆𝒙
Nominal exchange rate x
a country manages its currency in respect to ►Central bank sets fixed on unchanging value of
𝑭𝒐𝒓𝒆𝒊𝒈𝒏 𝒑𝒓𝒊𝒄𝒆 𝑰𝒏𝒅𝒆𝒙

foreign currencies. exchange it is called hard peg. ▪ Nominal Exchange Rate states how much of one
currency can be traded for a unit of another
►A fixed exchange rate avoids currency
Floating Exchange Rate Regime currency.
fluctuations and eliminates exchange rate risks.

►System imposes discipline on country’s monetary

Real Effective Exchange Rate ( REER)
The equilibrium value of the exchange rate of a
country's currency is market determined i.e the authorities and therefore likely to generate lower- ▪ The nominal effective exchange rate (a measure
demand for and supply of currency relative to level inflation. of the value of a domestic currency against a
other currencies determines the exchange rate.
weighted average of various foreign currencies)
►Fixed exchange rate system encourages greater
divided by a price deflator or index of costs.
trade and investment and also ensures stabilities.
▪ An increase in REER implies that exports
►Fixed exchange rate system countries have to
become more expensive and imports become
maintain adequate amount of foreign exchange
cheaper; therefore, an increase in REER indicates
reserves.
A floating exchange rate allows a government to a loss in trade competitiveness.
pursue its own independent monetary policy and
there is no need of market intervention or
maintenance of reserves. But, volatile exchange
rates generate a lot of uncertainties in relation
to international transactions.

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Determination of Nominal Exchange Rate Home-currency depreciation Devaluation ( Revaluation) Vs

Depreciation (Appreciation)
Devaluation
• is a deliberate downward adjustment by
central bank in the value of a country's
currency relative to another currency,
group of currencies or standard.

Appreciation

• A country’s currency cause changes in

Foreign-currency appreciation occurs when the import and export prices will lead to
▪ The supply of and demand for foreign exchange in home currency's foreign currency price changes in import and export volumes,
causing resulting in import spending and
the domestic foreign exchange market determine the increases or decreases, making the home export earnings.
external value of the domestic currency, or in other currency less valuable.
words, a country’s exchange rate. Effect of Depreciation

▪ The equilibrium rate of exchange is determined by Home-currency appreciation ▪ Exchange rate depreciation lowers the relative
price of a country's exports, raises the relative
the interaction of the supply and demand for a
price of its imports, increases demand both for
particular foreign currency.
domestic import-competing goods and for exports,
leads to output expansion, encourages economic
Changes in Exchange Rates activity, increases the international
♦ Portray depreciation or appreciation of one competitiveness of domestic industries, increases
the volume of exports and promotes trade balance.
currency.
♦ The terms, `currency appreciation’ and ‘currency Effect of Appreciation
depreciation’ describe the movements of the
exchange rate. ▪ Currency appreciation raises the price of exports,
decrease exports; increase imports, adversely
♦ when its value increases with respect to the value
Depreciation occurs when the home currency's affect the competitiveness of domestic industry,
of another currency or a basket of other currencies.
value decreases or increases with the foreign cause larger deficits and worsens the trade
On the contrary, currency depreciates when its value balance.
currency's price, making the home currency
falls with respect to the value of another currency or
more valuable.
a basket of other currencies.

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Foreign Exchange Market

The wide-reaching collection of markets and
institutions that handle the exchange of foreign
currencies is known as the foreign exchange
market.

Being an over-the-counter market, it is not a

physical place; rather, it is an electronically linked
network bringing buyers and sellers together and
has only very narrow spreads.

On account of arbitrage, regardless of physical

location, at any given moment, all markets tend to
have the same exchange rate for a given currency.
Arbitrage refers to the practice of making risk-
less profits by intelligently exploiting price
differences of an asset at different dealing
places.

Types of transactions in a Forex market

Spot Market
• Current transactions which are carried
out in the spot market and exchange
involves immediate delivery

Forward and /or Future

Market
• Contracts buy or sell currencies for
furture delivery which are carried out in
forward and/or future.
• Current transactions which are carried
out in the spot market and contracts to
buy or sell currencies for future
delivery which are carried out in
forward and futures markets

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Chapter 9 International Trade
Unit - 5: International Capital Movements
Green field investment
Meaning Reasons For Foreign Direct Investment • Green field investment (establishment of
•Foreign capital may flow into an economy in ♦ Profits a new overseas affiliate for freshly
different ways, such as foreign aid, grants, starting production by a parent
♦ Higher rate of return
company).
borrowings, deposits from non-resident Indians, ♦ Possible economies of large-scale operation
investments in the form of Foreign Portfolio
♦ Risk diversification
Investment (FPI) and Foreign Direct Investment Brownfield investments
♦ Retention of trade patents
(FDI) • Brownfield investments (a form of FDI
♦ Capture of emerging markets
which makes use of the existing
Important components ♦ Lower host country environmental and labour infrastructure by merging, acquiring or
Foreign aid or assistance standards, leasing, instead of developing a
♦ Bypassing of non-tariff and tariff barriers completely new one. For e.g., in India
Borrowings
100% FDI under automatic route is
♦ Cost–effective availability of needed inputs and
Deposits from non-resident Indians (NRI) allowed in Brownfield Airport projects.
tax and investment incentives.
Investments Benefits of foreign direct investment
Modes of FDI
Foreign portfolio Foreign direct
investment (FPI) investment (FDI) ♦ Include positive outcomes of competition such
· Opening of a subsidiary or associate company in a
as cost reducing and quality-improving innovations
Foreign Direct Investment foreign country ♦ Higher efficiency
· Equity injection into an overseas company ♦ Huge variety of better products and services
•a process whereby the resident of one country
·Acquiring a controlling interest in an existing at lower prices
(i.e. home country) acquires ownership of an asset
foreign company ♦ Welfare for consumers, multiplier effects on
in another country (i.e. the host country) and such
· Mergers and acquisitions (M&A) employment
movement of capital involves ownership, control as
♦ Output and income, relatively higher wages
well as management of the asset in the host · Joint venture with a foreign company
♦ Better access to foreign markets
country. · Green field investment
♦ Control of domestic monopolies and betterment
•Direct investments are real investments in · Brownfield investments of balance of payments position
factories, assets, land, inventories etc. and have
♦ Potential problems of foreign direct investment
three components, viz., equity capital, reinvested
♦ Include use of inappropriate capital- intensive
earnings and other direct capital in the form of
methods in a labour-abundant country
intra-company loans. FDI may be categorized as
♦ Increase in regional disparity
horizontal, vertical or conglomerate. Two- way
direct foreign investments reciprocal investments.

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♦ Crowding-out of domestic investments Foreign portfolio investment Vs Foreign Direct Investment

♦ Diversion of capital resulting in distorted FDI FPI
pattern of production and investment
Investment involves creation of physical assets Investment is only in financial assets
♦ Instability in the balance of payments and
exchange rate and indiscriminate repatriation of Has a long-term interest and therefore remains Only short-term interest and generally remain
the profits. invested for long invested for short periods
♦ Anti-ethical market distortions Relatively difficult to withdraw Relatively easy to withdraw
♦ Off–shoring or shifting of jobs Not inclined to be speculative Speculative in nature
♦ Overexploitation of natural resources causing
Often accompanied by technology transfer Not accompanied by technology transfer
environmental damage
♦ Exercising monopoly power Direct impact on employment of labour and wages No direct impact on employment of labour and
♦ Decrease competitiveness of domestic wages
companies Enduring interest in management and control No abiding interest in management and control
♦ Potentially jeopardize national security and Securities are held with significant degree of Securities are held purely as a financial investment
sovereignty influence by the investor on the management of the and no significant degree of influence on the
♦ Worsen commodity terms of trade and cause
enterprise management of the enterprise
emergence of a dual economy
FDI in India
Foreign portfolio investment
Mostly a post reform phenomenon is a major source of non- debt financial resource for economic
• is the flow of ‘financial capital’ with stake in a development.
firm at below 10 percent, and does not involve
manufacture of goods or provision of services,
The government has at different stages, liberalized FDI by increasing sectoral caps, bringing in more
ownership management or control of the asset on
activities under automatic route and easing of conditions for foreign investment.
the part of the investor.

Overseas direct investments by Indian companies, made possible by progressive relaxation of capital
controls and simplification of procedures for outbound investments from India, have undergone substantial
changes in terms of size, geographical spread and sectoral composition. Outward Foreign Direct Investment
(OFDI) from India stood at US$ 1.86 billion in the month of June 2016.

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Chapter 10 Indian Economy
Status Of Indian Economy: Pre Indian Economy: Post-Independence 'Green Revolution'
Independence-Period (1850 -1947) (1947- 1991) • This radical change materialised by
innovative farm technologies, including
►India is believed to have had the largest economy high yielding seed varieties and intensive
Industrial Policy Resolution (1948)
of the ancient and the medieval world and use of water, fertilizer and pesticides is
envisaged an expanded role for the public sector
controlled between one third and one fourth of the referred to as 'Green Revolution'.
and licensing to the private sector.
world's wealth. It was prosperous and self-reliant
and had flourishing cities and self-sufficient Policies in 1950's ►Many government policies aimed at prevention of
villages. were guided by both Nehruvian and Gandhian growth of monopolies and equitable distribution of
philosophies with the former visualizing a socialistic income and wealth such as reservation of many
►The advent of the Europeans and the rule of society with emphasis on heavy industries and the
products for exclusive manufacture by the small-
British from 1757 to 1947 brought about a marked latter stressing on small scale and cottage industry
scale sector and the Monopolies and Restrictive
shift in the economic history of India. and village republics.
Trade Practices Act, 1969 (MRTP) (which placed
►The industrial revolution in Britain led to Industrial Policy Resolution of 1956 several restrictions on large enterprises in terms
increased production, targeting India for raw supported undue priority and enormous expansion of licensing, capacity addition, mergers and
materials and markets, but adverse imperial of the scope of the public sector which resulted in acquisitions) effectively killed the incentive for
policies and easy importation reduced Indian dampening of private initiative and enterprise. creating wealth.
manufacturing competitiveness and domestic
In the first three decades after independence ►The economic performance during the period of
demand.
(1950-80), India's average annual rate of growth of 1965-81 is the worst in independent India's
GDP, often referred to as the 'Hindu growth rate', history. The license-raj, the autarchic policies
►Rapid industrialization of the economy was the
was a modest 3.5 percent.
cornerstone of Nehru’s development strategy. The that dominated the 1960s and 1970s, and the
concept of ‘planned modernization’ meant a external shocks such as three wars, major
The first major shift in Indian economic strategy
systematic planning to support industrialization. was in the mid-1960s. Due to continuous failures of droughts, and the oil shocks of 1973 and 1979
monsoon, droughts struck India in 1966 and 1967 contributed to the decelerated growth lasting two
and food crisis set in. The need for increased decades.
productivity in agriculture kick-started a strategic
change in agriculture policies.

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The Era Of Reforms
Monetary reforms Trade policy reforms
►The reform initiatives- covering three areas,
The monetary and financial sector reforms were in ►The trade policy reforms included liberalisation
namely industry, trade and taxation spanning 1981
the form of interest rate liberalization, reduction of external trade, removal of licensing for imports,
to 1989, is referred to as ‘early liberalization’ or
in controls on banks by the Reserve Bank of India dismantling of quantitative restrictions on imports
‘reforms by stealth’ to denote its ad hoc and not in respect of interest rates and facilitating greater and exports and phased reduction and
widely publicized nature. They were aimed at competition in the banking sector by private simplification of tariffs.
changing the prevailing thrust on ‘inward-oriented’ participation and foreign competition, reduction in
trade and investment practices. reserve requirements, liberalisation of bank branch NITI Aayog
licensing policy and establishing prudential norms of
►The major reforms in 1980’s included de licensing accounting in respect of classification of assets, ►On 1st January 2015, the apex policy-making
of 25 broad categories of industries, granting of disclosure of income and provisions for bad debt. body namely Planning Commission, was replaced by
the facility of ‘broad-banding’ to allow flexibility the National Institution for Transforming India
Reforms in Capital Markets (NITI) Aayog with the objective to 'spur
and rapid changes in the product mix of industries
without going in for fresh licensing, increase in the innovative thinking by objective 'experts' and
Reforms in Capital Markets included granting of
asset limit of MRTP firms from 20 crore to 100 statutory recognition to the Securities and promote 'co-operative federalism' by enhancing
crore, introduction of modified value-added Exchange Board of India (SEBI) to facilitate the voice and influence of the states'.
(MODVAT), establishment of the Securities and mobilization of adequate resources and their
efficient allocation. ►NITI Aayog is expected to serve as a 'Think
Exchange Board of India (SEBI) as a non-statutory
Tank' of the government. [and] as 'directional and
body ,extension of the Open General Licence 'New Industrial Policy' policy dynamo'. The key initiatives of NITI Aayog
(OGL), export incentives, liberalisation of imports,
The 'New Industrial Policy' announced by the are: 'Life', The National Data and Analytics
reduction in tariffs and removal of price and
government on 24 July 1991 sought to substantially Platform (NDAP), Shoonya, E-Amrit, India Policy
distribution controls on cement and aluminium.
deregulate industry so as to promote growth of a Insights (IPI), and 'Transforming India's Gold
more efficient and competitive industrial economy. Market'.
Fiscal reforms
►The fiscal reforms included introduction of a The policy put an end to the 'License Raj' by
stable and transparent tax structure, better tax removing licensing restrictions for all industries
except for 18 on strategic considerations.
compliance, control of government expenditure,
reduction /abolition of subsidies, disinvestment of
part of government's equity holdings and
encouraging private sector participation.

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