How Savings and Investment Balance the Economy using graph and table.

TABLE

STEP WHAT HAPPENS EXAMPLE

Savings People save more in 1 crore saved by many people
banks
Banks lend Banks give loans to A factory borrows money
businesses
Investment Business invest in Company buys machine
projects
Jobs created Business hire workers Factory hire 100 workers
Income rises Workers earn and Workers buy goods and services
spend money
More savings High income means People save more in banks
more saving
Growth continues More investment More business grow
happens

GRAPH
Blue Line (Savings): People save money over time.
Green Line (Investment): Banks lend savings to businesses for investment.
Red Line (Economic Growth): As investment increases, the economy grows.

When people save more, there is more money for investment, leading to economic growth. But
if savings are too high and investment is low, growth slows down. A good balance is needed
for a healthy economy.
The Keynesian theory of income, output, and employment

The theory was formulated by John Maynerd Keynes in his book General theory of
employment, interest and money in 1936. The theory as a critique of classical theory.
The 1930s Depression-with mass unemployment and stagnant economies-exposed flaws in this
view.
Keynes challenged classical economics, which assumed markets naturally reach full
employment. Keynesian theory stated full employment is rare. Government intervention is
necessary.

Assumptions

[Link]-run focus: "In the long run, we are all dead" economies need immediate fixes, not
waiting for self-correction.
[Link] technology & capital: Production capacity is constant in the short term.
3. Increasing cost. It means if we want to produce more we have to incur a cost.
[Link] economy: Focuses on domestic demand (consumption, investment, government
spending).

Effective Demand:
To determine the level of output and employment. We have to determine effective demand.
Economic equilibrium depends on effective demand where aggregate demand
(ADF) equals aggregate supply (ASF).

AGGREGATE SUPPLY IN ASF

The Aggregate Supply Function (ASF) represents the total supply of goods and services that
all producers in an economy are willing to sell at different price levels. To understand this,
think about individual producers. Every producer incurs costs when they make products, such
as expenses for raw materials, labor, and utilities. As rational businesses, producers aim to
cover these costs and make a profit. Therefore, they expect a minimum amount of revenue from
selling their goods, this is their "minimum expected receipts." When we combine the supply
decisions of all individual producers in the economy, we get the Aggregate Supply Function.
It shows how much total output producers are willing to supply at various price levels.
Generally, as prices increase, producers are willing to supply more because higher prices allow
them to cover costs and earn more profit. However, in the short run, production may face limits
due to fixed resources like labor or capital. Through the ASF we understand how the economy
produces goods and services and helps analyze how changes in costs, technology, or wages
affect overall production and employment levels.

The cost of production includes expenses like raw materials and labor, which producers need
to cover to avoid losses. They expect to earn at least this amount, known as the minimum
expected receipts. When we combine the supply needs of all producers, we create
the Aggregate Supply Function (ASF), showing the total revenue required at various output
levels.

ASF SCHEDULE

Level of emp/output Minimum expected receipts

10 400
20 600
30 800
40 1000
50 1200
50 1400

The Aggregate Supply Function (ASF) schedule shows how the minimum expected receipts
that producers need change as the level of employment and output increases. As more people
are employed and more goods are produced, the minimum expected receipts also rise because
producers have higher costs to cover. However, once the economy reaches full employment,
it becomes difficult to increase output and employment further. At this point, even if
emp/output levels does not increase, the minimum expected receipts can still rise due to factors
like increased costs of materials or wages.
As seen in the table above , while the output might stay the same, the minimum expected
receipts can go up from ₹1,200 to ₹1,400, reflecting that producers still expect more revenue
to cover their rising costs even when they can't produce more goods.

GRAPHICALLY PLOTTED ASF

ASF

Min cap rec

yf
employment

On the Y-axis of the graph, we plot the minimum expected receipts, which represent the
revenue producers need to cover their costs. On the X-axis, we plot employment, which
reflects the number of people working in the economy.
Initially, as employment increases, output also rises, and producers require higher receipts to
cover the growing costs of production. The curve begins at zero because no employment means
no production or costs. However, once the economy reaches full employment (QF) where all
available workers are employed, output and employment cannot increase further. Despite this,
production costs continue to rise due to factors like higher wages or more expensive materials,
causing the curve to keep increasing even though output remains constant. This illustrates that
costs can grow even when production has reached its maximum limit.
ADF

Keynesian Aggregate demand function is the aggregation of all individual demand functions
from differentr sectors in the economy. It reflects how much consumers, businesses, and the
government are willing to spend.

The formula for Aggregate demand is as follows.

AD=C+I+G+Nx

Consumption (C): Spending by households on goods and services.

Investment (I): Business spending on capital goods like machinery and buildings.

Government Spending (G): Expenditures by the government on public services and

infrastructure.

Net Exports (Nx): The value of a country's exports minus its imports.

The Aggregate Demand Function (ADF) can be understood from a consumer's perspective as
the maximum amount consumers are willing to pay for goods and services in an economy.
When consumers make purchasing decisions, they often set an upper limit on the price they
are willing to pay for a product or service. This upper limit reflects their budget constraints and
the perceived value of the product, and it determines whether or not they will make the
purchase. The term "maximum expected sale proceeds" refers to the highest amount consumers
are ready to pay, highlighting their willingness to spend based on affordability and alternatives
available in the market. If the price of a product is below this maximum willingness to pay,
consumers are more likely to buy, whereas if it exceeds this limit, they will refrain from
purchasing. This concept is crucial in understanding aggregate demand because it directly
influences consumer behavior, pricing strategies, and overall economic activity. Higher
aggregate demand occurs when more consumers are willing to pay higher prices, leading to
increased sales and economic growth. The aggregate demand from a consumer's perspective
revolves around their willingness to pay and its impact on purchasing decisions and economic
dynamics.

The amount consumers are willing to spend on goods and services is heavily influenced by
their income levels. When people earn more money, they generally have a higher capacity to
spend, which means they can afford to pay more for products. This increased spending
contributes to higher overall economic output, as businesses respond to demand by producing
more goods and services. As output increases, it often leads to more employment opportunities
because companies require additional workers to meet the heightened demand for their
products. As a result, employment levels rise as businesses expand their operations.
The Aggregate Demand Function (ADF) is considered a positive function because, as the total
output of goods and services in an economy increases, the average price that consumers are
willing to pay for those goods also tends to rise.

Table

Level of output Maximum expected sale proceeds

10 550
20 700
30 850
40 1000
50 1150
50 1300

The Aggregate Demand Function (ADF) schedule in this example shows how output levels
(production) and maximum expected sale proceeds (total spending consumers are willing to
pay) are linked. Starting at an output level of 10 units, the maximum sale proceeds are 550. As
output increases from 10 to 20, 20 to 30, 30 to 40, and 40 to 50 (the full employment level),
and after 50 we see no change in output. On the other hand, the sale proceeds rise steadily to
from 550, 700, 850, 1000, 1150, and 1300, respectively.

SCHEDULE

Plotting the data from the Aggregate Demand Function (ADF) schedule on a graph allows us
to visualize the relationship between output levels and maximum expected sale proceeds.

ADF
Y

Cap sale pro

a
 X
Volume of employment

On y axis we have maximum expected sale proceeds. On x axis we have volume of

employment. The Aggregate Demand Function (ADF) does not begin from the origin because
even at a zero level of income, individuals have basic consumption needs that must be met.
Therefore, it starts from a point above the origin, reflecting the minimum level of spending
required for essential goods and services. As the level of employment and output increases, we
observe a rise in the demand price or maximum expected sale proceeds resulting to an upward
sloping ADF curve.

Determination of Equilibrium at less than full employment.

ADF=ASF
ASF= Supply/costprice
ADF=Demand price/Revenue

Cost = revenue [eq price]

ASF=ADF, C=R, Equilibrium level of output and employment.

ASF greater than ADF, C is greater than R, output and employment have a tendency to
decrease.

ASF lesser than ADF, C is less than R, Output and employment have a tendency to increase.

ASF=ADF
INTEREST RATE FLEXIBILITY/ GOODS MARKET MODEL-
savings=investments.

Classicals always believed S=I

In classical economics, the equilibrium between savings and investments is maintained through
flexible interest rates acting as a self-correcting mechanism. Savings represent the portion of
income not spent on consumption, while investments reflect spending on capital goods.
They said total demand = total supply = full employment.

Classical economists argued that interest rates, the "price" of borrowing, adjust automatically
to ensure savings (S) always equal investments (I).

Classical economists believed that savings and investments are always equal, and if there is
any imbalance between the two, the rate of interest (ROI) will automatically adjust to bring
them back into equilibrium. Savings refer to the portion of income that people do not spend,
while investments represent the money businesses use to buy equipment, build factories, or
expand operations. According to this view, interest rates play a crucial role in balancing savings
and investments because they act as a reward for saving and a cost for borrowing. When the
interest rate is high, people are motivated to save more since they earn higher returns on their
savings. However, businesses tend to invest less because borrowing money becomes
expensive. On the other hand, when the interest rate is low, people save less because the reward
for saving is smaller, while businesses invest more because borrowing is cheaper. This
relationship ensures that savings and investments are functions of the interest rate.

If there is a situation where savings exceed investments (S > I), the surplus savings will push
interest rates down (ROI falls). Lower interest rates discourage saving and encourage
borrowing for investment, which brings savings and investments back into balance.
Conversely, if investments exceed savings (I > S), the high demand for funds will drive interest
rates up (ROI rises). Higher interest rates encourage more saving and discourage excessive
borrowing for investment until equilibrium is restored. In this way, the rate of interest acts as
an automatic stabilizer that ensures savings always equal investments in the economy. This
mechanism helps maintain stability and ensures that all saved money is productively used in
investments.

In the graph we have savings curve and investment curve and they are intersecting at point E.

E= that is equilibrium point when S=I and r is the interest rate. As interest rate increases, moves
upwards from i to i1, we see that savings are more …as seen in d and s.

As the rate of interest decreases, the ROI falls. Savings is greater than investment making us
come back to the equilibrium level.

If there is a shift from i1 to i , we see, sd that is the excess of investment over savings, our roi
tends to rise pushing us back to equilibrium which is E and we are back to S=I.
Inflation measurement
It is typically measured using indexes like the Consumer Price Index (CPI) or the
Wholesale Price Index (WPI).

Inflation is commonly measured using the Consumer Price Index (CPI), which tracks the
average price change of a basket of goods and services over time. For instance, if the CPI
increases by 3% over a year, it means that the general price level of goods and services has
risen by 3%.

CPI is a weighted average of prices for a representative basket of goods and services, including
items such as food, clothing, housing, transportation, and healthcare.

How is CPI Calculated?

The CPI is calculated using the following formula:

CPI = (Cost of the basket of goods now (current year) ÷ Cost of the basket in the past
(base year) × 100

Components of CPI
The CPI basket includes a wide range of goods and services:
Food
Clothing
Housing
Transportation
Healthcare
Education
Entertainment

Uses of CPI
1. Inflation Measurement: CPI is a primary tool for measuring inflation, which helps
policymakers set monetary policies to stabilize the economy.
2. Cost of Living Adjustments: CPI data is used to adjust wages, pensions, and other
benefits to keep pace with inflation.
3. Economic Analysis: It provides insights into consumer spending patterns and
economic conditions.

Limitations of CPI
While CPI is a useful indicator, it has limitations:
• It may not accurately reflect regional price variations or changes in consumer behavior.
• It does not account for all aspects of living standards, such as quality of life
improvements.
INFLATION: SOCIAL COST
Inflation can have several social costs that affect individuals and communities.

Reduced Purchasing Power:

As prices rise, people can buy fewer goods and services with the same amount of money. This
is particularly hard for those living on fixed incomes or with limited financial resources.

Uncertainty and Anxiety:

Inflation can create uncertainty about future prices, making it difficult for people to plan their
finances. This can lead to anxiety and stress.

Inequality:
Inflation can exacerbate income inequality. Those with fixed incomes or limited savings may
struggle more than those who have investments that increase in value with inflation.

Savings Erosion:
Inflation erodes the value of savings over time. Money saved today will be worth less in the
future if inflation is high.

Cost of Living Crisis:

High inflation can lead to a cost-of-living crisis, where many people struggle to afford basic
necessities like food and housing.

Inflation affects not just the economy but also individuals' lives by reducing purchasing
power, creating uncertainty, and exacerbating inequality.
 Major commercial banks in India

Public Sector Banks

• State Bank of India
• Bank of Baroda
• Bank of India
• Bank of Maharashtra
• Canara Bank
• Central Bank of India
• Indian Bank
• Indian Overseas Bank
• Punjab National Bank
• Punjab & Sind Bank
• Union Bank of India
• UCO Bank

Private Sector Banks

• Axis Bank Ltd.
• HDFC Bank Ltd.
• ICICI Bank Ltd.
• Kotak Mahindra Bank Ltd.
• IndusInd Bank Ltd.
• Yes Bank Ltd.
• Federal Bank Ltd.
• Dhanlaxmi Bank Ltd.
• South Indian Bank Ltd.
• Karur Vysya Bank Ltd.
• City Union Bank Ltd.

Commercial banks play a crucial role in the economy by providing various financial
services.

Objectives of Commercial Banks

Profit Maximization
Like any business, commercial banks aim to maximize profits for their shareholders through
efficient management and interest on loans.

Liquidity Maintenance
They ensure enough liquid assets are available to meet daily withdrawal demands, building
trust with depositors.

Safety of Funds
Protecting customer deposits is paramount, employing security measures to prevent loss or
theft.

Economic Growth and Development

By facilitating investments, commercial banks contribute to job creation and overall
economic growth.

Functions of Commercial Banks

Accepting Deposits
They accept various types of deposits, such as savings accounts, current accounts, and fixed
deposits, which form the main source of their funds.

Granting Loans
Commercial banks provide loans for personal, business, and educational purposes, earning
interest on these loans.

Credit Creation
By lending a portion of deposited funds, banks create credit in the economy, which increases
the money supply.

Payment and Settlement Services

They facilitate payments through checks, electronic transfers, and other methods, simplifying
transactions for customers.

Investment Services
Banks may invest funds in securities to generate returns and manage risk effectively.
Central banks serve as the apex bank that oversees and regulates the entire banking sector.
They are responsible for maintaining financial stability, managing the monetary system, and
controlling the supply of money.

RBI - Reserve Bank of India

Establishment:
The RBI was established in 1935 based on the recommendations of the Hilton Young
Commission. It began operations on April 1, 1935, with the Reserve Bank of India Act, 1934,
providing its statutory framework.

Need for Central Banks

[Link] of monetary system.

[Link] and regulation of banking system.
[Link] banking facility.
4. To improve credit facilities.

Objectives of Central Bank

The primary objectives of a central bank include:

Price Stability: Central banks aim to maintain low and stable inflation rates, typically around
2%, to ensure the purchasing power of the currency remains stable over time.

Financial Stability: They work to prevent financial crises by regulating banks, managing
systemic risks, and acting as a lender of last resort to provide liquidity during times of
financial stress.

Economic Growth: Central banks support sustainable economic growth by managing

monetary policy, which includes setting interest rates and controlling the money supply.

Regulation and Supervision: They oversee and regulate financial institutions to ensure their
solvency and stability, maintaining confidence in the banking system.

Exchange Rate Stability: Central banks manage foreign exchange reserves to maintain
stable exchange rates, supporting international trade and financial transactions.

Functions of Central Bank

1. Issue of Notes :

The Reserve Bank has a monopoly for printing the currency notes in the country. It has the
sole right to issue currency notes of various denominations except one rupee note (which is
issued by the Ministry of Finance).
 2. Banker to the government:

The second function of the Reserve Bank is to act as the Banker, Agent and Adviser to the
Government of India and states. It performs all the banking functions of the State and Central
Government and it also tenders useful advice to the government on matters related to
economic and monetary policy. It also manages the public debt of the government.

3. Banker’s Bank:

The Reserve Bank performs the same functions for the other commercial banks as the other
banks ordinarily perform for their customers. RBI lends money to all the commercial banks
of the country.

4. Controller of the Credit:

The RBI undertakes the responsibility of controlling credit created by commercial banks. RBI
uses two methods to control the extra flow of money in the economy. These methods are
quantitative and qualitative techniques to control and regulate the credit flow in the
country. When RBI observes that the economy has sufficient money supply and it may cause
an inflationary situation in the country then it squeezes the money supply through its tight
monetary policy and vice versa.

5. Custodian of Foreign Reserves:

To keep the foreign exchange rates stable, the Reserve Bank buys and sells foreign currencies
and also protects the country's foreign exchange funds. RBI sells the foreign currency in the
foreign exchange market when its supply decreases in the economy and vice-versa.
Currently, India has a Foreign Exchange Reserve of around US$ 487 bn.

6. Other Functions:

The Reserve Bank performs a number of other developmental works. These works include
the function of clearinghouse arranging credit for agriculture (which has been transferred to
NABARD) collecting and publishing the economic data, buying and selling of valuable
commodities etc. also acts as the representative of the Government in the IMF and represents
the membership of India.

7. Lender of last resort

The Reserve Bank of India (RBI) acts as a lender of last resort by providing emergency
loans to solvent banks facing temporary liquidity issues. This role helps maintain financial
stability and prevents systemic crises by ensuring banks can meet their obligations. By doing
so, RBI supports the overall economy and maintains confidence in the banking system.

Additional note
Comparison with other banks

First Central Bank- Bank of England

Established: 1694, making it one of the oldest central banks.
Functions: Similar to RBI, it acts as a banker to the government, regulates the banking
system, and manages monetary policy.
Unique Role: It has a significant role in setting interest rates and managing inflation in the
UK.

Federal Reserve System (USA)

Established: 1913, following a series of financial crises.
Functions: It regulates the U.S. banking system, sets monetary policy, and acts as a lender of
last resort.
Unique Role: It has a dual mandate to maximize employment and stabilize prices.
CREDIT CREATION

Credit creation by commercial banks refers to the process where banks expand the money
supply in an economy by issuing loans and advances to customers. While banks don't
physically print new money, they create credit by recording loans as deposits in the
borrower's account, which increases the money circulating in the economy.

Deposit Mobilization: The process begins when individuals and businesses deposit
funds into their bank accounts. These deposits become the primary source of funds for
banks to lend.

Loan Issuance: Banks keep a portion of these deposits as a reserve, as mandated by

the central bank (Cash Reserve Ratio or CRR), and lend the remaining funds to
borrowers.

For instance, if the reserve ratio is 10%, a bank can lend 90% of the deposits.

Credit Multiplier Effect: When a bank issues a loan, the borrower often deposits the
funds back into the banking system. This money is then re-lent, creating a cycle that
increases the money supply. The re-depositing and re-lending continues, amplifying
the initial deposit amount, known as the money multiplier effect.

If a person deposits ₹10,000 in a AXIS bank with a 10% reserve ratio, the AXIS bank can
lend ₹9,000.
When this ₹9,000 is deposited back to HDFC bank, the HDFC bank can lend ₹8,100 (90% of
₹9,000), and this cycle continues, amplifying the initial deposit through multiple loans.

Formula:

Total credit creation = Original deposit × Credit multiplier coefficient or OD × 1/CRR

Where:
Credit multiplier coefficient = 1/r and
r = Cash reserve ratio (CRR)
For instance, if ₹10,000 is deposited in a bank with a CRR of 10%:
Credit multiplier coefficient = 1/10% = 1/0.1 = 10
Total credit creation = 10,000 × 10 = ₹1,00,000.

Credit creation is influenced by factors such as the availability of cash deposits with banks,
the desire of banks to create credit, and the demand for credit in the market.

How does the cash reserve ratio impact credit creation

The Cash Reserve Ratio (CRR) is a crucial tool used by central banks to control credit
creation. It is the percentage of a commercial bank's total deposits that they must maintain as
liquid cash with the central bank
Increasing CRR: When the central bank increases the CRR, commercial banks are required
to keep a higher proportion of their deposits as reserves. This reduces the amount of funds
available for banks to lend, leading to a decrease in credit availability and potentially slowing
down economic growth. An increase in the CRR decreases the bank's lending power,
resulting in a contraction of the money supply in the economy.

Decreasing CRR: Conversely, when the CRR is lowered, banks have more funds available
to lend. This leads to an increase in credit availability and can potentially stimulate economic
growth. If the RBI reduces the cash reserve ratio, credit creation will increase because banks
have more money at their disposal.

The CRR helps in controlling inflation by limiting excessive credit creation, thus preventing
the economy from overheating. Changes in the CRR can also indirectly impact interest rates.
FLOW IN ECONOMICS: / FLOW OF INCOME

The circular flow model describes the flow of money and goods and services between different
sectors of the economy.
The circular flow of income describes the movement of goods or services and income among
the different sectors of the economy. It illustrates the interdependence of the sectors and the
markets to facilitate both real and monetary flow.

The real flow refers to the flow of factor services and flow of goods and services. The flow of
factor services from the households to the firms and the flow of goods and services from firms
to the household is the real flow. The flow of factor services generates money flows in the form
of factor payments which the firms pay the household and similarly the household need to pay
the firms for the flow of goods and services. The movement to the money/cash payment from
one sector to the other sector corresponding to the real flow is referred to as the monetary flow.
Thus, the income of one sector becomes the expenditure of the other and the supply of goods
and services by one sector becomes the demand of the other sector. The real flow and monetary
flow move in a circular manner in an opposite direction. A continuous flow of production,
income and expenditure is known as circular flow of income.

4 sectors:

Household Sector

This sector includes all the individuals in the economy. The primary function of
this sector is to provide the factors of production. The factors of production include
land, labour, capital and enterprise. The household sectors are the consumers who
consume the goods and services produced by the firms and in return make
payments for the same.

Firms Sector

This sector includes all the business entities, corporations and partnerships. The
primary function of this sector is to produce goods and services for sale in the
market and make factor payments to the household sector.
Government Sector

This sector includes the center, state, and local governments. The prime function
of this sector is to regulate the functioning of the economy. The government sector
incurs both revenue as well as expenditure. The government earns revenue from
tax and non-tax sources and incurs expenditure for provide essential public
services to the people.

Foreign Sector

This sector includes transactions with the rest of the world. Foreign trade implies
net exports (exports minus imports). Exports include goods and services produced
domestically and sold to the rest of the world and imports include goods and
services produced abroad and sold domestically.

3 MARKETS

Goods Market

In this market the goods and services are exchanged among the four
macroeconomic sectors. The consumers are the household, government and the
foreign sector while the producers are the firms.

Factor Market

The factors of production are traded through this market. For the production of final goods and
services, the firms obtain the factor services and make payments in the form of rent, wages and
profits for the services to the household sector.

Financial Market

This market consists of financial institutions such as banks and non-bank

intermediaries who engage in borrowing (savings from households) and lending of
money.
THE CIRCULAR FLOW OF INCOME IN 2 SECTOR MODEL

In this model, the economy is assumed to be a closed economy and consists of

only two sectors, i.e., the household and the firms. A closed economy is an
economy that does not participate in international trade.

In this model, the household sector is the only buyer of the goods and services
produced by the firms and it is also the only supplier of the factors of production.

The household sector spends the entire income on the purchase of goods and
services produced by the firms implying that there is no saving or investment in
the economy.

The firms are the only producer of the good and services. The firms generate
income by selling the goods and services to the household sector and the latter
earns income by selling the factors of production to the former.

Thus, the income of the producers is equal to the income of the households is
equal to the consumption expenditure of the household. The demand of the
economy is equal to the supply. In this model, Y = C where, Y is Income and C
is Consumption.

The circular flow of income in a two sector model is explained with the help of the
following diagram, called Model 1.
CIRCULAR FLOW OF INCOME IN 3 SECTOR MODEL

The three sector model of circular flow of income highlights the role played by the government
sector. This is a more realistic model which includes the economic activities of the government
however; we continue to assume the economy to be a closed one. There are no transactions
with the rest of the world. The government levies taxes on the households and the firms and it
also gives subsidies to the firms and transfer payments to the household sector. Thus, there is
income flows from the household and firms to the government via taxes in one direction and
there is income outflow from the government to the household and firms in the other direction.
If the government revenue falls short of its expenditure, it is also known to borrow through
financial market. . This sector adds three key elements to the circular flow model, i.e., taxes,
government purchases and government borrowings. This is explained with the help of the
following diagram (Model 2).
CIRCULAR FLOW OF INCOME IN 4 SECTOR MODEL
This is the complete model of the circular flow of income that incorporates all the
four macroeconomic sectors. Along with the above three sectors it considers the
effect of foreign trade on the circular flow. With the inclusion of this sector the
economy now becomes an ‘open economy’. Foreign trade includes two
transactions, i.e., exports and imports. Goods and services are exported from one
country to the other countries and imports come to a country from different
countries in the goods market. There is inflow of income to the firms and
government in the form of payments for the exports and there is outflow of income
when the firms and governments make payments abroad for the imports. The
import payments and export receipts transactions are done in the financial market.
This is explained with the help of a diagram (Model 3).
 Theory of Output, Income, and Employment
The theory of output, income, and employment can be understood through two main
perspectives: Classical Theory and Keynesian Theory.

Classical Theory of Output, Income, and Employment

The Classical Theory, rooted in a capitalist economy, suggests that markets operate best with
minimal government intervention, relying on the "invisible hand" of supply and demand to
achieve equilibrium. It believes that full employment is the natural state of the economy, and
any unemployment is temporary as wages adjust to restore balance. In this view, money is just
a medium for transactions, and markets self-correct through changes in prices and wages. On
the other hand, the Keynesian Theory emerged as a response to the limitations of Classical
Theory, particularly during economic downturns like the Great Depression.

Keynes argued that insufficient aggregate demand could lead to prolonged unemployment,
emphasizing the need for government intervention to stimulate demand through public
spending. He believed that wages are "sticky," meaning they don’t easily decrease, which can
prevent quick recovery from economic slumps. Thus, while Classical economists trust in the
self-regulating nature of markets, Keynesians advocate for active policies to manage economic
fluctuations and ensure stability and growth.

CLASSICAL THEORY

SAY’S LAW

Say’s Law, a key principle of the Classical Theory of economics, was developed by French
economist Jean-Baptiste Say in the 19th century. It asserts that production creates its own
demand, meaning that when goods are produced, they generate enough income for people to
buy those goods. In simple terms, the act of producing goods automatically ensures they are
consumed, as the income earned from production is spent on purchasing other goods. This is
why Say’s Law argues that there can be no overproduction in an economy, whatever is
produced will ultimately be consumed, ensuring that aggregate demand (AD) equals aggregate
supply (AS).

The law also emphasizes that savings equal investments. According to Say, whatever portion
of income is saved is not idle but is instead invested back into the economy, fueling further
production and growth. This self-regulating mechanism ensures that resources are efficiently
allocated without the need for government intervention. Classical economists believed that this
natural balance in the economy is maintained by the "invisible hand" of free markets, where
supply and demand forces operate automatically to correct any imbalances. However, this idea
was later criticized by Keynesian economists, who argued that insufficient demand could lead
to prolonged unemployment and economic stagnation.

This self-regulating process is what Classical economists believed would keep the economy
balanced without needing much help from the government. However, later economists like
John Maynard Keynes argued that sometimes demand isn't enough on its own, especially
during economic downturns when people might not spend their income.

WAGE PRICE FLEXIBILITY MODEL

The Wage-Price Flexibility Model is a fundamental concept in Classical economics that

explains how economies can achieve full employment even in the presence of unemployment.
Classical economists assert that if unemployment arises, it is temporary and can be resolved by
adjusting wages. The model suggests that when there is unemployment, businesses may
respond by cutting wages for their existing employees. This reduction in wages lowers the
overall cost of production for companies, making it cheaper to produce goods and services. As
production costs decrease, businesses can afford to lower the prices of their products, which
makes them more attractive to consumers. Consequently, as prices drop, demand for these
goods increases because consumers are more willing to buy items that are now more affordable.
This surge in demand leads to higher sales for businesses, prompting them to ramp up
production to meet this newfound demand. To do so, companies will need to hire additional
workers, thereby reducing unemployment.

The model operates on the assumption that wages and prices are flexible and can adjust freely
without government intervention. It also presumes that money wages reflect real wages
(adjusted for inflation). Ultimately, the Wage-Price Flexibility Model illustrates a self-
correcting mechanism in the economy where lower wages lead to reduced production costs,
lower prices, increased consumer demand, and ultimately higher employment levels, guiding
the economy back toward full employment naturally through market forces.

Key Assumptions in the Model

1. Flexible Wages and Prices: Wages and prices can adjust freely without restrictions.
2. Money Wage = Real Wage: Classical economists assumed that wages automatically
adjust for inflation (real purchasing power remains constant).
3. Self-Regulating Economy: The market corrects itself without government
intervention.
POVERTY

Introduction:

Poverty refers to a situation when people are deprived of basic necessities of life. It is often
characterized by inadequacy of food, shelter and clothes. India is one of the poorest countries
in the world. Many Indian people do not get two meals a day. They do not have good houses
to live in. Their children do not get proper schooling.

The most widely held and understood definition of absolute poverty is defined in
economic terms — earning less than $1.90 per day. According to this standard, anyone
who lacks sufficient financial resources falls below the poverty line and is unable to
meet a basic standard of living. However, being poor is more complicated than simply
not having enough money or having a low income.

Classification of Poverty-

Poverty can be divide into two types Absolute Poverty and Relative Poverty

Absolute Poverty: - It is the complete lack of the means necessary to meet basic personal
needs, such as food, clothing and shelter.

o First proposed in 1990, a dollar-a-day poverty line quantified absolute poverty. In 2015,
the World Bank raised this line to $1.90 per day.

Relative Poverty: - it is the condition in which people lack the minimum amount of income
needed in order to maintain the average standard of living in the society in which they live.
Relative poverty is considered the easiest way to measure the level of poverty in an individual
country.
 o For example, in a place where the average salary is 10,000 rupees, a person earning
5,000 could be said to be relatively poor.

Major Causes of Poverty in India

The major causes of poverty in India are as follows:

Increase in population: The rapid population growth in India has put immense pressure on
the available resources. This has made it difficult to meet the basic needs of all individuals.

Low agricultural productivity: The agricultural sector suffers from low productivity. This is
due to factors such as:

o fragmented land holdings,

o lack of access to modern technology,
o inadequate irrigation facilities, and
o reliance on traditional farming methods.

Unemployment and underemployment: The lack of sufficient job opportunities and the
prevalence of underemployment contribute to poverty. Many individuals, particularly in rural
areas, are engaged in informal jobs that do not provide a stable income.

Lack of access to quality education: Education is a crucial factor in breaking the cycle of
poverty. However, many individuals in India lack access to quality education and skills
training. This limits their employment prospects and income-earning potential.

Social and economic inequalities: India has significant social and economic disparities. This
includes unequal distribution of wealth, income, and opportunities. These inequalities
perpetuate poverty.

Inadequate social infrastructure: Insufficient investment in social infrastructure such as

healthcare, sanitation, and housing leads to:

o poor living conditions,

o limited access to essential services, and
 o increased vulnerability to health risks and financial shocks.

Gender inequality: Gender disparities and discrimination against women contribute to

poverty. Women often face limited economic opportunities. They have restricted access to
resources and decision-making power.

Weaknesses in governance and corruption: Corruption, inefficiency, and lack of

transparency in governance can hinder the effective implementation of poverty alleviation
programs. It affects the equitable distribution of resources, further exacerbating poverty.

Regional disparities: Poverty is concentrated in certain regions of India. This is particularly

true in rural and remote areas. These regions often lack basic infrastructure, leading to
persistent poverty.

Natural disasters and climate change: India is prone to natural disasters. These can cause
significant damage to infrastructure, agricultural productivity, and livelihoods. Climate change
further exacerbates these risks. This disproportionately affects vulnerable communities and
pushes them into poverty.

Deprivation of resources: Natural deprivation of resources as well as forced or situational

deprivation can cause poverty. Lack of proper resources and opportunities deprive people from
their target lifestyle and employment options and push them towards poverty.

A Solution of the problem of poverty : Few points

The following strategy can solve the problem of poverty:

Ø Adopt a strategy of pro-poor growth instead of emphasizing liberalisation and GDP

growth
Ø Stimulating Agricultural growth
Ø Increasing the productivity and job quantity of the unorganised sector
Ø Improving the share of wages in the process of growth to achieve poverty reduction
Ø Empowerment of the poor through education and skill formation
Ø Empowerment through provision of better health
 Ø Empowering the poor through provision of housing
Ø Empowerment through skill formation for our expanding IT sector
Ø Providing employment through National Rural employment guarantee scheme

Few points on specific Measures taken by government to generate employment opportunities.

Employment guarantee scheme (EGS):

Employment Guarantee scheme was first introduced by the Government of Maharashtra on

28th March 1972. This scheme was intended to provide productive employment to the rural
population and thereby solve the problem of rural unemployment and poverty. Under this
scheme, government assures to provide minimum employment opportunities. Due to its
success in Maharashtra, EGS was implemented in other states as well.

Swarnjayanti Gram Swarozgar Yojana(SGSY):This scheme was launched in April, 1999

after restructuring the integrated Rural Development programme (IRDP) and allied schemes.
It is the only self-employment scheme for the rural poor in India.

Swarna Jayanti Shahari Rozgar Yojana(SJSRY): This scheme was launched in December,
1997. It provides gainful employment to the urban unemployed and underemployed. It included
self-employment, women self-employment programme, skill training for employment
promotion and urban wage employment programme. for this scheme, Central Government
shares 75% of the cost and state Government shares 25% of the cost.

Pradhan Mantri Rozgar Yojana(PMRY): This scheme is being implemented since 1993 to
create and provide sustainable self-employment opportunities to more than one million
educated unemployed youth.

Training Rural Youth for Self-employment (TRYSEM): It was initiated in 1979 with the
objective of tackling unemployment problem among the rural youth. It aimed at training about
2 lakh rural youth every year to enable them to become self-employed. TRYSEM was merged
into swarnajayanti Gram Swarozgar Yojana in April 1999.

Jawahar Rozgar Yojana (JRY): On 1st April 1989, the Government announced a new wage
employment scheme, the Jawahar Rozgar Yojana for intensive employment creation in 120
backward districts. It was restricted to rural area. With effect from April 1999, it was renamed
as Jawahar Gram Samrudhi Yojana (JGSY).

Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS): Since

2nd October 2009, National Rural Employment Guarantee scheme has been renamed as
Mahatma Gandhi National Rural Employment Guarantee Scheme. This scheme provides at
least 100 days of guaranteed wage employment in a financial year to at least one member of
every rural household whose adult member volunteers to do unskilled manual work.

Deen Dayal Upadhyaya Grameen Kaushalya Yojana 2014: It is the most important
placement linked skill training programme under the Ministry of Rural Development
announced on September 23, 2014. The mission of this scheme is to reduce poverty as well as
provide gainful and sustainable employment through regular wages. The focus of this
programme is on the rural youth from poor families, in the age group of 15-35 years.

National Policy for skill Development and Entrepreneurship – 2015: the first National
policy on skill development was notified in 2009 to promote private sector participation via
innovative funding models.
The objective of this scheme is to co-ordinate and strengthen factors essential for growth of
entrepreneurship across the country. This would include: i) Promote entrepreneurship culture.
ii) Encourage entrepreneurship as a viable career option through advocacy. iii)
Promote entrepreneurship among women.

Start-up India Initiative: It was introduced in January 2016 with an aspiration to impart more
“strength and inspiration to the talented young generation of India to do something new for
India and humanity”.
Pradhan Mantri Kaushal Vikas Yojana-(2016-20): The objective of this scheme is to
encourage skill development among youth by providing monetary rewards for successful
completion of approved training programmes. The government has allocated a budget of
`12,000 crores till 2020 for implementation of the scheme.
Inflation:

Inflation and unemployment are the two most talked-about words in the contemporary society.

These two are the big problems that plague all the economies.

Almost everyone is sure that he knows what inflation exactly is, but it remains a source of great
deal of confusion because it is difficult to define it unambiguously.

1. Meaning of Inflation:

Inflation is often defined in terms of its supposed causes. Inflation exists when money supply
exceeds available goods and services. Or inflation is attributed to budget deficit financing. A
deficit budget may be financed by the additional money creation. But the situation of monetary
expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining
‘inflation’.

Different definitions of inflations have been given by different Economists some of which are as
follows:

Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the
price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in
the general level or average of prices. In other words, inflation is a state of rising prices, but not
high prices.

According to Coulborn inflation can be defined as, “too much money chasing too few goods.”

According to Samuleson-Nordhaus, “Inflation is a rise in the general level of prices.

In simple terms, Inflation is an economic concept. It refers to the hike in prices of goods, commodities,
and services in a particular economy. With the hike in prices of goods and services, the purchasing
value of money will decrease. So the purchasing power of the consumer will also see a decline.
For example, say the price of a loaf of bread 10 years ago was Rs.20/- and today it is, say Rs 35/-. So
the 15/- increase in the price of a loaf of bread is due to the inflation in the economy.

2. Types of Inflation:

As the nature of inflation is not uniform in an economy for all the time, it is wise to distinguish
between different types of inflation. Such analysis is useful to study the distributional and other
effects of inflation as well as to recommend antiinflationary policies. Inflation may be caused by
a variety of factors. Its intensity or pace may be different at different times. It may also be classified
in accordance with the reactions of the government toward inflation.

Thus, one may observe different types of inflation in the contemporary society:

A. On the Basis of Causes:

(i) Currency inflation:

This type of inflation is caused by the printing of currency notes.

(ii) Credit inflation:

Being profit-making institutions, commercial banks sanction more loans and advances to the
public than what the economy needs. Such credit expansion leads to a rise in price level.

(iii) Deficit-induced inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this
gap, the government may ask the central bank to print additional money. Since pumping of
additional money is required to meet the budget deficit, any price rise may then be called the
deficit-induced inflation.

(iv) Demand-pull inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such
inflation is called demand-pull inflation (henceforth DPI). But why does aggregate demand rise?
Classical economists attribute this rise in aggregate demand to money supply. If the supply of
money in an economy exceeds the available goods and services, DPI appears. It has been described
by Coulborn as a situation of “too much money chasing too few goods.”

DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal axis and
price level on the vertical axis. In Range 1, total spending is too short of full employment output,
YF. There is little or no rise in the price level. As demand now rises, output will rise. The economy
enters Range 2, where output approaches towards full employment situation. Note that in this
region price level begins to rise. Ultimately, the economy reaches full employment situation, i.e.,
Range 3, where output does not rise but price level is pulled upward. This is demand-pull inflation.
The essence of this type of inflation is that “too much spending chasing too few goods.”

(v) Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of
inflation is known as cost-push inflation (henceforth CPI). Cost of production may rise due to an
increase in the prices of raw materials, wages, etc. Higher wage means high cost of production.
Prices of commodities are thereby increased.
A wage-price spiral comes into operation. But, at the same time, firms are to be blamed also for
the price rise since they simply raise prices to expand their profit margins. Thus, we have two
important variants of CPI wage-push inflation and profit-push inflation.

Anyway, CPI stems from the leftward shift of the aggregate supply curve:

B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping inflation. If the
prices increase by 3% or less annually, then such inflation is creeping inflation. Such inflation is not
harmful to the economy. In fact, as per the Federal Reserve, a 2% inflation rate is desirable. It is
necessary for the economic growth of a country.

(ii) Walking Inflation:

The inflation rate falls between 3% to 10%. Such inflation can be harmful to the economy. The
economic growth of the country is too accelerated to sustain. Consumers start stocking goods fearing
the prices will rise further. This causes excess demand and the prices increase further.

(iii) Running Inflation:

A rapid acceleration in the rate of rising prices is referred as Running Inflation. This type of
inflation occurs when prices rise by more than 10% per annum.

(iv) Galloping Inflation:

Galloping inflation also known as Jumping inflation occurs when prices rise by double or triple
digit inflation rates of more than 20% but less than 1000% per annum.

(v) Hyperinflation:

When prices rise at an alarming high rate with quadruple or four digit inflation rate of above
1000% per annum then is termed as Hyperinflation. It is a situation where the prices rise so
fast that it becomes very difficult to measure its magnitude. During a worst case scenario of
hyperinflation, value of national currency of an affected country reduces almost to zero.
Paper money becomes worthless and people start trading either in gold and silver or
sometimes even use the old barter system of commerce. Two worst examples of
hyperinflation recorded in world history are of those experienced by Hungary in year 1946
and Zimbabwe during 2004-2009 under Robert Mugabe's regime.

(vi) Walking Inflation

Walking inflation may be converted into running inflation. Running inflation is dangerous.
If it is not controlled, it may ultimately be converted to galloping or hyperinflation. It is an
extreme form of inflation when an economy gets shattered.”Inflation in the double or triple
digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”.

4. Effects of Inflation:
People’s desires are inconsistent. When they act as buyers they want prices of goods and services
to remain stable but as sellers they expect the prices of goods and services should go up. Such a
happy outcome may arise for some individuals; “but, when this happens, others will be getting the
worst of both worlds.”
When price level goes up, there is both a gainer and a loser. To evaluate the consequence of
inflation, one must identify the nature of inflation which may be anticipated and unanticipated. If
inflation is anticipated, people can adjust with the new situation and costs of inflation to the society
will be smaller.

In reality, people cannot predict accurately future events or people often make mistakes in
predicting the course of inflation. In other words, inflation may be unanticipated when people fail
to adjust completely. This creates various problems.
BUSINESS CYCLE

Rapid economic growth witnessed by many developed economies during the past two
centuries has not been a smooth one. There have been periodical ups and downs in the GDP
levels of these countries. Along with output, there have been fluctuations in various
economic aggregates such as income, employment and prices and their long term trends.
These economies have experienced phases of expansion and contraction in output and other
economic aggregates alternatively. These alternating phases of upswings and downswings
are known as business cycles.

Theoretical explanations of business cycles evolved in the early 20th century. Periods of
expansion and contraction in an economy exhibited a remarkable degree of regularity. The
characteristics of these phases are carefully documented by economists like Wesley Mitchell,
Simon Kuznets and Frederick Mills.

PHASES OF BUSINESS CYCLE

The business cycle describes the fluctuations in economic activity that economies experience
over time.

Expansion Phase
The expansion phase is the first stage of the business cycle, marked by significant growth in
key economic indicators such as employment, income, output, wages, profits, and the
demand and supply of goods and services. During this phase, businesses thrive as they create
more jobs to meet rising consumer demand, leading to increased incomes and spending.
Debtors typically manage their debts well, as stable employment allows them to pay on time.
Investment levels rise as companies are eager to expand operations and innovate, driven by
positive economic conditions. Additionally, the velocity of money supply is high, indicating
that money circulates rapidly within the economy, further stimulating growth. This phase
continues as long as economic conditions remain favorable; however, it eventually reaches a
peak where growth stabilizes before transitioning into a contraction phase.

Peak Phase
The peak phase is the second stage of the business cycle, occurring when the economy
reaches its maximum growth limit. At this saturation point, key economic indicators such as
production, employment, and income are at their highest levels, but they no longer continue
to grow. Prices also peak during this stage, often leading to inflation as demand for goods and
services outstrips supply. This phase marks a critical turning point in economic growth; while
conditions may seem favorable, the high levels of activity can lead to overheating in the
economy. As a result, consumers begin to restructure their budgets in response to rising
prices and may cut back on spending, particularly on non-essential items. This shift in
consumer behavior signals the beginning of a downturn, as demand starts to decline, setting
the stage for the subsequent contraction phase of the business cycle.

Contraction Phase (Recession)

The recession phase follows the peak phase in the business cycle and is characterized by a
significant decline in demand for goods and services. As consumer spending decreases,
producers initially fail to recognize this shift and continue to produce at previous levels,
leading to an oversupply in the market. This excess supply causes prices to fall as businesses
attempt to attract customers with discounts and promotions. As a result, key economic
indicators such as income, output, and wages begin to decline. Employment levels drop as
companies cut back on production and lay off workers in response to reduced demand. The
overall economic environment becomes increasingly challenging, with consumers becoming
more cautious about spending, further exacerbating the downturn. During the Great
Recession from 2007 to 2009, many businesses faced plummeting sales, leading to
widespread layoffs and a significant contraction in economic activity.

Depression
When a recession continues for an extended period, it can lead to a more severe economic
downturn known as a depression. During this phase, the economy experiences not just a
decline in the growth rate but also a reduction in the absolute level of Gross Domestic
Product (GDP). As sales plummet, businesses struggle to repay their debts, leading to
increased bankruptcies and financial distress. The overall sentiment among businesses
becomes pessimistic, causing them to hesitate in making new investments, which further
decreases demand for credit. Banks respond by tightening their lending practices, as the risk
of loan defaults rises significantly. However, over time, certain sectors of the economy may
begin to show signs of recovery and optimism. This gradual improvement in economic
conditions eventually leads to the reversal of the recession phase and the start of the recovery
phase, where growth begins to pick up again as consumer confidence returns and spending
increases.

Recovery Phase
The recovery phase is the stage of the business cycle that follows a recession, during which
individuals and organizations start to regain confidence in the economy. In this phase, there is
an increase in consumer spending and demand for goods and services, which encourages
businesses to ramp up production, make new investments, and hire more employees. For
instance, as people feel more secure in their jobs and start spending money again, retailers
may see higher sales, prompting them to restock inventory and expand their
[Link], during the recession phase, some businesses may have made
necessary investments to replace outdated machinery or maintain existing equipment. This
proactive approach can help them become more efficient as the economy begins to recover.
Price levels also play an important role in this phase; typically, input prices (costs for
materials and labor) decline more than product prices during a recession. This situation
reduces production costs for companies, leading to increased profits as demand picks [Link]
businesses invest in new projects and hire more workers, the economy begins to show signs
of growth again. This process creates a positive feedback loop: increased production leads to
more jobs, which boosts consumer spending even further. Eventually, as recovery gains
momentum, the economy transitions back into the expansion phase, completing the business
cycle.
MONEY

Anything is Money, which is generally acceptable as a medium of

exchange, and at the same time it must act as a measure and a store of

value. Anything implies a thing to be used as money need not be

necessarily composed of any precious metal. The only necessary condition

is that, it should be universally accepted by people as a medium of

exchange. Functions of Money

Money performs five important functions:

1. Medium of exchange: Money acts as a medium of exchange as it's

generally accepted. On the payment of money, purchase of goods

and services can be made i.e. goods and services are exchanged for

money. Money bifurcates buying and selling activities separately so

it facilitates the exchange transactions.

2. Measure of value: Money is a common measure of value so it is

possible to determine the rate of exchange between various goods

and services purchased by the people. Exchange value of

commodity can be expressed in terms of money.

3. Store of value: Money acts as a store of value. Money being

generally acceptable and its value being more or less stable, it is

 ideal for use as a store of value. Being nonperishable and also

comparatively stable in value, the value of other assets can be stored

in the form of money. Property can be sold and its value can be held

in money and converted into other assets as and when necessary.

4. Standard or Deferred payment: Money is also inevitably used as

the unit in terms of which all future or deferred payments are stated.

Future transactions can be carried on in terms of money. The loans,

which are taken at present, can be repaid in money in the future. The

value of the future payments is regulated by money.

5. Transfer of value: Value of any asset can be transferred from one

person to another or to any institution or to any place by transferring

money. The transfer of money can take place irrespective of places,

time and circumstances. Transfer of purchasing power, which is

necessary in commerce and other transactions, has become available

because of money.

Forms of Money

There are four forms of money.

1. Commodity money: Commodity money started as barter. The exchange of

cattle and sheep advanced to one of gold and silver because metals are not

perishable, their purity and weight can be measured easily and they can be

traded for any good or service. Unlike diamonds, metals can be melted down

and reformed into smaller quantities for smaller purchases without losing

value.

2. Representative money: Representative money is money that consists of

token coins, paper money or other physical tokens such as certificates that

can be reliably exchanged for a fixed quantity of a commodity such as gold

or silver. The value of representative money stands in direct and fixed

relation to the commodity that backs it, while not itself being composed of

that commodity

3. Metallic money: Metallic money refers to coins made out of various metals

like gold, silver, bronze, nickel, etc. A coin is a piece of metal of a given

size, shape, weight and fineness whose value is certified by the State.

4. Paper Money: Paper money consists of currency notes issued by the State

Treasury or the Central Bank of the country. In India, one rupee notes are

issued by the Minister of Finance of the Government of India, while all other

currency notes of higher denominations are issued by the Reserve Bank of

India.

5. Credit Money: In modern economic societies, with the development of

banking activity, along with paper money, another form of convertible

money has developed in the form of credit money or bank money. Bank

demand deposits, withdrawal by issuing cheques, have started functioning

 as money, and cheques are now conventionally accepted as a mode of

payment by the business community in general.

Demand for Money

This refers to how much money people want to hold at any given time,

influenced by factors like interest rates and economic conditions.

The demand for money is affected by several factors, including the level of

income, interest rates, and inflation as well as uncertainty about the future.

The way in which these factors affect money demand is usually explained in

terms of the three motives for demanding money: the transactions,

the precautionary, and the speculative motives.

Transaction motive

The transactions motive for demanding money arises from the fact that most

transactions involve an exchange of money. Because it is necessary to have

money available for transactions, money will be demanded. The total number

of transactions made in an economy tends to increase over time as income rises.

Hence, as income or GDP rises, the transactions demand for money also rises.

Precautionary motive

People often demand money as a precaution against an uncertain future.

Unexpected expenses, such as medical or car repair bills, often require

immediate payments. The need to have money available in such situations is

referred to as the precautionary motive for demanding money.

Speculative Motive

Speculative demand for money is the desire to have money for transactions

other than those necessary for living, namely for investment and profitable

purposes. Speculative demand is one of the three desires governing demand

for money, the others being precautionary demand and transactions demand.

The firms hold cash for the speculative purposes to avail the benefit of bargain

purchases that may arise in the future. For example, if the firm feels the prices

of raw material are likely to fall in the future, it will hold cash and wait till the

prices actually fall.

Money Supply

M1=Currency with the public +Demand deposits of Banks + Other

deposits with RBI

M1=C+DD+OD

M2=Currency with the public + Demand deposits of Banks + Other

deposits with RBI+ Saving Deposits in Post Offices

M2=C+DD+OD+SD or M2=M1+SD

M3=Currency with the public + Demand deposits of Banks + Other

Deposits with RBI +Time Deposits in Banks

M3= C+DD+OD+TD or M3=M1+TD

M4= Currency with the public + Demand deposits of Banks + Other

Deposits with RBI +Time

Deposits in Banks+ Saving Deposits in Post Offices

M4=C+DD+O

D+SD or

M2=M1+SD
NOMINAL AND REAL GDP

Gross Domestic Product (GDP) is a crucial economic indicator that measures the
total value of goods and services produced by a country. There are two primary ways
to calculate GDP: Nominal GDP and Real GDP.

Nominal GDP

Nominal GDP is the total value of all goods and services produced in a country using
current market prices. It does not consider inflation, meaning if prices go up, the GDP
might look higher even if the actual production hasn’t increased.

Case 1 : Nominal GDP

Year 2000:
Price of 1 kg of apples = ₹50
Total apples produced = 1 crore kg
Nominal GDP = ₹50 crore

Year 2020:
Price of 1 kg of apples = ₹100 (prices doubled due to inflation)
Total apples produced = still 1 crore kg
Nominal GDP = ₹100 crore

It will look like the economy doubled, but in reality, only prices increased.

Case 2: Nominal GDP

In 2000, 1 kg of mangoes cost ₹50, and India produced 1 crore kg → GDP = ₹50 crore
In 2020, price rose to ₹100 per kg, and the same 1 crore kg was produced → GDP = ₹100
crore

Nominal GDP can make an economy look like it’s growing, even if only prices increased.

Real GDP

Real GDP measures the total economic output while removing the effect of inflation. It uses
prices from a base year to show how much the economy has actually grown in terms of
production, not just rising prices.

Case 1 : Real GDP (Adjusting for Inflation)

Using 2000 prices (₹50 per kg) to compare

Real GDP = 1 crore kg × ₹50 = ₹50 crore

So, Real GDP shows no actual economic growth, just rising prices. Real GDP is a better
measure because it removes inflation and shows actual production growth.

Case 2: Real GDP Case (Adjusting for Inflation)

We use 2000 prices (₹50 per kg) to compare:

Real GDP = 1 crore kg × ₹50 (base year price) = ₹50 crore

The actual production remained the same, so no real growth happened.

While nominal GDP appears to show growth from $100 billion to $150 billion, the
real GDP would actually reveal a decline to $75 billion when adjusted for inflation.

Key Differences

Nominal GDP

Current market prices.

Not adjusted for inflation.

May overstate economic growth.

Real GDP

Base year prices.

Adjusted for inflation.

More accurate economic performance measure.

BOP

According to Bo Sodersten, “The balance of payments is merely a way of

listing receipts and payments in international transactions for a country”.

According to Kindle Berger, "The balance of payments of a country is a

systematic record of all economic transactions between the residents of the
reporting country and residents of foreign countries during a given period
of time".

(BoP) is an accounting statement which records economic transactions between

Normal Resident of a specific country with the rest of the world.

It is a systematic record of all economic transactions between one country and the
rest of the world.

It includes all transactions, visible as well as invisible.

It relates to a period of time. Generally, it is an annual statement.

It adopts a double-entry book-keeping system. It has two sides: credit side and
debit side. Receipts are recorded on the credit side and payments on the debit
side.
BOP is a wider term and includes:

1. Visible Items: Those items which are visible/ touchable/ tangible/ physical
– i.e., they can be seen and measured and touched. BOP includes the export
and import of such physical goods.

2. Invisible Items: Are those which cannot be seen (and hence invisible) or
touched but can be felt mainly services. The import and export of services
is included like banking/consultancy services of IT/ Legal/ Architecture/
Management/ CA etc./ insurance and logistics services.

3. Unilateral Transfers: As the name suggests are transactions which are one
way.

4. Capital Transfers: Are transfer of title or ownership of capital assets across

borders. It includes purchase/ sale of capital assets like land, building, plant
and machinery etc. but across borders.

Types of BOP/Balance of Payment is classified into as:

1. Favourable Balance of Payments: Excess of goods and services exported

plus capital transferred to abroad over the goods and services imported and
capital transfers from abroad is known as favourable balance of payments.
 2. Unfavorable balance of payments: An imbalance in a nation's balance of
payments in which payments made by the country exceed payments
received by the country. This is also termed a balance of payments deficit.

COMPONENTS OF BOP

It is divided into two main accounts: the Current Account and the Capital
Account.

CURRENT ACCOUNT

The Current Account focuses on the flow of goods, services, income, and
unilateral transfers. Its primary components include visible trade, invisible trade,
unilateral transfers, and income receipts and payments. Visible trade refers to the
export and import of tangible goods, where a surplus occurs when exports exceed
imports, indicating a favorable trade balance. Invisible trade encompasses
services such as tourism, banking, and insurance, capturing the value generated
from service-related transactions. Unilateral transfers involve one-way
transactions like remittances or gifts sent from abroad, while income receipts and
payments track earnings from investments and payments made to foreign
investors. Together, these components provide a detailed picture of how a country
interacts economically with other nations.

CAPITAL ACCOUNT
The Capital Account complements the Current Account by recording financial
transactions that help finance any deficits in the Current Account or absorb
surpluses. It includes loans to and borrowings from abroad, investments to and
from abroad, and changes in foreign exchange reserves. Loans to and borrowings
from abroad capture all financial assistance received or provided by both private
and public sectors. For instance, if a government borrows funds from
international institutions for development projects, this transaction is recorded in
the Capital Account. Investments to and from abroad reflect cross-border capital
flows, where foreign investments in domestic assets are recorded as inflows while
domestic investments abroad are noted as outflows. Changes in foreign exchange
reserves are critical for central banks as they manage currency stability;
fluctuations in these reserves can indicate shifts in economic policy or responses
to market pressures.

Interrelationship Between Accounts

The Current Account and Capital Account are interconnected; a deficit in one
account can be financed by a surplus in the other. For example, if a country
experiences a Current Account deficit due to high imports, it may need to borrow
more money from abroad or attract foreign investments (surplus in the Capital
Account) to cover this shortfall.

BOP is essential for various stakeholders such as policymakers, investors, and

economists because it provides insights into a country's economic health and
global competitiveness. Policymakers can use BOP data to formulate monetary
and fiscal policies aimed at correcting imbalances such as implementing tariffs
or quotas to manage trade deficits and helps assess a country's economic health.
Disequilibrium of Balance of Payment

When a country’s current account is at a deficit or surplus, its balance of payments

(BOP) is said to be in disequilibrium. A disequilibrium in the balance of payment
means its condition of Surplus Or deficit.

A Surplus in the BOP occurs when Total Receipts exceeds Total Payments. Thus,
BOP= CREDIT>DEBIT. A Deficit in the BOP occurs when Total Payments
exceeds Total Receipts.
Thus, BOP= CREDIT<DEBIT.

Types of Disequilibrium of Balance of Payment

Broadly speaking, there are five different types of disequilibrium in the BOP:

1. Cyclical Disequilibrium.

2. Secular Disequilibrium.

3. Structural Disequilibrium.

4. Short run Disequilibrium.

5. Fundamental Disequilibrium

1. Cyclical Disequilibrium: Cyclical Disequilibrium in the

BOP arises due to the influences of cyclical fluctuations. Cyclical
Disequilibrium in the BOP occur as a result of business cycle/Trade
cycle follow different paths and patterns in different countries

2. Secular Disequilibrium: Secular disequilibrium in the

balance of payments is a longterm, phenomenon, caused by

persistent, deep-rooted dynamic changes that slowly take place in the
economy over a long period of time. It may be caused by changes in
several dynamic forces or factors such as capital formation,
population growth, technological changes etc.

3. Structural Disequilibrium: Structural disequilibrium arises

from structural changes occurring in few sectors of the economy at

home or abroad which may alter the demand for supply conditions
for exports or imports or both. A change in foreign demand for
exports can arise from a change in technology, the invention of the
cheaper substitute. Structural disequilibrium is caused by changes in
technology, tastes and attitude towards foreign investment. Political
disturbances, strikes, lockouts, etc., which affect the supply of
exports, also cause structural disequilibrium.

4. Short run Disequilibrium: Disequilibrium caused on a

temporary basis for a short period, say one year is called short run
disequilibrium. Such disequilibrium does not pose a serious threat as
it can be overcome within a short run. Such an disequilibrium may
be caused due to international borrowing and lending. When a
country goes for borrowing or lending it leads to short run
disequilibrium. Such disequilibrium is justified as they do not pose a
serious threat

5. Fundamental or Long Run Disequilibrium: The term

fundamental disequilibrium has been originally used by the I.M.F.,

to indicate a persistent and long-term disequilibrium in a country’s
balance of payments. Fundamental disequilibrium is generally
caused by dynamic factors and particularly leads to chronic deficit in
the balance.
Causes of Disequilibrium in Balance of Payment:

The following are the important causes producing disequilibrium in the

balance of payments of a country:
1. Trade Cycles: Cyclical fluctuations, their phases and amplitudes,

differences in different countries, generally produce cyclical disequilibrium

2. Huge Developmental and Investment Programmes: Huge

development and investment programmes in the developing economies are
the root causes of the disequilibrium in the balance of payments of these
countries. Their propensity to import goes on increasing for want of capital
for rapid industrialisation; while exports may not be boosted up to that extent
as these is the primary producing countries.

3. Changing Export Demand: A vast increase in the domestic

production of foodstuffs, raw materials, substitute goods, etc. in advanced

countries has decreased their need for import from the agrarian
underdeveloped countries. Thus, export demand has considerably changed,
resulting in structural disequilibrium in these countries.

4. Population Growth: High population growth in poor countries

also had adversely affected their balance of payments position. It is easy to

see that an increase in population increases the needs of these countries for
imports and decreases the capacity to export.

5. Huge External Borrowings: Another reason for a surplus or

deficit in the balance of payments arises out of international borrowing and
investment. A country may tend to have an adverse balance of payments
when it borrows heavily from another country, while the lending country
will tend to have a favourable balance and the receiving country will have a
deficit balance of payments.

6. Inflation: Owing to rapid economic development, the resulting

income and price effects will adversely affect the balance of payments
position of a developing country. With an income, the marginal propensity to
import being high in these countries, their demand for imported articles will
rise.

7. Demonstration Effect: Demonstration effect is another most

important factor causing deficit in the balance of payments of a country —
especially of an underdeveloped country. When people of underdeveloped
nations come into contact with those of advanced countries through
economic, political or social relations, there will be a demonstration effect on
the consumption pattern of these people and they will desire to have western
style goods and pattern of consumption so that their propensity to import
increases, whereas their export quantum may remain the same or may even
decline with the increase i in income, thus causing an adverse balance of
payments for the country.

8. Reciprocal Demands: Since intensity of reciprocal demand for

products of different countries differs, terms of trade of a country may be set
differently with different countries under multi-trade transactions which may
lead to disequilibrium in a way

Measures to Correct Disequilibrium in Balance of Payment

Following are the main methods of Correct Disequilibrium in Balance

of Payments:
 1. Monetary Policy: The monetary policy is concerned with money

supply and credit in the economy. The Central Bank may expand or contract
the money supply in the economy through appropriate measures which will
affect the prices.

2. Fiscal Policy: Fiscal policy is government's policy on income and

expenditure. Government incurs development and non - development

expenditure. It gets income through taxation and non - tax sources.
Depending upon the situation government expenditure may be increased or
decreased.

3. Exchange Rate Depreciation: By reducing the value of the

domestic currency, government can correct the disequilibrium in the BOP in

the economy. Exchange rate depreciation reduces the value of home
currency in relation to foreign currency. As a result, import becomes costlier
and export becomes cheaper. It also leads to inflationary trends in the
country.

4. Devaluation: devaluation is lowering the exchange value of the

official currency. When a country devalues its currency, exports become

cheaper and imports become expensive which causes a reduction in the BOP
deficit.

5. Deflation: Deflation is the reduction in the quantity of money to

reduce prices and incomes. In the domestic market, when the currency is
deflated, there is a decrease in the income of the people. This puts curb on
consumption and government can increase exports and earn more foreign
exchange.

6. Exchange Control: All exporters are directed by the monetary

authority to surrender their foreign exchange earnings, and the total available
foreign exchange is rationed among the licensed importers. The license-
holder can import any good but amount if fixed by monetary authority.

7. Export Promotion: To control export promotions the country may

adopt measures to stimulate exports like: export duties may be reduced to

boost exports; cash assistance, subsidies can be given to exporters to increase
exports; goods meant for exports can be exempted from all types of taxes.

8. Import Substitutes: Steps may be taken to encourage the

production of import substitutes. This will save foreign exchange in the short
run by replacing the use of imports by these import substitutes.

9. Import Control: Import may be kept in check through the

adoption of a wide variety of measures like quotas and tariffs. Under the
quota system, the government fixes the maximum quantity of goods and
services that can be imported during a particular time period.

Is Balance of Payments Always in Equilibrium?

Balance of payments always balances means that the algebraic sum of the
net credit and debit balances of current account, capital account and official
settlements account must equal zero.
How bank rate, open market operation, cash reserve ratio, taxation, and
government expenditure help in controlling inflation.

Inflation means prices keep rising, making things expensive. The government and central bank
(like RBI in India use different tools to control inflation and keep the economy stable.

1. Bank Rate (Interest Rate on Loans for Banks)

The central bank increases the bank rate (interest rate it charges to commercial banks).
This makes loans expensive for businesses and people.
Since borrowing becomes costly, people and businesses spend less, reducing demand and
slowing down inflation.

2. Open Market Operations (Buying/Selling Government Bonds)

The central bank sells government bonds to the public and banks.
This takes money out of the economy, reducing people's ability to spend.
With less money in circulation, demand falls, and inflation slows down.

3. Cash Reserve Ratio (CRR) (Money Banks Must Keep in Reserve)

The central bank increases CRR, meaning banks must keep more money in reserve and can
lend less.
Since banks give fewer loans, less money is available for spending.
This reduces demand and slows inflation.

4. Taxation (Increasing Taxes to Reduce Spending)

The government can increase taxes (like GST or income tax).
People will have less money left to spend, reducing demand.
Lower demand helps control price rises.

5. Government Expenditure (Reducing Government Spending)

The government can spend less on projects like roads, bridges, and welfare programs.
When the government spends less, less money flows into the economy.
This helps control excess demand and slows down inflation.
Savings and investment. How does the economy reach a
state of balance through savings-investment approach
Savings

Savings is the money left over after you pay for your expenses. It is typically stored in safe
places like savings accounts or cash, where there is little risk of losing the money. Savings are
often used for short-term goals (e.g., buying a phone, emergencies) or as a safety net for future
needs.
You earn Rs 1,000 and spend Rs 800, the remaining Rs 200 is savings.

Investments

Investment involves using your money to buy assets (e.g., stocks, bonds, real estate) with the
goal of growing its value over time. Investments carry risks but offer higher potential returns
compared to savings. They are often used for long-term goals like retirement or buying a house.
If a company uses Rs 200 to buy a new machine to produce more goods, that is an
investment.

How Does the Economy Reach Balance Through Savings-

Investment?
Savings Provide Funds for Investment:

When individuals save money in banks, these funds are pooled and lent to businesses or
individuals for investment purposes (e.g., building factories or buying equipment). This creates
jobs and boosts economic growth.

Investment Generates Returns:

Investments lead to production and income generation. Businesses use borrowed funds to
expand operations, produce goods/services, and pay wages. This increases people’s income,
allowing them to save more.
How Savings and Investment Balance the Economy using graph and table.

TABLE

STEP WHAT HAPPENS EXAMPLE

Savings People save more in 1 crore saved by many people
banks
Banks lend Banks give loans to A factory borrows money
businesses
Investment Business invest in Company buys machine
projects
Jobs created Business hire workers Factory hire 100 workers
Income rises Workers earn and Workers buy goods and services
spend money
More savings High income means People save more in banks
more saving
Growth continues More investment More business grow
happens

GRAPH
Blue Line (Savings): People save money over time.
Green Line (Investment): Banks lend savings to businesses for investment.
Red Line (Economic Growth): As investment increases, the economy grows.

When people save more, there is more money for investment, leading to economic growth. But
if savings are too high and investment is low, growth slows down. A good balance is needed
for a healthy economy.
 Fiscal Policy

Fiscal policy is one of the key tools that governments attempt to regulate and influence the
economy to achieve Macroeconomics Goal. Fiscal policy refers to the government's budgetary
policy, which involves the government controlling its level of spending and taxation within the
economy. It is the sister strategy to monetary policy.

Some of the major instruments of fiscal policy are as follows: Budget, Taxation, Public
Expenditure, public revenue, Public Debt, and Fiscal Deficit in the economy.

Understanding of the Instruments of fiscal policy:

Budget: The government outlines its planned revenue and expenditures for a specific period,
usually a year.

Taxation: Taxes are the primary source of government revenue. They can be levied on income,
consumption, profits, and property.

Public Expenditure refers to the government's spending on goods, services, and projects to
provide public benefits.

Public Revenue: This includes all the income generated by the government through taxes, fees,
fines, and other sources.

Public Debt: Sometimes, the government may need to borrow money to cover budget deficits
or finance large-scale projects.

Fiscal Deficit occurs when government expenditures exceed revenues in a given fiscal year.

Basically, fiscal policy means the use of taxation and public expenditure by the government for
stabilization or growth of the economy. Fiscal policy is an important constituent of the overall
economic framework of a country and is therefore intimately linked with its general economic
policy strategy.
According to Culbarston, “By fiscal policy we refer to government actions affecting its receipts
and expenditures which ordinarily as measured by the government’s receipts, its surplus or
deficit.” The government may change undesirable variations in private consumption and
investment by compensatory variations of public expenditures and taxes.

Fiscal policy also feeds into economic trends and influences monetary policy. When the
government receives more than it spends, it has a surplus. If the government spends more than
it receives it runs a deficit. To meet the additional expenditures, it needs to borrow from
domestic or foreign sources, draw upon its foreign exchange reserves or print an equivalent
amount of money. This tends to influence other economic variables. So, fiscal policy not only
impacts how the government manages its finances but also influences economic trends like
interest rates, inflation, and overall economic growth.

On a broad generalization, excessive printing of money leads to inflation. If the government

borrows too much from abroad it leads to a debt crisis. Excessive domestic borrowing by the
government may lead to higher real interest rates and the domestic private sector being unable
to access funds resulting in the “crowding out” of private investment. So it can be said that the
fiscal deficit can be like a double edge sword, which need to be tackled very carefully.

Types of Fiscal policy

There are two main types of fiscal policy. They are:

Neutral Fiscal policy: Fiscal policy is said to be neutral when the level of government
spending in relation to tax revenue is stable over time. This type of policy is usually
undertaken when an economy is in equilibrium- neither rapidly expanding nor contracting. In
this instance, government spending is fully funded by tax revenue, which has a neutral effect
on the level of economic activity.

Discretionary fiscal policy: Discretionary fiscal policy refers to government fiscal policy that
alters government spending or taxes. Its purpose is to expand or shrink the economy as
needed. It has two sub-types as:
 (i) Expansionary Fiscal Policy: Discretionary fiscal policy is said to be Expansionary when
the government spends more money than its revenue collected through taxes. This type of
fiscal policy is usually undertaken during recessions to increase the level of economic activity.
(ii) Contractionary Fiscal Policy: Discretionary fiscal policy is said to be Contractionary when
government spending is lower than tax revenue. This type of Fiscal policy is undertaken to pay
down government debt and to curb inflation.

Main Objectives of Fiscal Policy in India

When governments make fiscal policy decisions, they have multiple objectives in mind. The
main objectives are as follows:

Economic Growth: Governments aim to foster economic growth as it leads to overall

prosperity for citizens. However, they must be cautious, as overly aggressive fiscal policies can
have negative long-term consequences. There are various projects like building up dams on
rivers, electricity, schools, roads, industrial projects etc run by the government to mitigate the
regional imbalances in the country. This is done with the help of public expenditure.

Full Employment/Employment Generation:

The first and foremost objective of fiscal policy in a developing economy is to achieve and
maintain full employment in an economy. In such countries, even if full employment is not
achieved, the main motto is to avoid unemployment and to achieve a state of near full
employment. Therefore, to reduce unemployment and under-employment, the state should
spend sufficiently on social and economic overheads. These expenditures would help to create
more employment opportunities and increase the productive efficiency of the economy.

The government is making every possible effort to increase employment in the country through
effective fiscal measures. Investment in infrastructure has resulted in direct and indirect
employment. Lower taxes and duties on small scale industrial units encourage more investment
and consequently generate more employment. Various rural employment programmes have
been undertaken by the Government of India to solve problems in rural areas. Similarly,
selfemployment scheme is taken to provide employment to technically qualified persons in the
urban areas.

Getting people into jobs is a top priority for governments. Higher taxes can benefit the
government and reduce spending on social security. Alternatively, they may invest in
infrastructure or lower taxes to boost employment indirectly through increased consumer
spending.

Price stability: Various classes of society such as consumers, laborers and employees,
agriculturists, producers, traders, etc. are affecting by fluctuation in prices. The general public
is adversely affected by increasing prices. The fiscal policy endeavors to bring stability in
prices by removing demerits of increase/decrease in prices. The impact of the price increase
can be reduced by providing subsidy or decreasing taxes.

Control Debt: Operating a budget deficit is not a harm. It creates more and more debt over
time. If the tax receipts and economic growth do not increase its line, a nation witnesses an
unsustainable debt. Thus, a rational fiscal policy tends to control to avoid drastic action.

Reduction in inequalities of Income and Wealth: Fiscal policy aims at achieving equity or
social justice by reducing income inequalities among different sections of the society. The
direct taxes such as income tax are charged more on the rich people as compared to lower
income groups. Indirect taxes are also more in the case of semi-luxury and luxury items which
are mostly consumed by the upper middle class and the upper class. The government invests a
significant proportion of its tax revenue in the implementation of Poverty Alleviation
Programmes to improve the conditions of poor people in society.
Governments seek to redistribute wealth from the rich to the poor to reduce inequality. Higher
taxes on the wealthy fund social programs, although avoidance and evasion can limit their
effectiveness in the short term.

Control Inflation: One of the main objectives of fiscal policy is to control inflation and
stabilize price. Therefore, the government always aims to control the inflation by reducing
fiscal deficits, introducing tax savings schemes, productive use of financial resources, etc.
Strong economic development can lead to inflation. Although inflation is primarily influenced
by monetary policy, governments also take steps to address it. This may involve increasing
taxes to reduce disposable incomes and curb excessive consumption.

INSTRUMENTS OF FISCAL POLICY

DEFICIT POLICY
Deficit Financing refers to financing the budgetary deficit. Budgetary deficit here means excess of
government expenditure over government income. It means “Taking loans from reserve bank of India by
the government to meet the budgetary deficit” . Reserve bank gives loans buy issuing new currency notes.
Increase in money supply leads to fall in value of money. Fall in value of money in turn leads to increase in
price level. So deficit financing should be kept low as it leads to price rise in economy. Thus due to deficit
financing necessary funds are made available for economic Growth and on the other inflation of country
increases.

PUBLIC EXPENDITUTRE
Public expenditure influences the economic activities of country very much. Public expenditure may be of
two kinds i.e. developmental and non developmental. Expenditure on developmental activities requires
huge amount of capital. So much capital cannot be made available by private sector alone. It requires
substantial increase in public expenditure.

Public expenditure may be made in many ways:- (1) Development of state enterprises, (2) Support to
private sector, (3) Development of infrastructure & (4) Social Welfare.

TAXATION POLICY
Taxes are the main source of revenue of government. Government levies both direct and indirect taxes in
India. Direct taxes are those which are directly paid by the assesses to the government i.e. income tax,
wealth tax etc. Indirect tax are paid indirectly by the public to the government i.e. excise duty, custom duty,
VAT etc. Direct tax are progressive in nature. Indirect taxes are not progressive. These change from all the
segments of society at same rate.

The main objectives of taxation policy are: (1) Mobilization of resources, (2) To promote saving, (3) To
promote saving & (4) To bring Equality of income and wealth

MONETARY POLICY

Monetary policy refers to the use of instruments under the control of the central bank (RBI) to regulate the
availability, cost and use of money and credit.

According to Johnson, “Monetary policy is defined as policy employing central bank’s control of the supply
of money as an instrument for achieving the objectives of general economic policy.”

OBJECTIVES OF MONETARY POLICY

1. Balance of Payments
2. Economic Growth

3. Price Stability

4. Full Employment

INSTRUMENTS OF MONETARY POLICY

BANK RATE
Bank Rate is also known as discount rate. It is the rate at which RBI lends to the commercial banks or
rediscounts their bills. If bank rate is increased ,then commercial banks also charge higher rate of interest
on loans given by banks to public because now commercial banks get funds from RBI at higher rate of
interest. Higher rate of interest will contract credit in the economy i.e. public will take lesser loans because
of higher rate of interest.

CASH RESERVE RATIO (CRR)

Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to keep with RBI in
the form of reserves or balances . Higher the CRR with the RBI lower will be the liquidity in the system and
vice-versa. RBI is empowered to vary CRR between 15 percent and 3 percent. But as per the suggestion by
the Narshimam committee Report the CRR was reduced from 15% in the 1990 to 5 percent in 2002.

Statutory Liquidity Ratio (SLR)

It means a certain percentage of deposits is to be kept by banks in form of liquid assets. This is kept by
bank itself the liquid assets here include government securities, treasury bills and other securities notified
by RBI. If SLR is more then banks have to keep more part of deposits in specified securities and banks will
have less surplus funds for granting loans. It will contract credit. SLR is fixed by RBI and usually it has been
ranging between 25% to 40%. By an amendment of the Banking regulation Act(1949) in January 2007, the
floor rate of 25% for SLR was removed.

REPO RATE & RESERVE REPO RATE

Repo rate is the rate at which RBI lends to commercial banks generally against government securities.
Reverse Repo rate is the rate at which RBI borrows money from the commercial banks.
Reduction in Repo rate helps the commercial banks to get money at a cheaper rate and increase in Repo
rate discourages the commercial banks to get money as the rate increases and becomes expensive. As the
rates are high the availability of credit and demand decreases resulting to decrease in inflation. This
increase in Repo Rate and Reverse Repo Rate is a symbol of tightening of the policy.

OPEN MARKET OPERATIONS

It means that the bank controls the flow of credit through the sale and purchase of securities in the open
market. When securities are purchased by central bank, then RBI makes payment to commercial banks
and public. So, the public and commercial banks now have more money with them. It increases money
supply with commercial banks and public. This will expand credit in the economy.
How Monetary and fiscal policy contribute to
macroeconomic stability and economic growth

Fiscal and monetary policies are essential tools used by governments and central banks to
achieve macroeconomic stability and promote economic growth.

How fiscal policy contribute to macroeconomic stability and

economic growth
Contributions to Macroeconomic Stability and Growth
Stimulating Demand: During economic downturns, the government can increase spending or
cut taxes to boost demand. For example, building infrastructure creates jobs and increases
consumer spending, which helps the economy recover from a recession.

Counteracting Inflation: Conversely, in times of high inflation, the government might reduce
spending or increase taxes to cool down the economy. This helps stabilize prices and maintain
purchasing power

Investment in Public Goods: Fiscal policy can direct funds toward essential services like
education, healthcare, and infrastructure. These investments enhance productivity and long-
term economic growth by improving human capital and physical infrastructure.

Redistribution of Income: Through progressive taxation and social programs, fiscal policy
can reduce income inequality, which can lead to a more stable economy as lower-income
households tend to spend a higher proportion of their income

Budget Surpluses and Deficits: Maintaining budget surpluses during economic booms allows
governments to save for downturns, while running deficits during recessions can stimulate
growth by injecting money into the economy

How monetary policy contribute to macroeconomic stability

and economic growth

Controlling Inflation: By adjusting interest rates, central banks can influence inflation.
Raising interest rates can help reduce inflation by making borrowing more expensive, while
lowering rates can encourage spending and investment during economic slowdowns

Influencing Investment: Lower interest rates make loans cheaper for businesses and
consumers, encouraging investment in capital goods and consumer spending. This can lead to
increased production capacity and job creation.
Stabilizing Financial Markets: Central banks can act as lenders of last resort during financial
crises, providing liquidity to prevent bank failures and stabilize the financial system. This
stability is crucial for maintaining consumer confidence and economic growth

Managing Employment Levels: By influencing economic activity through interest rate

changes, monetary policy can help maintain lower unemployment rates. When the economy is
growing, central banks might raise rates to prevent overheating; when it’s slowing down, they
may lower rates to stimulate job creation

Expectations Management: Central banks also work on managing public expectations

regarding inflation and economic stability through communication strategies (like forward
guidance). Stable expectations can lead to more consistent economic behavior from consumers
and businesses.

Both fiscal and monetary policies play critical roles in promoting macroeconomic stability and
fostering economic growth.

Fiscal Policy focuses on government spending and taxation to influence aggregate demand
directly.
Monetary Policy manages interest rates and money supply to control inflation and support
investment.
These policies help create an environment conducive to sustainable economic growth while
stabilizing the economy during fluctuations.
 Anticipated and imperfectly anticipated inflation.

ANTICIPATED INFLATION

Anticipated inflation is when people expect prices to rise in the future. Because they know
this will happen, they can prepare for it.
When individuals and businesses anticipate inflation, they can make plans to minimize its
effects. This could mean saving money, adjusting prices, or investing in assets likely to increase
in value.
Case 1
Saving more money
Imagine you are a student who gets Rs 500 every week for snacks. You hear that the price of
your favourite chocolate is going to increase next month due to inflation. Instead of spending
all your money now, you decide to save some so that you can buy chocolates before the price
goes up.
Case 2
Adjusting prices
Suppose a bakery sells a loaf of bread for Rs 25. If the bakery owner expects the price of flour
and sugar to increase soon, they might increase the price of bread to Rs 30 in advance. This
way, they don’t lose profit when their costs go up.
Case 3
Investing in valuable assets
A person who has Rs 100000 in savings realizes that inflation will reduce the value of money
over time. Instead of keeping all the money in a bank, they decide to buy gold or property
because these things usually increase in value during inflation. Later, they can sell them at a
higher price and protect their wealth.

IMPERFECTLY ANTICIPATED INFLATION

Imperfectly anticipated inflation happens when people expect one rate of inflation but
experience a different rate. This unpredictability can create financial challenges because people
are not prepared for the actual changes in prices.
Case 1
Salary and inflation
Imagine a worker expects prices to rise by 5% next year. Their boss gives them a 5% salary
increase to match the expected inflation. But in reality, inflation turns out to be 10%.

Case 2
Business Pricing Mistake
A restaurant owner expects ingredient prices to go up by 3% next month. So, they slightly
increase menu prices to prepare for it. However, inflation actually goes up by 8%, and the cost
of ingredients rises much more than expected! The restaurant loses money because their new
prices don’t cover their higher costs.
 Economics – the study of how individuals and societies make decisions about ways to

use scarce resources to fulfil wants and needs.

• Central economic problems: What to produce, how to produce, for whom to produce

and what provisions to make for the future.

• What are resources? The things used to make other . BUT, there’s a fundamental

problem ‘Scarcity’.

• Choices: All goods and services are limited we need to make a choice.

• Positive/Normative economics

The study of economics is traditionally divided into two fields-micro and macro.

MICRO

Microeconomics deals with the behavior of disaggregated individual decision makers such as

a single consumer or a saver or a single production unit(firm) or an industry(collection of firms

producing similar or closely related products).It deals with an individual's economic behavior.

It has a very narrow scope i.e. an individual, a market etc.

It is helpful in analysis of an individual economics unit like firm

MACRO
Macroeconomics ,on the other hand, Macroeconomics is the study of the economy as a whole,

focusing on large-scale economic factors and how they interact.

The term Macro is derived from the Greek word “MAKROS” which means large.

It evolved only after the publication of keynes' book. General theory of employment, interest

and money.

It deals with the aggregates such as national income, output, employment and the general price

level etc, therefore it is called the Aggregative Economics.

It deals with aggregate economic behavior of the people in general.

It has a very wide scope i.e. a country.

The study of government policy meant to control and stabilize the economy over time, that is,

to reduce fluctuations in the economy is known as macroeconomics.

Macroeconomics also includes the study of monetary policy, fiscal policy, and supply-side

economics.

Scope of Macroeconomics
The scope of macroeconomics has been explained as under:

Theory of National Income: Macro economics studies the concept of national income, its

different elements, methods of its measurement and social accounting.

Theory of Employment: It studies the problems of employment and unemployment.

Marco Theory of distribution: There are macro economic theories of distribution.

Economic development: Economic development is a long run process. In it, we analyze the

problems and theories of development.

Theory of International Trade: It also studies principles determining trade among different

countries. Tariff's protection and free-trade polices fall under foreign trade.
Theory of Money: Under macro economics functions of money and theories relating to money

are studied.

Theory of Business Fluctuations: It also deals with the fluctuations in the economy.

Theory of General Price Level: Inflation and Deflation issues.

Understanding National Income Accounting

National income accounting is a framework used to measure the economic

performance of a country.

It helps in assessing the total market value of all final goods and services produced

within a nation during a specific period, typically a year.

Why is National Income Important?

National income accounting helps in:

Measuring Economic Performance:

The most common measure used is Gross Domestic Product (GDP).

Policy Making:

Governments use this data to create policies that can stimulate growth or address economic

issues.
Comparative Analysis:

It allows for comparisons between different countries or regions over time.

Assessing Living Standards:

National income accounting also helps assess the standard of living in a country by

calculating GDP per capita (GDP divided by the population).

The calculation of national income can be approached through three primary methods:

the Product Method, the Expenditure Method, and the Income Method.

Three Methods of Calculating National Income

Product Method (Value Added Method)

The Product Method calculates the total value added by all firms in an economy. It focuses

on the final goods produced, which helps avoid double counting (counting the same product

multiple times).

Case 1:

• A farmer grows wheat valued worth at Rs 100.

• The farmer sells Rs 50 worth of wheat to a Shop.

 • The shop uses this wheat to make bread, which he sells for Rs 200.

Thus, the total production in the economy is simply:Total Production = Value of Bread = Rs

200.

Expenditure Method

This method calculates national income by adding up all expenditures made on final goods

and services within the economy.

The formula is:

Y=C+I+G+(X−M)

where:

C = Consumption

I = Investment

G = Government spending

X = Exports

M = Imports

Case 1:

If consumption is Rs 300,

investment is Rs 100,

government spending is Rs 200,

exports are Rs 50,

imports are Rs 30,

then:

Y=300+100+200+(50−30)=620

Income Method

This method calculates national income by summing all incomes earned from production,

including wages, profits, rents, and interest payments.

Case 1

For two companies:

Company A: Wages = Rs 20, Profits = Rs 30

Company B: Wages = Rs 60, Profits = Rs 90

The total national income would be:

Total Income=(20+60)+(30+90)=200

Price Indices in National Income Accounting

To analyze economic performance over time, economists use various price indices:
GDP Deflator: It measures the ratio of nominal GDP to real GDP, indicating how much

prices have changed since a base year.

Consumer Price Index (CPI): This index tracks changes in the price level of a basket of

consumer goods and services.

Wholesale Price Index (WPI): It measures the average change in selling prices received by

domestic producers for their output.

 SOLUTIONS TO INFLATION

1. Monetary Policy

Monetary policy involves actions by central banks to control inflation by managing the money
supply and interest rates.
Raising interest rates makes borrowing more expensive, reducing consumer spending and
demand for goods, which helps lower inflation.

2. Fiscal Policy

Fiscal policy involves government actions like taxation and spending to manage inflation.
Increasing taxes reduces disposable income, leading to lower consumer spending and demand,
which can help curb inflation.

3. Supply Chain Improvements

Improving supply chains can help reduce inflation by making goods more available and
affordable.
Investing in better transportation networks can reduce delivery times and costs, making goods
cheaper for consumers.

4. Promoting Competition

Encouraging competition among businesses helps keep prices low by preventing monopolies.
Strict antitrust laws can prevent companies from colluding to raise prices.

5. Price Controls and Subsidies

Implementing price controls or offering subsidies can temporarily protect consumers from high
prices.
Governments can set price caps on essential goods like food or fuel to prevent sudden price
hikes.

6. Encouraging Savings

Encouraging people to save can reduce the amount of money circulating in the economy,
helping to control inflation.
Offering higher interest rates on savings accounts can incentivize people to save rather than
spend.

7. Exchange Rate Policies

Managing exchange rates can reduce imported inflation by stabilizing the local currency.
A strong currency can make imports cheaper, reducing inflationary pressures from imported
goods.
For example, if a country's currency strengthens against others, it can import goods at lower
prices.

8. Currency Measures
Currency measures like demonetization or new currency issuance can be used in extreme cases.
Demonetizing high-denomination currency notes can reduce unaccounted money in
circulation, potentially lowering inflation. Removing large denomination notes can reduce
black market transactions.

Additional notes

Built-in inflation
It happens when wages and prices keep going up together. It starts when workers ask for higher
wages because prices are rising, making things cost more. Businesses agree to pay more but
then raise their prices to cover these higher costs. This makes prices go up even more, so
workers ask for even higher wages, and the cycle continues.