NCERT NOTES

FOR ECONOMICS
12th Standard
Introductory Macroeconomics
CONTENTS
Introduction ...................................................................................................................................... 1 - 2

National Income Accounting ....................................................................................................... 3 - 9

Money and Banking .................................................................................................................. 10 - 15

Determination of Income and Employment ....................................................................... 16 - 18

Government Budget and the Economy .............................................................................. 19 - 28

Open Economy Macroeconomics ......................................................................................... 29 - 39

 1 INTRODUCTION
Macroeconomics attempts to study the 'macro' (meaning 'large') phenomenon affecting the economy as a
whole. It usually simplifies the analysis of how the country's total production and the level of employment are
related to attributes, also called variables, like prices, rate of interest, wage rates, profits, etc.
In simple terms, macroeconomics studies the behaviour of entire economy such as the aggregate output
levels of all the goods and services in an economy, general price levels of goods and services, employment
level in different production units, etc.

Distinction between Microeconomics and Macroeconomics:

Microeconomics Macroeconomics

It studies the behaviour of individual or small It tries to address situa ons facing the economy as a
economic agents. whole.

It studies the demand and supply of individual It studies the aggregate effects of the forces of
market segments. demand and supply in the economy.

It focuses on consumers choice, test and It focuses on consump on levels in an economy and
preference and income. na onal income.

The decision makers are any individual, firms, Macroeconomic policies are pursued by the State
households, business units, etc. itself or statutory bodies like the Reserve Bank of
India (RBI), Securi es and Exchange Board of India
(SEBI) and similar ins tu ons.

The ul mate goal is profit maximisa on. The ul mate goal is macroeconomic stabiliza on.

Note: Even a large company is 'micro' in the sense that it had to act in the interest of its own shareholders
which was not necessarily the interest of the country as a whole.

Importance of Macroeconomic Studies:

INTRODUCTION

Adam Smith, the founding father of modern economics, had suggested that if the buyers and sellers in the
market take decisions based on their own self-interest, there is no need to think of the wealth and welfare of
the country as a whole separately. But it was found that in some cases:
● The markets did not or could not exist.
● The markets existed but failed to produce equilibrium of demand and supply.

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 ● In a large number of situations, society (or the State, or the people as a whole) had decided to pursue
certain important social goals unselfishly (in areas like employment, administration, defence,
education and health) for which some of the aggregate effects of the microeconomic decisions made
by the individual economic agents needed to be modified.
Therefore, it is crucial to study the effects of taxation and other budgetary policies, money supply, interest
rates, wages, employment and output in the market.

Emergence of Macroeconomics:
● Macroeconomics emerged as a separate subject in the 1930s due to John Maynard Keynes, a British
economist.
● The classical school of thought, before Keynes, believed that all the labourers who are ready to work
will find employment and all the factories will be working at their full capacity.
● However, the Great Depression of 1929 and the subsequent years saw the output and employment
levels in the countries of Europe and North America fall by huge amounts. It affected other countries of
the world as well.
● Demand for goods in the market was low, many factories were lying idle, workers were thrown out of
jobs and unemployment rate touched to a new hights.
● These events led to persistent development of macroeconomic frameworks explained by Keynes.
● His approach was to examine the working of the economy in its entirety and examine the
interdependence of the different sectors.

Unemployment rate: It is defined as the number of people who are not working and are looking for jobs
divided by the total number of people who are working or looking for jobs.

Interesting points

● Today, the economic system of most of the developed countries is capitalistic in nature, where the
production activity is mainly carried out by capitalist enterprises.
● A typical capitalist enterprise has one or several entrepreneurs, who exercise control over major
decisions and bear a large part of the risk associated with the enterprise.
● Factors of Production: They are the inputs require for the production of goods and services. The
factors of production are capital, land, labour and entrepreneur.
● Revenue: The money that is earned by enterprises by selling goods and services is called revenue.
● Profits: It is the earnings of the entrepreneurs. It is the part of the revenue that remained after the
INTRODUCTION

payments of rent (on land), interest (on capital) and wages (on labour).
● Investment expenditure: It is the expenditure made out of profits in buying new machinery or to
build new factories, so that production can be expanded. These expenses which raise productive
capacity.

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 NATIONAL INCOME ACCOUNTING
2
National income accounting is referred to as the methods and principles that are used for measuring the
income earned by a country in a particular financial year. It is the net result of all economic activities of any
country.

Circular Flow of Income:

It states that income in a simple economy flows in a circular loop, as follows:
● There is no government or the external sector (Foreign Firms) in this simple economic model.
● The households receive their income from the firms, for the services that they perform for the firms.
● Households dispose of their entire earnings only in one way by spending it entirely on goods and
services produced by the domestic firms (that is, households do not save anything).
● In other words, factors of production use their remunerations to buy the goods and services which they
assisted in producing.
● Thus, the entire income of the economy, comes back to the producers in the form of sales revenue.
● The firms again use this revenue to pay for factor services and thus the loop continues again.

Fig 2.1: Circular flow of income

NATIONAL INCOME ACCOUNTING

Based on this concept, the aggregate value of goods and services can be calculated through various ways.

Methods to Calculate Aggregate Value of Production:

There are three methods to calculate the said value, that is: Product or Value-Added Method, Expenditure
Method and Income Method.

The Product Method:

● It is also known as value-added method.

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 ● This method is used to calculate the aggregate value of goods and services produced by all the firms
in an economy during a financial year.
● To calculate aggregate value of production, the value of intermediate goods is subtracted from the
value of production of the firm.
Value Added by a firm = Value of production of the firm – Value of intermediate goods
● Value of aggregate amount of goods and services produced by the economy can be measured by
summing the gross value added of all the firms in an economy during a year and the value so obtained
is the Gross Value Added (GVA)
● If Depreciation is reduced from GVA to account for the normal wear and tear of the Capital Factors of
Production, it is said as Net Value Added (NVA).

Deprecia on: It is the deduc on of value, which is made from the value of gross investment, as during
use throughout the year regular wear and tear happens in capital equipment like machinery. So this
deduc on accommodates for this wear and tear. A er adjus ng the GVA for relevant Product taxes and
Subsidies, GDP is obtained.

Expenditure Method:
● It is an alternative method to calculate the GDP.
● Under this method, the aggregate value of all goods and services produced in a year, are calculated by
looking on the expenditure made by different sectors.
● In this method, following expenditures are added:
⮚ The final consumption expenditure made by the firms on the goods and services produced by other
firms.
⮚ The households which undertake consumption expenditure on various goods and services.
⮚ The final investment expenditure incurred by other firms on the capital goods produced by a firm.
⮚ The expenditure (both consumption and investment) incurred by the government on the final
goods and services produced by firm.
⮚ The export revenues that the firms earn by selling their goods and services abroad.

NATIONAL INCOME ACCOUNTING

Income Method:
● The sum of final expenditures in the economy must be equal to the incomes received by all the factors
of production taken together (final expenditure is the spending on final goods, it does not include
spending on intermediate goods).
● Revenues earned by the firms put together must be distributed among the factors of production (land,
labour, capital and entrepreneurship) as salaries, wages, profits, interest earnings and rents. Let there
be M number of households in the economy.
● Therefore, GDP under this method is obtained by adding up salaries, wages, profits, interest
earnings and rents.

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 Factor Cost, Basic Prices and Market Prices:
● Net Production Taxes: Production taxes and subsidies that are paid or received in relation to
production and are independent of the volume of production such as land revenues, stamp, and
registration fee.
Net Production Taxes = Production Taxes – Production Subsidies.
● Net Product Taxes: Product taxes and subsidies, are paid or received per unit or product, e.g., excise
tax, service tax, export and import duties etc.
Net Product Taxes = Product Taxes – Product Subsidies.
● Factor cost: It includes only the payment to factors of production; it does not include any tax or subsidy.
● Basic prices: In addition to the factor cost, they include the net production taxes but not net product
taxes.
● Market prices: Net Product taxes are added to the basic prices. (Market prices include both the Indirect
Taxes.)

In India, the most highlighted measure of national income has been the GDP at factor
cost.
The Central Statistics Office (CSO) has been reporting the GDP at factor cost and at
market prices.
In its revision in January 2015 the CSO replaced GDP at factor cost with the GVA at basic
prices, and the GDP at market prices, which is now called only GDP, is now the most highlighted
measure.
GVA at basic price = GVA at factor costs + Net production taxes
GVA at market price = GVA at basic prices + Net product taxes

Some other Macro-Economic Identities

Gross Domestic Product:
● It measures the aggregate production of final goods and services taking place within the domestic
NATIONAL INCOME ACCOUNTING

economy during a year.

⮚ Any citizen of India working abroad and earning wages will be included in the GDP of that particular
country but not in the GDP of India.
⮚ However, citizens of India even work abroad and contribute to the Indian Economy from their
earnings outside the Domestic Territory of India.

Gross National Product (GNP):

● It measures the monetary value of all the finished goods and services produced by the country's
factors of production irrespective of their location.
GNP ≡ GDP + Net factor income from abroad

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 ● GNP = GDP + Factor income earned by the domestic factors of production employed in the rest of the
world – Factor income earned by the factors of production of the rest of the world employed in the
domestic economy.
● Factor income earned by the domestic factors of production employed in the rest of the world – Factor
income earned by the factors of production of the rest of the world employed in the domestic economy,
is also called the Net Factor Income from Abroad (NFIA).

Net National Product (NNP):

● It is the net value of national output after subtracting depreciation.
● Depreciation is the certain amount of capital which is consumed due to wear and tear. It does not form
the part of any one's income and hence should be deducted to get a more accurate measure.
Net National Product (NNP) = Gross National Product (GNP) – Depreciation

Personal Income:
It is that part of the National Income, which is received by the households. Following amounts are to be
adjusted for in the NI to obtain personal income:
● Undistributed Profits (UP): The part of profit earned by the firms and government enterprises, which
is not distributed to the factors of production.
● Corporate Tax: Which is imposed on the earnings made by the firms and does not accrue to the
households.
● Net interest payments made by households: The interest paid by the households to the firms or the
government for any past loan/borrowing of any kind taken by them, adjusted by any interest payment
that the households may receive from the firms or the government.
● Transfer payments to the households from the government and firms: Transfer payments that the
households receive from government and firms (for example pensions, scholarship, prizes etc.)

Personal Income (PI) ≡ NI – Undistributed profits – Net interest payments made by households
– Corporate tax + Transfer payments to the households from the government and firms.

NATIONAL INCOME ACCOUNTING

Personal Disposable Income:
● It refers to personal income minus taxes at a personal level.
● It measures the amount of net income that remains after households pay all their tax levies.
● The Personal Tax Payments (income tax etc.) and Non-tax Payments (such as fines etc.) are deducted
from PI, and then we obtain what is known as the Personal Disposable Income.

Personal Disposable Income = PI – Personal tax payments – Non-tax payments

National Disposable Income:
● It is to give an estimate about the total amount of goods and services, that the domestic economy has
at its disposal.

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 National Disposable Income = Net National Product at market prices + Other current transfers from the
rest of the world.
Other current transfers from rest of the world, include amounts received on account of gifts, aids, etc.

Private Income:
Private Income = Factor income from net domestic product accruing to the private sector + National debt
interest + Net factor income from abroad + Current transfers from government + Other net transfers from the
rest of the world.

Nominal and Real GDP

Real GDP:
● It is calculated in a way such that the goods and services are evaluated at some constant set of prices.
● As these prices remain fixed, the changes in Real GDP over different years are thus only when the real
volume of production undergoes change.
● It provides a more precise picture of a nation's actual rate of economic growth. When calculating real
GDP, a base year is selected to control for inflation; the real GDP figures capture the quantities of goods
produced in different years using the prices from the same base year.

Nominal GDP:
● It is simply, the GDP which is calculated at the current prevailing prices in the market.
● It includes all of the changes in market prices that have occurred during the current year due to inflation
or deflation.
● The market price of GDP

GDP Deflator:
● It is the ratio of nominal GDP to real GDP.
● This ratio gives us an idea that how prices in an economy have moved during the subsequent years
(Nominal GDP), in relation to the prices of a base year, which are used to determine the Real GDP.
NATIONAL INCOME ACCOUNTING

Consumer Price Index (CPI):

● It is another way to measure the change of prices in an economy.
● Generally expressed in percentage terms, this is the index of prices of a given basket of commodities
which are bought by the representative consumer.
● The price for the said basket of commodities is calculated for a pre-determined base year and
compared to the price for the same basket of commodities in the current year.
● The increase/decrease of prices in the current year over the base year is represented in percentage
terms.
● Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI).

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GDP and People's Welfare:
Generally, higher levels of GDP are understood as better prosperity and well-being for the people, residing in
that economy.

However, there are certain other factors to consider apart from just GDP growth:
● Uniformity in Distribution of GDP: It is to be understood, that if the GDP rise is only concentrated in
the hands of a few individuals/ firms, it may not mean increased prosperity for all the residents of a
nation.
● Non-monetary exchanges: Many productive activities, like the domestic services by the women at
home, barter exchanges happening in the informal sectors etc. are not translated into monetary
terms, and hence often not counted in GDP estimations of a country. This may lead to
underestimation of GDP, not giving a clear idea about the productive activities and the well being of an
country.
● Externalities: Externalities refer to the benefits (or harms) a firm or an individual causes to another
for which they are not paid (or penalised).
⮚ For example: During the course of manufacturing, an industry may pollute a local river or lake,
impacting the fish in the waterbody and in turn hampering the catch that the fishermen may be able
to obtain. GDP being an estimation of people's welfare may be overestimated by not accounting for
such negative externalities like pollution, environmental degradation etc.
However, there may also be positive externalities.

Interesting Points:
● Final Goods: Products which will not go through any further stages of production and are meant for
final consumption.
● Intermediate Goods: Goods used as inputs in the manufacturing of other goods. (example: Steel
sheets used in making automobiles). To estimate the value of output, the value of Final Goods in
monetary terms is considered, as the value of Final Goods already include the value of all the inputs
that have been consumed/used in their production.
● Consumption Goods: Goods that are consumed as and when they are purchased by the ultimate

NATIONAL INCOME ACCOUNTING

consumer. Examples include: Food, clothing, services like recreation etc.
● Capital Goods: Goods of durable character, used to facilitate the production process and to transform
other goods but not get transformed themselves. (example: Machinery, Implements etc.)
● Consumer Durables: Goods meant for consumption, but do not get used up in a short term instead
they have a long life and undergo normal wear and tear. (example: Television, Radio etc.)
● Flow Variables: Concepts that are defined over a period of time. (example: salary, profit etc. as they are
defined for a particular period of time.)
● Stock Variables: Concepts that are defined at a particular point of time. (example: Buildings or
Machines in a factory etc.)
● Gross Investment: That part of the final output that comprises of capital goods.

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 ● Net Investment: New addition to capital stock in an economy. [Net Investment = Gross investment –
Depreciation].
● Inventory (a Stock Variable): The stock of unsold finished goods, or semi-finished goods, or raw
materials which a firm carries from one year to the next.
NATIONAL INCOME ACCOUNTING

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 3 MONEY AND BANKING
Money is the commonly accepted medium of exchange. In a modern economy, money forms the cornerstone
in enabling varied economic exchanges between varied parties.
In an economy which consists of only one individual there cannot be any exchange of commodities and
hence there is no role for money. However, if there is more than one economic agent who engage
themselves in transactions through the market, money becomes an important instrument for facilitating
these exchanges.

Functions of Money:
● Medium of Exchange: By overcoming the limitation of double coincidence of wants money acts as a
medium in terms of which different commodities can be measured and hence exchanged.
● Unit of Account: The value of all kinds of different goods and services can be expressed in terms of
money. For example: the value of a certain wristwatch is Rs 500, which means that the wristwatch can
be exchanged for 500 units of money, where a unit of money is rupee in this case.
● Store of Value: Money is not perishable, and its storage costs are also considerably lower. It is also
acceptable to anyone at any point of time. Thus, money can act as a store of value for individuals.

Note:
For well-functioning, the value of money must be sufficiently stable. A rising price level may erode
the purchasing power of money, which means the same unit of money can purchase less of a
commodity.
It may be noted that any asset other than money can also act as a store of value, e.g. gold, landed
property, houses or even bonds (to be introduced shortly). However, they may not be easily
convertible to other commodities and do not have universal acceptability.

Demand for Money and Supply of Money

Demand for Money:

It tells us as to what makes people, desire a certain amount of money. It is determined by:
● The value of transactions: Money is required to conduct transactions; the value of transactions
determines the money people want to keep. The larger is the quantum of transactions to be made, the
larger is the quantity of money demanded.
● Income Levels: Quantum of transactions depends on the income levels. A rise in income will lead to rise
in demand for money.
MONEY AND BANKING

● Interest rates: At higher interest rate, demand for money comes down as people park their money
(savings) in interest earning bank deposits and vice-versa.

Supply of Money:
In a modern economy, there are many forms of money including cash, bank deposits etc. The supply of these
are created by two types of institutions: Central Bank of the economy and the Commercial Banking
System.

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 ● Central Bank:
⮚ It is a very important institution in a modern economy. Almost every country has one central bank.
⮚ India got its central bank in 1935. Its name is the 'Reserve Bank of India'.
⮚ It issues the currency of the country.
⮚ It controls money supply of the country through various methods, like bank rate, open market
operations and variations in reserve ratios.
⮚ It acts as a banker to the government.
⮚ It is the custodian of the foreign exchange reserves of the economy.
⮚ It also acts as a bank to the banking system.

Note: Currency issued by the central bank can be held by the public or by the commercial banks, and is
called the 'high-powered money' or 'reserve money' or 'monetary base' as it acts as a basis for credit
creation.

● Commercial Banks:
⮚ They accept deposits from the public and lend out part of these funds to those who want to borrow.
⮚ The interest rate paid by the banks to depositors is lower than the rate charged from the borrowers.
⮚ This difference between these two types of interest rates, called the 'spread'. It is the profit
appropriated by the bank.
⮚ People prefer to keep money in banks because banks offer to pay some interest on any deposits
made. Also, it may be safer to keep excess funds in a bank, rather than at home.
⮚ Cheques and debit cards make transactions more convenient and safer, even when they do not
earn any interest.
⮚ However, a bank must balance its lending activities to ensure that sufficient funds are available to
repay any depositor on demand, to maintain depositor confidence.

Money Creation by the Banking System:

● Money creation is a process by which the money supply of a country is increased. Banks play a crucial
role in money creation.
● Money is created by banks through lending activities. Banks can lend because they do not expect all
the depositors to withdraw what they have deposited at the same time.
● When the banks lend to any person, a new deposit is opened in that person's name. Thus, the total
MONEY AND BANKING

money supply increases, as these new deposits are added to the already existing deposits with the
bank.

Money Multiplier:
● It is concept, through which money creation by the banking system can be understood.
● Assume that a bank gets an initial deposit of Rs.100. The CRR for instance is say 10%. Meaning that
the bank can lend 90% of the deposit, which is Rs 90.

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 ● For these Rs.90 that have been lent, a new account in the name of the borrower will be opened in the
bank.
● After opening a new bank account, the total desists with the bank is Rs (100 + 90) = Rs. 190.
● Now, if again 90 % of this amount would be lent. This cycle will continue till the required reserve will
itself become the original Rs.100.
● This process is called the money multiplier and it increases the money supply till the extent of 1/ Cash
Reserve Ratio.
Money Multiplier = 1/ Cash Reserve Ratio
● Thus, with the Cash Reserve Ratio of 10%, initial deposits of Rs.100 create deposits of 1/10% * 100 =
Rs.1000.

Limits to Credit Creation:

● The RBI determines a limit on the amount that banks can lend, to ensure that no bank is Over Lending.
● It also decides a certain percentage of deposits which every bank must keep as reserves. This is a
legal requirement and is binding on the banks. This is called the 'Required Reserve Ratio' or the
'Reserve Ratio' or 'Cash Reserve Ratio' (CRR)
⮚ CRR is the percentage of deposits which a bank must keep as cash reserves with the bank.
● Apart from the CRR, banks are also required to keep some reserves in liquid form in the short term. This
ratio is called Statutory Liquidity Ratio or SLR.

Policy Tools to Create Money Supply:

RBI plays a very important role as the only issuer of currency in India, and also provides funds to the
commercial banks. Being ready to lend to the banks at all times is another important function of RBI as the
Lender of Last Resort.
RBI uses Quantitative as well as Qualitative methods to control money supply in the market.

Quantitative Methods:
● This method uses tools (also known as monetary policy instruments) such as CRR, SLR, Bank rate,
Open Market Operations (OMOs), to control the supply of money in the market. To control money
supply RBI changes the rates of such instruments based on the requirements.
● Open Market Operations: It refers to buying and selling of government bonds in the open market. This
function is entrusted to the RBI.
MONEY AND BANKING

⮚ When RBI buys a Government bond in the open market, it pays for it by giving a cheque. This
cheque increases the total amount of reserves in the economy and thus increases the money supply.
⮚ Selling of a bond by RBI to private individuals or institutions leads to reduction in quantity of
reserves and hence the money supply.
⮚ There are two types of open market operations: outright and repo. Outright open market operations
are permanent in nature: when the central bank buys these securities (thus injecting money into the
system), it is without any promise to sell them later.

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 ⮚ Similarly, when the central bank sells these securities (thus withdrawing money from the system), it
is without any promise to buy them later. As a result, the injection/absorption of the money is of
permanent nature.
● Repurchase agreement (Repo): When the RBI buys the security, this agreement of purchase also has
specification about date and price of resale of this security (The lending Interest Rate is called repo
rate).
● Reverse Repo: is an agreement where instead of outright sale of securities the central bank may sell
the securities through an agreement which has a specification about the date and price at which it
will be repurchased. The rate at which the money is withdrawn in this manner is called the reverse
repo rate.
⮚ The Reserve Bank of India conducts repo and reverse repo operations at various maturities:
overnight, 7-day, 14- day, etc. This type of operations has now become the main tool of monetary
policy of the Reserve Bank of India.
● Bank rate: It is the rate at which RBI gives loans to the commercial banks. By changing it, the money
supply can be influenced. Due to an increase in the bank rate, loans taken by commercial banks become
more expensive; this reduces the reserves held by the commercial bank and hence decreases money
supply and vice-versa in case of decrease in the bank rate.

Qualitative Methods:
● It includes persuasion by the Central bank in order to make commercial banks discourage or encourage
lending, which is done through moral suasion, margin requirement, etc.
● Moral Suasion: It is a moral act of persuasion appeal aimed to influence or change behaviour using
verbal or rhetorical techniques.
● Margin Requirement: This is the difference between the value of the security being provided as
collateral and the loan being granted.

Demand and Supply of Money: A Detailed Analysis:

● Money is the most liquid of all assets and can be exchanged for other commodities very easily.
● On the other hand, it has an opportunity cost of the interest foregone, that could have been earned by
putting that money into for instance a Fixed Deposit, instead of holding it in cash.
● While deciding on the amount of money to be held at a certain point of time, the consideration of the
trade-off between the advantage of liquidity and the disadvantage of the foregone interest, has to be
considered. Demand for money balance is thus often referred to as liquidity preference.
● Money is held for two broad motives: transaction motive and speculative motive.
MONEY AND BANKING

Transaction Motive:
● The principal motive for holding money is to carry out transactions.
● The expenditure pattern generally does not meet our receipts, that is the time at which money is
received and the time at which expenditure transactions are conducted from that amount of money,
are different.

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 ● For instance, salary of Rs.100 is received on the first day of the month, but expenditures from this
amount are evenly spread throughout the month.
● While transactions are conducted, money changes hand that is, it moves from one entity to other.
● The number of times a unit of money changes hands during the unit period is called the velocity of
circulation of money
● The total value of annual transactions in an economy includes transactions in all intermediate goods
and services and is much greater than the nominal GDP.
● However, normally, there exists a stable, positive relationship between value of transactions and the
nominal GDP.
● An increase in nominal GDP implies an increase in the total value of transactions and hence a greater
transaction demand for money.
● Transaction demand for money is positively related to the real income of an economy and also to its
average price level.

Speculative Motive:
● Speculation means the assumptions about the future value of a commodity/ asset etc.
● In case people in an economy, have positive speculation about the future prices of an asset like say
bonds etc. they would convert their current money holding into bonds, to make profits in the future.
● However, if they speculate that the prices of bonds will go down in the future, they will convert their
current bond holdings into money, to prevent future losses.

Supply of Money:
● The things that constitute money are as follows:
● Currency notes and coins issued by the monetary authority of the country.
⮚ In India currency notes are issued by the Reserve Bank of India (RBI).
⮚ Coins are issued by the Government of India.
● The balance in savings, or current account deposits, held by the public in commercial banks is also
considered money since cheques drawn on these accounts are used to settle transactions.
⮚ Such deposits are called Demand Deposits, as they are available on demand of the account holder.
● Deposits having a fixed period to maturity for example fixed deposits.
⮚ Such deposits are referred to as time deposits.
MONEY AND BANKING

Legal Definitions of Money Supply:

● The value of the currency notes and coins is derived from the guarantee provided by the issuing
authority (the RBI).
● The value of the paper itself in a Rs.100 note is negligible. RBI will be responsible for giving the
person purchasing power equal to the value printed on the note, hence providing it value and
acceptability.

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 ● Currency notes and coins are therefore called fiat money. They do not have intrinsic value like a gold or
silver coin.
● Currency notes and coins are also called legal tenders as they cannot be refused by any citizen of the
country for settlement of any kind of transaction.
● Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of
payment. Hence, demand deposits are not legal tenders.
● The total stock of money in circulation among the public at a particular point of time is called money
supply (Stock Variable)
● RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4, defined
as follows:
⮚ M1 = CURRENCY (NOTES PLUS COINS) HELD BY THE PUBLIC + NET DEMAND DEPOSITS HELD
BY THE COMMERCIAL BANKS.
o Note: Only deposits of the public held by the banks are to be included in money supply. The
interbank deposits, which a commercial bank holds in other commercial banks, are not to be
regarded as part of money supply.
⮚ M2 = M1 + SAVINGS DEPOSITS WITH POST OFFICE SAVINGS BANKS
⮚ M3 = M1 + NET TIME DEPOSITS OF COMMERCIAL BANKS
⮚ M4 = M3 + TOTAL DEPOSITS WITH POST OFFICE SAVINGS ORGANISATIONS (EXCLUDING
NATIONAL SAVINGS CERTIFICATES)
● M1 and M2 are known as Narrow Money. M3 and M4 are known as Broad Money
● These measures from M1 to M4 are in the decreasing order of liquidity (M1 being the most liquid and
M4 being the least liquid). M3 is the most commonly used measure of Money Supply. Known as
aggregate monetary resources.
Demonetisation:
● It is an act of cancelling the legal tender status of a currency unit in circulation.
● The Government of India, in the year 2016, demonetised currency notes of Rs 500 and Rs 1000, with
an aim to tackle the problem of corruption, black money, terrorism, and circulation of fake currency in
the economy.
● Some of the positive impacts of demonetisation:
⮚ Improved tax compliance.
⮚ Savings of more individuals were channelized into the formal financial system.
⮚ Banks have more resources at their disposal which can be used to provide more loans at lower
MONEY AND BANKING

interest rates.
⮚ Demonstration of State's decision to put a curb on black money, showing that tax evasion will no
longer be tolerated.
⮚ Tax evasion will result in financial penalty and social condemnation.
⮚ Tax compliance will improve and corruption will decrease.
⮚ Households and firms have begun to shift from cash to electronic payment technologies.

15
 DETERMINATION OF INCOME AND
4 EMPLOYMENT
Determination of income and employment is the core of the subject matter of macroeconomics. Aggregate
demand and aggregate supply together determine the level of income and employment in an economy.

Aggregate Demand and Its Components:

Aggregate demand is the total demand for all goods and services produced in an economy. Aggregate
demand is the sum of consumption (both autonomous and induced consumption) and investment.

Consumption:
● It is the demand for goods and services used by people in an economy for day-to-day consumption.
● Consumption is most importantly determined by the household income. In general, consumption
expenditure increases with an increase in income and decreases with the decrease in household
income.
● A consumption function describes the relation between consumption and income. The simplest
consumption function assumes that consumption changes at a constant rate as income changes.
● Some important terms related to Consumption Function:
⮚ Autonomous Consumption: A certain level of consumption takes place even when income is
zero. Since this level of consumption is independent of income, it is called autonomous
consumption.
⮚ Induced Consumption: It is the portion of consumption that varies with the disposable income.
⮚ Consumer Demand is the sum of Autonomous Consumption and Induced Consumption.
⮚ Marginal propensity to consume (MPC): It is the change in consumption per unit change in income.
MPC lies between 0 and 1, this means that as income increases wither the consumer does not
increase consumption at all (MPC = 0) or use entire change in income on consumption (MPC = 1) or
use part of the change in income for changing consumption (0< MPC<1).
⮚ Marginal propensity to save (MPS): It is the change in savings per unit change in income.

DETERMINATION OF INCOME AND EMPLOYMENT

⮚ Average propensity to consume (APC): It is the consumption per unit of income.
⮚ Average propensity to save (APS): It is the savings per unit change in income.

Investment:
● It is defined as addition to the stock of physical capital (machines, buildings, roads etc.) that adds to
the future productive capacity of the economy and changes in the inventory (stock of finished goods)
of a producer.
● Investment goods (such as machines) are also part of the final goods unlike intermediate goods like
raw materials, which are used up in the production process.
● The decision to invest is taken by the producers, largely based upon the prevailing market interest
rates.

Determination of Income:
● Income is the money earned or received by individual or business, especially on a regular basis, for a
work or through investments or through productions.

16
 ● The national income can be determined by summing up the all the incomes earned by individuals,
firms, governments from various economic activities. The term output can be interchangeably used as
income.
● Aggregate demand is an important determinant of income. The aggregate demand for final goods is
the sum total of consumption expenditure and investment expenditure on goods.
● However, the major economic activities of the government also affect the aggregate demand for final
goods and services can be summarized by the fiscal variables Tax (T) and Government Expenditure (G)
⮚ Government, through its expenditure on final goods and services, adds to the aggregate demand
like other firms and households.
⮚ On the other hand, taxes imposed by the government take a part of the income away from the
household, which reduces the disposable income.
● Therefore, the income can be determined by summing up consumption (autonomous), investment
(autonomous), government expenditure and induced consumption after taxes (Income – taxes).

Paradox of Thrift: If all the people of the economy increase the proportion of income they save, the total
value of savings in the economy will not increase - it will either decline or remain unchanged. This result is
known as the Paradox of Thrift, which states that as people become thriftier (tend to spend less) they end
up saving less or same as before.
This happens as follows:
When people become thriftier, the consume less than before hence pulling down the AD.
Due to the reduction in AD, a situation of excess supply is created in the market.
Due to piling up of stocks, and reduced production activity, the flow of factor payments
from firms to the households also reduce.
This pull downs the incomes of the households, as the MPC had already reduced due to
DETERMINATION OF INCOME AND EMPLOYMENT

people becoming thriftier the fall in incomes will again reduce the AD in the market.
Due to the reduction in incomes, the impact of reduced consumption is not evenly observed on the
savings by the people, they either save the same or even lesser.

Equilibrium:
● An equilibrium situation in the market which arises, when the aggregate demand is equal to the
aggregate supply.
● Aggregate demand that is the demand for all finished goods and services produced in an economy,
whereas the aggregate supply that is the total supply of finished goods and services available in an
economy.

Investment Multiplier:
● It is the ratio of the change in national income to the initial change in planned investment
expenditure.

17
● It can also be defined as the ratio of the total increment in equilibrium value of final goods output to the
initial increment in autonomous expenditure is called the investment multiplier of the economy.
● Thus, for instance, if a change in investment of Rs 2000 may cause a change in national income of Rs
8000, the multiplier (8000/2000) is 4.

Interesting points

● Full Employment Level of Income: That level of income where all the factors of production are fully
employed in the production process. (Factors of production include Land, Labour, Physical Capital
and Human Capital).
● Deficient Demand: A situation where the equilibrium level is less than the full employment of
output since demand is not enough to employ all factors of production. It leads to decline in prices in
the long run.
● Excess Demand: A situation where the equilibrium level of output is more than the full
employment level, since demand is more than the level of output produced at full employment level.
It leads to rise in prices in the long run.

DETERMINATION OF INCOME AND EMPLOYMENT

18
 5 GOVERNMENT BUDGET
AND THE ECONOMY
The government prepares the budget every year for fulfilling certain national objectives such as allocation of
scarce resources, distribution of income, reducing regional disparity, etc.
In a Mixed Economy where both the public as well as private sector exists, the government can influence the
economy in many ways, one such way is the government budget.

Government Budget:
● It is the annual financial statement of the government.
● It shows the receipts and expenditure of the government for a particular financial year.
● Article 112 of the Indian Constitution makes a requirement in India to present before the Parliament a
statement of estimated receipts and expenditures of the government in respect of every financial year
which runs from 1 April to 31 March.
● The budget comprises mainly of two accounts:
⮚ revenue account (revenue budget), that relate to the current financial year transactions; and
⮚ capital account (capital budget), that relate to the assets and liabilities of the government.

Objectives of Government Budget:

● Allocation of resources: Through budget the government allocates and mobilise resources that
benefit all. This also provide public goods and services such as national defence, roads, government
administration etc.
● Income redistribution:
⮚ The government sector affects the personal disposable income of households by making transfers
and collecting taxes to ensure a fair and equitable distribution of this income.
⮚ The redistribution objective is sought to be achieved through progressive income taxation, in
which higher the income, higher is the tax rate.
⮚ With respect to indirect taxes, necessities of life are exempted or taxed at low rates, comforts and
GOVERNMENT BUDGET AND THE ECONOMY

semi-luxuries are moderately taxed, and luxuries, tobacco and petroleum products are taxed
heavily.
● Economic stabilisation:
⮚ Economic stabilisation is crucial to correct fluctuations in income and employment. Any
intervention by the government to expand or to reduce the aggregate demand in the economy
constitutes the stabilisation function.
⮚ The overall level of employment and prices in the economy depend upon the level of aggregate
demand which in turn depends upon the spending by private and government entities.

Components of Budget:
The budget primarily consists of two components such as receipts and expenditures. The receipts are
further classified into revenue receipts and capital receipts whereas the expenditures are further classified
into revenue expenditure and capital expenditure.

19
Revenue Receipts:
● These receipts that do not lead to a claim on the government (that is, they neither create a liability nor
decrease an asset for the government). They are divided into tax and non-tax revenues.
● Tax revenues, further are divided into:
⮚ Direct Taxes: Like personal income tax and corporation tax etc.
⮚ Indirect Taxes: Like excise taxes (duties levied on goods produced within the country), customs
duties (taxes imposed on goods imported into and exported out of India) and service tax.
⮚ Other direct taxes like wealth tax, gift tax and estate duty (now abolished) have never brought in
large amount of revenue and thus have been referred to as 'paper taxes'.
● Non-tax revenue, of the central government mainly consists of:
⮚ Interest Receipts on account of loans by the central government.
⮚ Dividends and profits on investments made by the government,
⮚ Fees and other receipts for services rendered by the government.
⮚ Cash grants-in-aid from foreign countries and international organisations are also included. T
● The estimates of revenue receipts take into account the effects of tax proposals made in the Finance
Bill.

Capital Receipts:
● All those receipts of the government which create liability or reduce financial assets are termed as
capital receipts.
● These receipts can be debt creating or non-debt creating.
● Examples of these receipts include:
⮚ Money received by way of Loans (Liability of future re-payment is created here).
⮚ Money received by, sale of government assets, like sale of shares in Public Sector Undertakings

GOVERNMENT BUDGET AND THE ECONOMY

(PSUs) which is referred to as PSU disinvestment, sale of assets etc. (This reduces the asset pool
held by the government).

Revenue Expenditure:
● It is expenditure incurred for purposes other than the creation of physical or financial assets of the
central government.
● This, expenditure relates to the expenses incurred for the normal functioning of the government
departments and various services, interest payments on debt incurred by the government, and
grants given to state governments and other parties (even though some of the grants may be meant
for creation of assets).
● Subsidies, also constitute a significant part of the Revenue Expenditure, which are incurred on under-
pricing of goods, subsidised health, exports etc.

20
 Capital Expenditure:
● These are the expenditures of the government which result in creation of physical or financial assets or
reduction in financial liabilities.
● This includes expenditure on the acquisition of land, building, machinery, equipment, investment in
shares, and loans and advances by the central government to state and union territory governments,
PSUs and other parties.

Fig 5.1: Government Budget

Budget as a National Policy Statement:

GOVERNMENT BUDGET AND THE ECONOMY

● Instead of merely being a statement of receipts and expenditures, the budget has also become a
significant national policy statement.
● Along with the budget, three policy statements are mandated by the Fiscal Responsibility and Budget
Management Act, 2003 (FRBMA).
● The Medium-term Fiscal Policy Statement: It sets a three-year rolling target for specific fiscal
indicators and examines whether revenue expenditure can be financed through revenue receipts on a
sustainable basis and how productively capital receipts including market borrowings are being
utilised.
● The Fiscal Policy Strategy Statement: It sets the priorities of the government in the fiscal area,
examining current policies and justifying any deviation in important fiscal measures.
● The Macroeconomic Framework Statement: It assesses the prospects of the economy with respect to
the GDP growth rate, fiscal balance of the central government and external balance.

21
Balanced, Surplus and Deficit Budget:
● Balanced Budget: The government may spend an amount equal to the revenue it collects. In case the
government need to incur higher expenditure, a similar amount of revenue would have to be raised, in
order to keep the budget balanced.
● Surplus Budget: A situation, in which the amount of tax collection exceeds the required amount of
expenditure.
● Deficit Budget: This the most common situation, in which the Government's expenditure amount
exceeds the amount of revenue raised.

Measures of Government Deficit:

The amount of deficit (When the spending is more than the revenue earned), can be captured in different
ways, each having their own implications for the economy.

Revenue Deficit:
● This refers to the excess of the Government's revenue expenditure over its' revenue receipts.

Revenue deficit = Revenue expenditure – Revenue receipts

● The revenue deficit includes only such transactions that affect the current income and expenditure of
the government.
● Revenue deficit in 2018-19 was 2.3 per cent of GDP.

Implications of Revenue Deficit on the Economy:

● It implies that the government is dissaving and is using up the savings of the other sectors of the
economy to finance a part of its consumption expenditure.

GOVERNMENT BUDGET AND THE ECONOMY

● This situation means that the government will have to borrow to even finance the day-to-day
consumption requirements in addition to borrowing for investments.
● High borrowing will eventually lead to high debt and interest payment obligations, which will force the
government to eventually cut expenditure.
● However, since a major part of revenue expenditure is committed expenditure (in a sense that the
payment obligations have already been created even before the actual payment is done for example
salaries of government staff etc.), it cannot be reduced.
● Hence, often the government reduces productive capital expenditure or welfare expenditure.
● Overall, this leads to lower growth and adverse welfare implications.

Fiscal Deficit:
● It is the difference between the government's total expenditure and its total receipts excluding
borrowing.
Gross fiscal deficit = Total expenditure – (Revenue receipts + Non-debt creating capital receipts)

22
 ● Non-debt creating capital receipts are those receipts which are not borrowings and, hence do not
give rise to debt (E.g.: Proceeds from the sale of Public Sector Undertakings).
● These Non-debts creating capital receipts are obtained by subtracting, borrowing and other
liabilities from total capital receipts.
● The fiscal deficit will have to be financed through borrowing. Thus, indicating the total borrowing
requirements of the government from all sources.
● This borrowing can also be calculated as follows:
Gross fiscal deficit = Net borrowing at home (Money directly borrowed from the public through debt
instruments + indirectly from commercial banks through Statutory Liquidity Ratio) + Borrowing from
RBI + Borrowing from abroad

Implications of Fiscal Deficit:

● It is a key variable in judging the financial health of the public sector and the stability of the economy.
● It can be seen that revenue deficit is a part of fiscal deficit (Fiscal Deficit = Revenue Deficit + Capital
Expenditure - non-debt creating capital receipts).
● A large share of revenue deficit in fiscal deficit indicated that a large part of borrowing is being used to
meet its consumption expenditure needs rather than investment.

Primary Deficit:
● The goal of measuring primary deficit is to focus on present fiscal imbalances.
● Primary deficit is calculated to obtain an estimate of borrowing on account of current expenditures
exceeding revenues. It is simply the fiscal deficit minus the interest payments.
● The total borrowing requirements, of the government also include an amount incurred on account of
interest payments on old, accumulated debt (loans).
GOVERNMENT BUDGET AND THE ECONOMY

Gross primary deficit = Gross fiscal deficit – Net interest liabilities

● Net interest liabilities consist of interest payments minus interest receipts by the government on net
domestic lending.

Government Debt:
Budgetary deficits can be financed by either taxation, borrowing or printing money. To finance such deficit
the governments have mostly relied on borrowing, known as government debt.
However, if the government continues to borrow year after year, the outstanding debt accumulates causing
greater interest liability, which itself can become another reason for further borrowings.

Perspectives on the Handling of Government Debt:

● The debt of the government can be financed by raising money through taxation or printing new
currency.

23
 ● However, borrowing by the government today may create a burden on future generations, as
money borrowed today may be paid by the government some decades later, financed by new taxes on
the young generation, reducing their disposable incomes.
● Also, government borrowing from the people reduces the savings available to the private sector.
● There, are two broad views on the handling of government debt:
⮚ Second view holds that households are forward-looking and will base their spending not only on
their current disposable income but also on their expected future income and hence will increase
their savings today.
● They will understand that borrowing today means higher taxes in the future. Further, the consumer
will be concerned about future generations.
● Such an increase in household savings will offset the dissaving that the government would have to
do on account of budgetary deficit and the national savings will stay at a constant level.
● This, second view is also called as the Ricardian equivalence, named after nineteenth century
economists David Ricardo.

Other Perspectives on Deficits and Debt:

Inflationary perspective:
● One of the main criticisms of deficits is that they are inflationary.
● As increase in government spending or tax cut leads to an increase in AD.
● But firms may not be able to meet the increased demand due to which the prices of existing output will
rise (Situation of Inflation).
● However, if there are unutilised resources able to match the increased AD. A high fiscal deficit is
accompanied by higher demand and greater output and, therefore, need not be inflationary.

Crowding Out perspective:

GOVERNMENT BUDGET AND THE ECONOMY

● When government borrows, there is a decrease in investment due to a reduction in the amount of
savings available to the private sector.
● This is because if the government decides to borrow from private citizens by issuing bonds to finance
its deficits, these bonds will compete with corporate bonds and other financial instruments for the
available supply of funds.
● If some private savers decide to buy bonds, the funds remaining to be invested in private hands will be
smaller.
● Thus, some private borrowers will get 'crowded out' of the financial markets as the government
claims an increasing share of the economy's total savings.
However, the above perspectives hold true under the circumstances, where the government deficit and
resultant debt would not be able to augment the incomes in the economy. If due to deficit budgets, incomes
see a steady rise the negative externalities can be off set.
Similarly, investment in better infrastructural facilities today may prove to be very beneficial for the future
generations.

24
 Hence, debt should not be considered burdensome at the face of it, however judged in accordance with
the overall growth of the economy.

Deficit Reduction:
Government deficit can be reduced by an increase in taxes or reduction in expenditure.

Deficit Reduction scenario in India:

● The government has been trying to increase tax revenue with greater reliance on direct taxes as
indirect taxes are regressive in nature and they impact all income groups equally.
● Receipts are being raised through the sale of shares in PSUs.
● However, the major thrust has been towards reduction in government expenditure, through better
planning of programmes and better administration.

Suggestive Measures:
● Changing the scope of the government by withdrawing from some of the areas where it operated
before (non-core government activities).
● As, cutting back government programmes in vital areas like agriculture, education, health, poverty
alleviation, etc. would adversely affect the economy.
● However, it must be noted that larger deficits do not always signify a more expansionary fiscal policy
(aiming to increase income and output through increased government spending and reduced
taxes).
● The same fiscal measures can give rise to a large or small deficit, depending on the state of the
economy.
● For example, if an economy experiences a recession and GDP falls, tax revenues fall because firms and
GOVERNMENT BUDGET AND THE ECONOMY

households pay lower taxes when they earn less. Meaning that the deficit increases in a recession and
falls in a boom, even with no change in fiscal policy.

Fiscal Policy of the Government:

It is the policy by which the government adjusts its expenditure (spending) and tax rates to increase output
and income and seeks to stabilise the ups and downs in the economy.
The change in Government Spending and Taxation policies impact the functioning of the economy in the
following ways:

Changes is Government Expenditure:

● If taxes are kept constant, and the government consumption expenditure is increased, it increases the
Aggregate Demand (AD) in the economy.

25
 ● At the initial level of output, due to increased government spending, the AD would exceed the supply in
the economy (as government expenditure forms a part of the AD).
● Due to the increased AD, the equilibrium would be disturbed due to which the firms would increase
their production in order to meet the new levels of demand.
● This will set the market equilibrium to a point higher than before.
● This will increase the production capacity in the economy and also the incomes.
● As, under the concept of Circular Flow of Income if all income is spent on consumption then the total
demand in the economy (AD) = Income (Y). Hence increased AD = Increased Y.

Changes in Taxes:
● A cut in taxes increases disposable income at each level of income.
● Due to the increased disposable income, the consumption expenditure of the households will also
increase, in proportion to the tax cut.
● Changes in government expenditure impact the economy directly by increasing the AD, however,
changes in taxes impact this mechanism through changes in the disposable incomes of the
households.

Proportional Income Tax:

Under proportional income tax government collects a constant fraction, of income in the form of taxes. This
kind of taxation acts as an automatic stabiliser because:
● It makes disposable income, and thus consumer spending, less sensitive to fluctuations in GDP.
● When GDP rises, disposable income also rises but by less than the rise in GDP because a part of it is
siphoned off as taxes. This helps limit the upward fluctuation in consumption spending.
● During a recession when GDP falls, disposable income falls less sharply, and consumption does not
drop as much as it otherwise would have fallen had the tax liability been fixed. Thus, reducing the fall

GOVERNMENT BUDGET AND THE ECONOMY

in aggregate demand and stabilises the economy.

Fiscal Responsibility and Budget Management Act, 2003 (FRBMA):

The enactment of the FRBMA, in August 2003, marked a turning point in fiscal reforms, binding the
government through an institutional framework to pursue a prudent fiscal policy.
Aim: That, the central government must ensure intergenerational equity and long-term macro-economic
stability by achieving sufficient revenue surplus, removing fiscal obstacles to monetary policy and effective
debt management by limiting deficits and borrowing.

Main Features of the Act:

It mandates the Central Government to:
● Reduce fiscal deficit to not more than 3 percent of GDP.
● Eliminate the revenue deficit by March 31, 2009 and thereafter build up adequate revenue surplus.

26
 ● Reduction in fiscal deficit by 0.3 per cent of GDP each year and the revenue deficit by 0.5 per cent (if
not achieved through the tax revenue, must be achieved by reducing expenditure).
● The actual deficits may exceed the targets specified only on grounds of national security or natural
calamity or such other exceptional grounds as the central government may specify.
● The central government shall not borrow from the Reserve Bank of India except by way of advances to
meet temporary excess of cash disbursements over cash receipts.
● The Reserve Bank of India must not subscribe to the primary issues of central government securities
from the year 2006-07.
● Measures to be taken to ensure greater transparency in fiscal operations.
● The central government to lay before both Houses of Parliament three statements along with the
Annual Financial Statement:
⮚ Medium-term Fiscal Policy Statement
⮚ The Fiscal Policy Strategy Statement
⮚ The Macroeconomic Framework
● Quarterly review of the trends in receipts and expenditure in relation to the budget be placed before
both Houses of Parliament.
The act applies to the central government. However, most states have already enacted fiscal responsibility
legislations which have made the rule based fiscal reform programme of the government more broad based.
However, this act is for fiscal prudence there are fears that it may lead to reduction in welfare expenditure.
Since, the enactment of the FRBMA Indian economy has moved to the states of a middle income country and
much has changed both domestically and globally, while affirming faith in the fiscal principles set out in the
FRBM but to incorporate the changing scenario in the country for better future growth, the FRBM Review
Committee had been constituted.

Goods and Service Tax:

GOVERNMENT BUDGET AND THE ECONOMY

It is a single comprehensive indirect tax, operational from 1 July 2017. GST is levied on the supply of goods
and services, right from the manufacturer/ service provider to the consumer.
The 101st Constitution Amendment Act was enacted to facilitate the GST. The amendment introduced
Article 246A in the Constitution cross empowering Parliament and Legislatures of States to make laws with
reference to Goods and Service Tax imposed by the Union and the States. Thereafter CGST Act, UTGST Act
and SGST Acts were enacted for GST.

Main Features of the Act:

● It is a destination-based consumption tax with facility of Input Tax Credit in the supply chain.
● It is applicable throughout the country with one rate for one type of goods or service.
● It has subsumed (replaced) a large number of Central and State taxes and cesses:
⮚ These include Central taxes like Central Excise Duty, Service Tax, Central Sales Tax, Cesses like KKC
and SBC.

27
 ⮚ State taxes like VAT/Sales Tax, Entry Tax, Luxury Tax, Octroi, Entertainment Tax, Taxes on
Advertisements, Taxes on Lottery /Betting/ Gambling, State Cesses on goods etc
● Five petroleum products have been kept out of GST for the time being but with passage of time, they
will get subsumed in GST.
● State Governments will continue to levy VAT on alcoholic liquor for human consumption.
● Tobacco and tobacco products will attract both GST and Central Excise Duty.
● Under GST, there are 6 (six) standard rates applied i.e. 0%, 3%,5%, 12%,18% and 28% on supply of all
goods and/or services across the country.

Differences between old tax regimes and GST:

● Pre GST tax regime-imposed taxes not on the value added at each stage but on the total value of the
commodity or service with minimal facility of utilisation of Input Tax Credit (ITC).
● The total value included taxes paid on intermediate goods or services amounting to cascading of tax.
● Under GST, the tax is discharged at every stage of supply and the credit of tax paid at the previous
stage is available for set off at the next stage of supply of goods and/or services. It is thus effectively a
tax on value addition at each stage of supply.

Benefits of GST:
● Parity in taxation across the country and extend principles of 'value- added taxation' to all goods and
services.
● It has replaced various types of taxes and cesses, levied by the Central and State/UT Governments.
● GST has simplified the multiplicity of taxes on goods and services.
● The laws, procedures and rates of taxes across the country are standardised.
● It has facilitated the freedom of movement of goods and services and created a common market in the
country.

GOVERNMENT BUDGET AND THE ECONOMY

● It has also reduced the overall cost of production, which will make Indian products/services more
competitive in the domestic and international markets.
● Compliance will also be easier as all tax payment related services like registration, returns, payments
are available online through a common portal.
● It has expanded the tax base, introduced higher transparency in the taxation system, reduced human
interface between Taxpayer and Government and is furthering ease of doing business.

28
 OPEN ECONOMY
6 MACROECONOMICS
An open economy is one which interacts with other countries through various channels such as trade in
goods and services and most often in financial assets. Today, most modern economies are open. There are
three ways in which these linkages are established:
● Output Market: It enables trading in goods and services with other countries. This enables a choice
between foreign and domestic goods for both consumers and domestic and foreign markets for
producers.
● Financial Market: Most often an economy can buy financial assets from other countries. This gives
investors the opportunity to choose between domestic and foreign assets.
● Labour Market: Firms can choose where to locate production and workers to choose where to work.
There are various immigration laws which restrict the movement of labour between countries.
Due to open nature of the economy, Indians for instance, can consume products which are produced around
the world and some of the products from India are exported to other countries.

Influence of Foreign Trade on Aggregate Demand (AD):

Aggregate demand is the total demand for goods and services within a particular market. Foreign trade can
influence the AD in the country in two ways:
● First, when Indians buy foreign goods, this spending escapes as a leakage from the circular flow of
income decreasing AD.
● Second, our exports to foreigners enter as an injection into the circular flow, increasing AD for goods
produced within the domestic economy.

Exchange Mechanism in Foreign Trade:

● Generally, the economic agents involved in foreign trade accept currencies that are relatively stable
(value of currency does not change frequently) and have international acceptance.
● Different currencies have different values. Thus, in order to facilitate foreign trade, the government
announced that the national currency will be freely convertible at a fixed price into another asset.
● It requires the credibility of the issuing authority and a guarantee to transfer purchasing power in the
hands of even the international holders of the currency.
● This is generally ensured by allowing for convertibility of the currency into some common form of
OPEN ECONOMY MACROECONOMICS

asset.
● In modern times currencies are interpreted in terms of exchange rates that is the price of one currency
in terms of another currency.

There are two aspects of this commitment that has affected its credibility —

⮚ The ability to convert freely in unlimited amounts and the price at which this conversion takes place.
The international monetary system has been set up to handle these issues and ensure stability in
international transactions.
⮚ With the increase in the volume of transactions, gold ceased to be the asset into which national
currencies could be converted.

29
Balance of Payments (BoP):
It is a record of the transactions in goods, services and assets between residents of a country with the rest of
the world for a specified time period typically a year.
There are two main accounts maintained under BoP which are the current account and the capital account.

Current Account:
● It is the record of trade in goods and services and transfer payments.
● There are three main components in the current account which are, trade in goods, trade in services
and transfer payments.

Fig 6.1: Components of Current Account

● Trade in goods includes exports and imports of goods.

● Trade in services includes factor income and non-factor income transactions.

OPEN ECONOMY MACROECONOMICS

● Transfer payments are the receipts which the residents of a country get for 'free', without having to
provide any goods or services in return. They could be given by the government or by private citizens
living abroad.
● Balance on Current Account: Current Account is in balance when receipts on current account are
equal to the payments on the current account.
⮚ A surplus current account means that the nation is a lender to other countries.
⮚ A deficit current account means that the nation is a borrower from other countries.
● Balance on current account has two components such as balance of trade and ·balance on invisibles.
● Balance of trade (BoT): It is the difference between the value of exports and value of imports of
goods of a country in a given period of time.
⮚ Export of goods is entered as a credit item in BoT, whereas import of goods is entered as a debit
item in BoT.

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 ⮚ Surplus BoT or Trade surplus will arise if country exports more goods than what it imports.
Whereas deficit BoT or Trade deficit will arise if a country imports more goods than what it exports.
● Balance of invisibles (BoI): It is also referred to as net invisibles. It is the difference between the value
of exports and value of imports of invisibles of a country in a given period of time.
⮚ Invisibles include services, transfers and flows of income that take place between different
countries.
⮚ Services trade includes both factor and non-factor income. Factor income includes net
international earnings on factors of production (like labour, land and capital).
⮚ Non-factor income is net sale of service products like shipping, banking, tourism, software services,
etc.

Current Account Surplus Balanced Current Account Current Account Deficit

Receipts > Payments Receipts = Payments Receipts < Payments

Capital Account:
● It records all international transactions of assets. An asset is any one of the forms in which wealth can
be held, for example: money, stocks, bonds, Government debt, etc.
● There are three main components of capital account which are investment, external borrowings and
external assistance.
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Fig 6.2: Components of Capital Account

● Purchase of assets is a debit item on the capital account. If an Indian buy a UK Car Company, it enters
capital account transactions as a debit item (as foreign exchange is flowing out of India). Sale of assets
like sale of share of an Indian company to a Chinese customer is a credit item on the capital account.

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 ● Balance on Capital Account: Capital account is in balance when capital inflows (like receipt of loans
from abroad, sale of assets or shares in foreign companies) are equal to capital outflows (like
repayment of loans, purchase of assets or shares in foreign countries).
⮚ Surplus in capital account arises when capital inflows are greater than capital outflows.
⮚ Deficit in capital account arises when capital inflows are lesser than capital outflows.

Surplus and Deficits in the Balance of Payments:

● A country that has a deficit in its current account (spending more than it receives from sales to the rest
of the world) must finance it by selling assets or by borrowing from abroad.
● Thus, any current account deficit must be financed by a capital account surplus, that is, a net capital
inflow.

Current account + Capital account = 0

● In this case, in which a country is said to be in balance of payments equilibrium, the current account
deficit is financed entirely by international lending without any reserve movements.
● Alternatively, the country could use its reserves of foreign exchange in order to balance any deficit in its
balance of payments.
● The reserve bank sells foreign exchange when there is a deficit. This is called official reserve sale.
● The basic premise is that the monetary authorities are the ultimate financiers of any deficit in the
balance of payments (or the recipients of any surplus). We note that official reserve transactions are
more relevant under a regime of fixed exchange rates than when exchange rates are floating.

Autonomous Transactions:
● It is also called “above the line” items in BoP.
● International economic transactions are called autonomous when transactions are made due to some
reason other than to bridge the gap in the balance of payments, that is, when they are independent
of the state of BoP.

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● The balance of payments is said to be in surplus (deficit) if autonomous receipts are greater (less) than
autonomous payments.

Accommodating Transactions
● It is also called “below the line” items in BoP. It depends, whether there is a deficit or surplus in the
balance of payments.
● They are determined by the gap in the balance of payments.
● They are also determined by the net consequences of the autonomous transactions.
● Since the official reserve transactions are made to bridge the gap in the BoP, they are seen as the
accommodating item in the BoP (all others being autonomous).

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 Note:
According to the new classification, the transactions are divided into three accounts: current
account, financial account and capital account.
The most important change is that almost all the transactions arising on account of trade in financial
assets such as bonds and equity shares are now placed in the financial account.
However, RBI continues to publish the balance of payments accounts as per the old system.

The Foreign Exchange Market:

It is the market in which national currencies are traded for one another. The rate at which price of one
currency is determined in terms of another is called foreign exchange rate or forex rate.

Demand for Foreign Exchange:

● The demand for foreign exchange arises due to various reasons such as purchasing goods, sending
gifts abroad or purchasing financial assets of a certain foreign country.
● A rise in price of foreign exchange will increase the cost (in terms of rupees) of purchasing a foreign
good. This reduces demand for imports and hence demand for foreign exchange also decreases.

Supply of Foreign Exchange:

● Supply of foreign exchange arises due to the inflow of foreign currency flows into the home country.
● The reasons are exports by a country lead to inflow of forex, foreigners send gifts or make transfers;
and the assets of a home country are bought by the foreigners.
● A rise in price of foreign exchange will reduce the foreigner's cost (in terms of USD) while
purchasing products from India, other things remaining constant.
● This increases India's exports and hence supply for foreign exchange may increase.

Determination of the Exchange Rate:

Various countries use different methods to determine the exchange rates. These methods are as follows:
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Flexible Exchange:
● It is also known as floating exchange rate.
● Under this system, exchange rate is determined by the market forces of demand and supply.
● In a completely flexible system, the Central banks do not intervene in the foreign exchange market.
● An increase in exchange rate implies that the price of foreign currency (dollar) in terms of domestic
currency (rupees) has increased and vice-versa.
⮚ When the price of domestic currency (rupee) in terms of foreign currency (dollar) decreases, it is
called depreciation of domestic currency.
⮚ Similarly, when the price of domestic currency (rupees) in terms of foreign currency (dollars)
increases, it is called appreciation of the domestic currency.

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 ● In a flexible exchange regime, market determines the currency exchange rate. The exchange rate is
typically determined at the equilibrium point on the demand and supply curve.
● More demand for foreign goods may increase the exchange rate because more of domestic currency
has to be paid in order to obtain a unit of foreign currency.

Fixed Exchange Rates:

● In this system, the Government fixes the exchange rate at a particular level.
● The government can maintain any exchange rate in the economy. But it will be accumulating more and
more foreign exchange so long as this intervention goes on.
● Devaluation: It makes the domestic currency cheaper for foreigners by fixing a higher exchange rate
than the current one. It is done to encourage the exports.
● Revaluation: When the government decreases the exchange rate (thereby, making domestic currency
costlier) in a fixed exchange rate system

Demerits and Merits of Flexible and Fixed Exchange Rate Systems:

Demerits of Fixed Exchange Rate System:
● In order for this system to work, there must be credibility that the government will be able to maintain
the exchange rate at the level specified.
● In case of deficit in BoP, governments will have to intervene to take care of the gap by use of its official
reserves.
● In case people learn that the amount in these reserves is insufficient to do so they would begin to doubt
the ability of the government to maintain the fixed rate.
● This may give rise to speculation of devaluation. When this belief translates into aggressive buying of
one currency thereby forcing the government to devalue,
● It is said to constitute a speculative attack on a currency. Fixed exchange rates are prone to these kinds
of attacks.

Managed Floating Exchange Rate System:

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● It is also known as dirty floating exchange rate.
● It is a mixture of a flexible exchange rate system (the float part) and a fixed rate system (the managed
part).
● In this exchange rate regime, RBI intervene in the market to buy and sell foreign currencies in an
attempt to moderate exchange rate movements whenever they feel that such actions are appropriate.
● Official reserve transactions are, therefore, not equal to zero.

Exchange Rate Management: The International Experience and Evolution

● From around 1870 to the outbreak of the First World War in 1914, the prevailing system to determine
the exchange rate of various currencies was the gold standard.
● Under it, all currencies were defined in terms of gold.

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 ● Each country in the framework of this system, committed to guarantee the free convertibility of its
currency into gold at a fixed price.
● This also made it possible for each currency to be convertible into all others at a fixed price.
● Exchange rates were determined by its worth in terms of gold.
● To maintain the official parity each country needed an adequate stock of gold reserves.
● All countries on the gold standard had stable exchange rates.
● However, certain problem arose under this system:
⮚ World prices were at the mercy of gold discovery.
⮚ Subsequently, with mine being unable to produce sufficient gold, the world prices started to fall.
⮚ This gave rise to social unrest in many countries.
● Some alternate ways emerged such as:
⮚ For a period, silver supplemented gold introducing 'bimetallism'.
● Under fractional reserve banking the paper currency of countries was not entirely backed by gold;
typically, countries held one-fourth gold against its paper currency.
● Under gold exchange standard, countries although fixed their currency prices based on gold, but held
little or no gold reserves instead, held the currency of some large country which was on the gold
standard.
● Post-World War 2 Bretton Woods Conference was held in 1944. It made the following changes in the
International Exchange Rate Systems:
⮚ International Monetary Fund (IMF) and the World Bank were set up.
⮚ A system of fixed exchange rates was re-established.
⮚ This was different from the international gold standard in the choice of the asset in which national
currencies would be convertible.
⮚ A two-tier system of convertibility was established at the centre of which was the dollar.
⮚ The US monetary authorities guaranteed the convertibility of the dollar into gold at the fixed price of
$35 per ounce of gold.
● The second tier of the system was the commitment of monetary authority of each IMF member
participating in the system to convert their currency into dollars at a fixed price (called the official
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exchange rate).
● A change in exchange rates was to be permitted only in case of a 'fundamental disequilibrium' in a
nation's BoP – which came to mean a chronic deficit in the BoP of sizeable proportions.

Reasons for introducing this system:

● Distribution of gold reserves across countries was uneven with the US having almost 70 per cent of
the official world gold reserves.
● A credible gold convertibility would have required massive re-distribution of gold reserves.
● It was believed that the existing gold stock would be insufficient to sustain the growing demand for
international liquidity.
● Post–World War II scenario, countries devastated by the war needed enormous resources for

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 reconstruction, raising their imports which put pressure on their forex reserves to finance the BoP
deficit. These reserves mainly consisted of US Dollars at that time.

Problems with this system:

● The holdings of US Dollars by other countries, was in effect a liability for the US to convert dollars into
gold whenever needed.
● Such an extent of the liability in relation to its gold reserves could put convertibility in doubt.
● The central banks would thus have an overwhelming incentive to convert the existing dollar holdings
into gold, and that would, in turn, force the US to give up its commitment.
● This was called the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system.

Further Evolution:
● In 1967, gold was displaced by creating the Special Drawing Rights (SDRs), also known as 'paper
gold', in the IMF as a replacement to gold as an international reserve standard.
● However, SDRs were defined in terms of gold.
● At present, it is calculated daily as the weighted sum of the values in dollars of four currencies (euro,
dollar, Japanese yen, pound sterling).
● It derives its strength from IMF members being willing to use it as a reserve currency and use it as a
means of payment between central banks to exchange for national currencies.
● The original instalments of SDRs were distributed to member countries according to their quota in the
Fund (the quota was broadly related to the country's economic importance as indicated by the value of
its international trade).
Slowly many countries began to adopt the floating exchange rates, and IMF gave the freedom to countries to
decide, if they wanted to go for a floating market determined exchange rate, or peg (tie the exchange rate)
their currencies to a particular asset like the SDR.

The Current Scenario:

● Today, the global exchange rate system is characterized by multiple kinds of regimes, involving free

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floating exchange rates, pegging their exchange rates to other developed countries, introducing
common currencies like Euro etc.
● Most exchange rates fluctuate slightly on a day to day basis, with even those nations tilting towards
fixed exchange rate systems, only specifying a certain range for their currency instead of actually fixing
them.
● Gold is now not being used for exchange rate purposes, instead the prices of gold are controlled by
demand and supply.

Exchange Rate Management in India:

● Post-independence, in line with Bretton Woods system Rupee was pegged to the pound sterling.
● The rupee was devalued by 36.5 per cent in June 1966.

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 ● The rupee was delinked from the pound sterling in September 1975, due to the breakdown of
Bretton Woods system and declining share of UK in India's trade.
● During the period between 1975 to 1992, the exchange rate of the rupee was officially determined
by the Reserve Bank within a nominal band of plus or minus 5 percent of the weighted basket of
currencies of India's major trading partners.
● Requiring day-to-day intervention of the Reserve Bank, which resulted in wide changes in the size of
reserves.
● The exchange rate regime of this period can be described as an adjustable nominal peg with a band.
● In the beginning of 1990s, the situation for India became problematic requiring reforms in line with IMF
recommendations (explained in class 11th Notes).
● Along with other reforms there was a two-step devaluation of 1 8 –19 per cent of the rupee on July 1
and 3, 1991.
● In March 1992, the Liberalised Exchange Rate Management System (LERMS) involving dual
exchange rates was introduced.
● Under this system, 40 per cent of exchange earnings had to be surrendered at an official rate
determined by the Reserve Bank and 60 per cent was to be converted at the market determined rates.
● The dual rates were converged into one from March 1, 1993.
● Current account convertibility was achieved in August 1994. Meaning that the Rupee could now by
converted into any foreign currency at existing market rates for trade purposes for nay amount.
● The exchange rate of the rupee thus became market determined, with the Reserve Bank ensuring
orderly conditions in the foreign exchange market through its sales and purchases.
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