ECONOMICS NOTES

3RD SEMESTER

NOTE: PUBLIC FINANCE CHAPTER IS INCOMPLETE

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 INTRODUCTION

In macroeconomics, we simplify the analysis of how the country’s total production and the level
of employment are related to attributes (called ‘variables’) like prices, rate of interest, wage
rates, profits, and so on, by focusing on a single imaginary commodity and what happens to it.

Five Key Indicators of Macroeconomic Variables:

1. Real GDP: Real GDP measures the value of all goods and services produced in a country,
adjusted for inflation.
2. Unemployment: The unemployment rate measures the percentage of the labour force that
is unemployed and actively seeking employment.
3. Inflation rate: The inflation rate measures the rate at which the general level of prices for
goods and services is rising, eroding purchasing power.
4. Rate of Interest: The interest rate is the cost of borrowing money, usually set by a central
bank. It influences consumer spending, business investment, and overall economic
activity.
5. Stock Market: The stock market reflects the value of publicly traded companies and is
often considered a barometer of the economy’s health.
6. Exchange rate: An exchange rate is the value at which one currency can be exchanged for
another. It represents how much of one currency you need to pay to obtain a certain
amount of another currency. Generally, it is defined in terms of US dollars as most of
International transactions happen in US Dollars.

Important terms used in Macroeconomics:

Consumer goods: Consumer goods are goods bought for consumption by consumers for their
own use and not for any further economic activity. Consumer goods are also known as final
goods.

Capital Goods: Capital goods are physical assets that an organization uses in the process of
production to manufacture products and services that consumers will use later. Capital goods are
also known as tangible goods as they are physical in nature. capital goods do not create utility or
satisfaction for the buyer, instead, they are used to produce the final product, which does create
satisfaction or utility.

Intermediate Goods: An intermediate good is a good used to produce a final good or finished
good for the purpose of selling it to the consumers. Intermediate goods like salt can be a finished

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product, as it is consumed directly by consumers and can be used by producers to produce other
food products.

Depreciation: A reduction in the monetary value of fixed assets due to wear and tear caused by
continuous use or any other reason is known as Depreciation. In other words, depreciation
represents the annual loss of the tangible asset’s monetary value during the period of its life.

Concept of Stock and Flow:

● Stock: Stock refers to any quantity that is calculated at a particular point of time.
● Flow: Flow refers to the quantity that can be calculated over a period of time.

Gross Investment and Net Investment:

● Gross Investment: Gross Investment refers to the total expenditure or investment that is
made by an organization to acquire capital goods.
● Net Investment: Net investment is the actual addition made by the organizations to the
economy’s capital stock in a given period. Net Investment is estimated by subtracting the
depreciation value from the gross investment.

Note: If the value of the gross investment is higher than the value of depreciation at any given
time period, it shows that the net investment is positive, and the capital stock has increased.
Similarly, if the gross investment value is less than the depreciation value, it shows that the net
investment becomes negative, which leads to falling in capital stock.

Concepts of Macroeconomics:

Domestic Territory: Domestic Territory is an essential concept of national income accounting,

which simply means the political frontiers of a country.

Along with Political Frontiers, Domestic Territory also consists of the following items:

● Embassies, military establishments, and consulates of a country located abroad

● Ships and aircraft owned and operated by normal residents between two or more
countries
● Fishing vessels, oil and natural gas rigs, and floating platforms operated by the residents
of a country in the international waters where they have exclusive rights of operation.

The domestic territory does not include:

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 ● Embassies, military establishments, and consulates of a foreign country are not included
in the domestic territory of a country.
● Any International organisation such as WHO, UNO, etc.

Normal Residents: Any individual or an institution who ordinarily resides in a country and
whose center of economic interest lies in that country is the Normal Resident of that country.

The Centre of economic interest includes:

● The residents of a country live or are located within the domestic territory.
● From that location, these residents carry out basic economic activities of earnings,
spending, and accumulation.

Entities not included in the definition of Normal residents:

● Foreign tourists and visitors

● Foreign staff of embassies, diplomats, officials, and members of the armed forces
● International Organisations
● Employees of International Organisations
● Crew members of foreign vessels, commercial travelers, and seasonal workers
● Border workers

Domestic Product: The Domestic Product of an economy involves all the production activities
of a production unit that is situated in the economic territory of a country, no matter whether the
activity is carried out by the residents or non-residents of the country. The monetary value of the
Domestic Product determined is known as Domestic Income.

National Product: The National Product of an economy involves all the production activities
performed by the normal residents of an economy, no matter whether the activity is performed
within the economic territory or outside it. The money value of the National Product determined
is known as National Income.

Factor Income: The income received by factors of production for rendering factor services in
the production process is known as Factor Income. factors of production are the primary inputs
such as land, labour, capital, and entrepreneur

Transfer Income: The income received by an individual without rendering any productive
service in return is known as Transfer Income.

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Net Indirect Tax (NIT): It refers to the difference between indirect taxes and subsidies. Indirect
Taxes are the taxes imposed on the production and sale of goods and services.

Subsidies: Subsidies are the economic assistance given to firms and households by the
government with the aim of the general welfare. It is also known as financial assistance.

Net Indirect Tax = Indirect Taxes – Subsidies

Net Factor Income from Abroad (NFIA): It is the difference between the factor income earned
by a country from abroad/rest of the world and factor income paid by a country abroad/rest of the
world.

Net Factor Income from Abroad = Factor income earned from abroad – Factor income paid
abroad
National Income = Domestic Income + NFIA
Components of NFIA:

1. Net Compensation of Employees: It is the difference between income received from

work by the resident workers living or employed abroad for less than one year and
similar payments made by an economy to the non-resident workers staying or employed
within the economic/domestic territory of a country for less than one year.

2. Net Income from Property and Entrepreneurship: It is the difference between income
received and paid in the form of rent, dividend, interest, etc., from property and
entrepreneurship.

3. Net Retained Earnings: Retained earnings are part of the profit that is kept aside as a
reserve for the future after payment of corporate tax and dividends. Net Retained
Earnings is the difference between the retained earnings of the resident companies, which
are located abroad, and the retained earnings of the non-resident companies, which are
located within the domestic territory of the country.

Circular Flow of Income: The circular flow of income is an economic model that reflects how
money or income flows through the different sectors of the economy.

Two Sector Economy Model:

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It is assumed that only two sectors exist, i.e., households and firms. Households are consumers of
goods and services and the owners of the factors of production and the firm sector produces
goods and services and sells them to households.

In the circular flow of income (two-sector economy), there is an exchange of goods and services
between the two players, i.e., the firms and households, which leads to a certain flow of money
in the economy. Households provide the firms with the factors of production namely, Land
(Natural Resources), Labor, Capital, and Enterprise that generate goods and services, and
consumers spend their income on the consumption of these goods and services. The firms then
make factor payments to households in the form of rent, wages, interest, and profit. This flow of
goods and services and factors payments between firms and households reflects the circular flow
of money in an economy.

In the circular flow of an economy in a two-sector model it is assumed that no savings are made
in the economy.

Circular Flow in a Three-sector Economy: In a three-sector economy includes households,

firms, and the government sector.

In this model, the government of a country acts as both a firm and a consumer. In this model, the
government produces goods and services for the economy as a producer and spends money on
the consumption of goods and services produced by the firms as consumers.

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Circular Flow in a Four-sector Economy: A four-sector economy consists of households,
firms, government, and the foreign sector.

In a four-sector economy, money flows between households, firms, government, and the foreign
sector, creating a continuous circular flow of income. The household sector earns income by
providing factor services to firms, the government, and the foreign sector, and receives transfer
payments such as pensions and scholarships. This income is spent on goods and services,
imports, and taxes. Firms earn revenue from the sale of goods and services to households,
government, and the foreign sector, and also receive government subsidies. They use this
revenue to pay for taxes, factor services, and imports.

The government collects revenue through taxes, fees, and the sale of goods and services, using it
to make factor payments, transfer payments, and subsidies. The foreign sector earns money from
exporting goods and services to households, firms, and the government while paying for imports
and factor services.

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Circular Flow in a Five-sector Economy: The financial market acts as an intermediary,
collecting savings from households, firms, and the government and providing loans to these
sectors. This ensures that the inflows and outflows of money are balanced, maintaining the
continuity of the circular flow of income in the economy.

In any other book you’ll not find five sector model but ma’am ne class me yahi karaya hai.

Phases of Circular Flow of Income:

1. Generation Phase: In this phase, the firms produce goods and services with the help of
factor services.
2. Distribution Phase: In this phase, factor incomes such as wages, rent, interest, and profit
flow from firms to the households.
3. Disposition Phase: In this phase, the income received by the factors of production is spent
on the goods and services produced by the firms.

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Significance of Circular Flow of Income:

1. Helps in understanding the mutual interdependence among different sectors

2. Helps in estimating National Income
3. Shows the equilibrium position of an economy
4. Helps in identifying different types of leakages and injections

Leakages mean to withdraw money from the circular flow of an economy. Leakage from the
circular flow of income of an economy happens when the firms and households save a part of
their incomes.

Injections mean the addition or introduction of income to the circular flow of an economy.
Injections into the circular flow of income are a result of money borrowed by households and
firms from different external sources, like financial institutions.

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 NATIONAL INCOME AND RELATED AGGREGATES

National Income: National Income is the aggregate value of all goods and services firms
produce in a given financial year.

When aggregate revenue generated by the firms is paid out to factors of production, it equals
aggregate income or National Income.

There are different variants or aggregates of National Income:

1. Gross Domestic Product at Market Price (GDP MP)- It refers to the gross market value of
all the final goods and services produced during a year within the domestic territory of a
country.
2. Gross Domestic Product at Factor Cost (GDP FC)- It refers to the gross money value of
all the final goods and services produced during a year within the domestic territory of a
country.
GDPFC = GDPMP – Net Indirect Taxes
3. Net Domestic Product at Market Price (NDP MP)- This refers to the net market value of
all the final goods and services produced during a year within the domestic territory of a
country.
NDPMP = GDPMP – Depreciation
4. Net Domestic Product at Factor Cost (NDP FC)- It refers to the net money value of all
the final goods and services produced during a year within the domestic territory of a
country.
NDPFC = GDPMP – Net Indirect Taxes – Depreciation
5. Gross National Product at Market Price (GNP MP)- This refers to the gross market value
of all the final goods and services produced during a year by the normal residents of a
country.
GNPMP = GDPMP + Net Factor Income from Abroad
6. Gross National Product at Factor Cost (GNP FC)- This refers to the gross money value of
all the final goods and services produced during a year by the normal residents of a
country.

GNPFC = GNPMP – Net Indirect Taxes

7. Net National Product at Market Price (NNP MP)- This refers to the net market value of
all the final goods and services produced during a year by the normal residents of a
country.

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 NNPMP = GNPMP – Depreciation
8. Net National Product at Factor Cost (NNP FC)- This refers to the net money value of all
the final goods and services produced during a year by the normal residents of a country.

NNPFC = GNPMP – Net Indirect Taxes – Depreciation

Note: Besides these, there exists Gross National Disposable Income (GNDI) which measures the
income available to the nation for final consumption and gross saving.

GNDI = GNPMP+ Net Current Transfers from Abroad

Methods to calculate national income:

Value-added method

The value-added method is used to calculate national income at different stages of the production
process in a circular flow. Value-added refers to the addition in the value of a raw material or
intermediate good by an organization during the production process.

Every organization adds value to the product, which it buys from other firms as an intermediate
good. The sum total of value added by every organisation is the value of national income.

To calculate the national income through the value-added method, the difference between the
value of output and the value of intermediate goods is taken.

Value Added = Value of Output – Intermediate Consumption

The value added by each production company is also called Gross Value Added at Market Price
(GVAMP). Also, the sum total of all the Gross Value Added at Market Price of all the enterprises
of a country within its domestic territory during one year is equal to GDPMP or Gross Domestic
Product at Market Price.

∑GVAMP = GDPMP

National Income or NNPFC = GDPMP – Depreciation – Net Indirect Taxes + NFIA

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 Income Method

To calculate the national income of an economy through the Income Method, the incomes
received by residents of a country for the productive services provided by them during a year are
added together. The incomes for the productive services or factors of production are received by
the residents in the form of profits, wages, interest, rent, etc. Other names for Income Method are
Distributive Share Method and Factor Payment Method.

National Income = NDPFC or Domestic Income (Compensation of Employees + Rent and

Royalty + Interest + Profit + Mixed Income) + NFIA

Expenditure Method

In this method, the income is calculated as the aggregate of all expenditures incurred by
households, firms, government, and foreigners. It is assumed that all the factor income earned is
spent in the form of expenditure incurred in the production of the goods and services, and

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circulated by the businesses in an economy. Therefore, the total final expenditure incurred is the
Gross Domestic Product at Market Price.

GDPMP = ∑ Final Expenditure

GDPMP = Private Final Consumption Expenditure (PFCE) + Government Final Consumption

Expenditure (GFCE) + Gross Domestic Capital Formation (GDCF) or Domestic Investment +
Net Exports (X – M)

National Income or NNPFC = GDPMP – Depreciation – Net Indirect Taxes + NFIA

Precautions of Income Method:

1. The value of production for self-consumption should be included.

2. Imputed rent of self-occupied buildings should be included.
3. Transfer payments should not be included.
4. Corporation tax should not be included separately. (It is Included in profit)
5. Windfall gains should not be included.
6. Illegal income will not be included.
7. Wealth tax and gift tax should be excluded from national income.

Precautions of Expenditure Method:

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 1. Expenditure incurred on second-hand or semi-finished goods should not be included be
excluded.
2. Transfer payments by the government should be excluded.
3. Own account production should be included.

Precaution of Value added Method:

1. Only the value of final goods and services should be included.

2. Imputed rent should be included.
3. Illegal activities are not included.
4. Leisure time is not included.
5. Activities of homemakers not included.
6. Own account production of fixed capital by government firms and households should be
included.

New GDP series: India has moved to a new GDP series in recent years. The Central Statistical
Organization, which is in charge of calculating the national income, decided to adopt a new
series that is based on the year 2011-12.

Changes:

1. Change in the base year(2011–12) to calculate real GDP.

2. The data pool has been widened as we now take data from the Ministry of Corporate
Affairs, earlier we used annual surveys of industries.
3. The old series used factor cost to calculate GDP but now Market price is used.

Problems in calculating National Income:

1. Difficulty in collecting data(statistical and practical problems)

2. The conceptual problem as it considers only goods and services.
3. Lack of technical expertise of the staff collecting data- aggregates have to be converted
properly.
4. The problem of multiple counting.

Problem with GDP:

1. It does not take into account the voluntary work. It only takes market transactions.
2. GDP fails to measure inequality.

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 3. Black money and illegal activities give rise to a parallel economy which we are not
taking into consideration.
4. It fails to consider the barter system that is followed by some countries.
5. It undermines the concept of sustainable growth as it does not take into account
environmental damages.
6. It does not measure the actual well-being of the nation.

Alternatives to GDP:

1. Genuine Progress Index: GPI is a comprehensive metric that evaluates the overall
well-being of society by considering economic, environmental, and social factors. Unlike
GDP, which only measures economic activity, GPI accounts for the benefits of activities
like volunteering and the costs of factors such as pollution, crime, and resource depletion.
2. Gross National Happiness Index: GNH is a measure of prosperity that incorporates
various dimensions of well-being, including psychological well-being, health, education,
time use, cultural diversity, good governance, community vitality, ecological diversity,
and living standards.
3. Gross Sustainable Development Product: GSDP is an alternative measure that focuses
on sustainable development. It integrates economic, social, and environmental
dimensions to assess the long-term sustainability of a nation's development.
4. Human Development Index: HDI is a composite statistic that measures a country's
average achievements in three basic aspects of human development: health (life
expectancy), education (mean years of schooling), and income (GNI per capita).

Green GDP: it is the value of GDP after adjusting for environmental damages such as
biodiversity loss and climate change.

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 THEORY OF INCOME AND EMPLOYMENT

There are two theories of Income and Employment:

● Classical Theory
● Modern Theory

The classical economists believed in the existence of full employment in the economy. To them,
full employment was a normal situation and any deviation from this regarded as something
abnormal. Ricardo, J.B. Say, and J.S Mill were famous economists of this approach.

Those who are not prepared to work at the existing wage rate are not unemployed because they
are voluntarily unemployed. Thus full employment is a situation where there is no possibility of
involuntary unemployment in the sense that people are prepared to work at the current wage rate
but they do not find work.

The classical theory of output and employment is based on the following assumptions:

1. It is based on the say’s law of the market.

2. Full employment without inflation exists.
3. There is a laissez-faire capitalist economy without government interference.
4. It is a closed economy without foreign trade.
5. Labour is homogeneous.
6. The quantity of money is given and money is only the medium of exchange.
7. Wages and prices are perfectly flexible.
8. It assumes the long run.

Say’s Law of Market: Say’s law of markets is the core of the classical theory of employment.
“supply creates its own demand.” is the core principle of this theory. As per this theory, there
cannot be general overproduction and unemployment in the economy.

If there is general overproduction in the economy, then some laborers may be asked to leave their
jobs. The problem of unemployment arises in the economy in the short run. In the long run, the
economy will automatically tend toward full employment when the demand and supply of goods
become equal.

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When a producer produces goods and pays wages to workers, the workers, in turn, buy those
goods in the market. Thus the very act of supplying (producing) goods implies a demand for
them. It is in this way that supply creates its own demand.

Wage Price Flexibility: The classical economists believed that there was always full
employment in the economy. In case of unemployment, a general cut in money wages would
take the economy to the full employment level. This argument is based on the assumption that
there is a direct and proportional relation between money wages and real wages.

When money wages are reduced, they lead to a reduction in the cost of production and
consequently to the lower prices of products. When prices fall, demand for products will increase
and sales will be pushed up. Increased sales will necessitate the employment of more labour and
ultimately full employment will be attained.

In classical theory, output, and employment are determined by the production function and the
demand for labour, and the supply of labour in the economy.
Q=f (K, T, N)

Where total output (Q) is a function (f) of capital stock (K), technical knowledge (T), and the
number of workers (N).

Keynesian theory of economics:

Macroeconomics, as a separate branch of economics, emerged after the British economist John
Maynard Keynes published his celebrated book The General Theory of Employment, Interest
and Money in 1936.

The Keynesian Theory states that the equilibrium situation is usually expressed in terms of
Aggregate Demand (AD) and Aggregate Supply (AS). When aggregate demand for products and
services over a given period of time equals aggregate supply, an economy is in equilibrium.

Aggregate Demand: Aggregate Demand refers to the total demand for finished goods and
services in the economy over a specific period.

Aggregate Demand = Consumption + Investment

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Components of Aggregate Demand:
1. Government Expenditure (G): Government Expenditure is the total expenditure made by
the government on the acquisition of public goods and social services to satisfy the need
of the overall economy.
2. Private (Household) Consumption Expenditure (C): Consumption Expenditure or
Private/Household Consumption Expenditure refers to the total spending of an individual
or a household on the purchase of goods and services in an economy during an
accounting year.
3. Investment Expenditure (I): Investment Expenditure refers to the company’s total
expenditure on acquiring new capital goods and services like machinery and equipment,
changes in inventories, and investments in non-residential and residential structures.
4. Net Export (X – M): The term total export refers to the demand for the products that are
produced by domestic producers but are sold to the rest of the world, while total import
refers to the demand for the products that are manufactured outside the domestic
boundaries of the country but are imported to the country.

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

Consumption Function: The functional relationship between consumption and national income
is known as Consumption Function. It represents the willingness of households to purchase
goods and services at a given income level during a given period of time.

C = f(Y)
C= b. Y+ c(put bar symbol above c)

● C = Consumption
● (\bar{c}) = Autonomous Consumption
● b = MPC
● Y = Income

Propensity to consume:
1. Average Propensity to Consume (APC): It is the ratio of consumption expenditure to the
corresponding income level. APC= C/Y.
2. Marginal Propensity to Consume (MPC): It is the ratio of the change in consumption
expenditure to the change in total income. MPC=∆C/∆Y.

Consumption function has two types of consumption:

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 1. Autonomous Consumption: This means that the level of consumption is independent of
the changes in income. This is the amount of consumption that will take place even when
income is zero.

2. Induced Consumption: It means the level of consumption which changes with the change
in income. It is a rising function represented by b.Y. (b means MPC).

Investment Function: A strategy or concept of economics that helps in identifying the

connection between shifts in the investment patterns of people and other variable factors
affecting investment in an economy is known as an Investment Function.

Types of Investment:

1. Autonomous Investment: The investment on which the change in income level does not
have any effect and is induced only by profit motive is known as Autonomous
Investment. Autonomous Investment is income inelastic. It means that if there is a change
in income (increase/decrease), the autonomous investment will remain the same.
2. Induced Investment: The investment that depends upon the profit expectations and has a
direct influence on income level it is known as Induced Investment. Induced Investment
is income elastic. This means that the induced investment increases when income
increases and vice versa.

Determinants of induced investment

1. Marginal Efficiency of Investment: MEI is the expected rate of return from an additional
investment. The following two factors are required to determine MEI: Supply price and
prospective yield.

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 2. Rate of Interest: It is the cost of borrowing money for financing investment. There is an
inverse relationship between ROI and the volume of investment. If the Rate of Interest is
high, then the investment spending will be less and if the Rate of Interest is low, then the
investment spending will be more.

Investment Multiplier: The relationship between an initial increase in investment and the
subsequent rise in total revenue is expressed by the multiplier. when investments are increased
by a particular amount, the change in income does not only reflect the initial investment’s value
but also increases by several times. M = 1 / (1 - MPC)

Investment multiplier:

1. Change in investment leads to change in national income.

2. Change in national income is a multiple of change in investment.
3. This multiple is termed as multiplier.

Assumptions:

1. There is an autonomous investment in the economy.

2. MPC remains unchanged.
3. Consumption is the function of the current income. There is no time lag between
receiving income and consuming it.
4. There is always excess capacity to supply good and services in the economy.

Features of multiplier:

1. It is associated with a change in investment.

2. The size of the multiplier depends upon MPC.
3. Multiplier works in both forward and backward directions.
4. Value multiplier varies from unity to infinity. It will be less than 1.
5. The higher the MPC, the larger the multiplier will be. If MPC is 0, the value of Multiplier
is 1.

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Aggregate Supply: Aggregate supply refers to the monetary value of final goods and services
that all the producers are willing to supply in an economy in a given period.

Aggregate supply=National Income

Components of Aggregate Supply

Income is either consumed or saved.

National Income (Y) = Consumption (C) + Saving (S)

Propensity to save:
1. Average Propensity to Save (APS): It is the ratio of saving to the corresponding income
level. APS= S/Y.
2. Marginal Propensity to Save (MPS): It is the ratio of the change in saving to the change
in total income. MPS= ∆S/∆Y.

Aggregate Demand-Aggregate Supply Approach: The Keynesian Theory states that the
equilibrium situation is usually expressed in terms of Aggregate Demand (AD) and Aggregate
Supply (AS). When aggregate demand for products and services over a given period of time
equals aggregate supply, an economy is in equilibrium.

So, equilibrium is attained when:

AD = AS

Assumptions:

1. The determination of the equilibrium level will be examined using a two-sector model
(households and firms). Simply put, it is assumed that there is no foreign industry or
government in the economy.
2. It is also assumed that investment expenditure is autonomous, i.e., that income level does
not have any impact on investments.
3. It is assumed that the pricing level is constant.
4. Also, to determine equilibrium output, short-run will be considered.

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The overall output of goods and services from the national income is known as the aggregate
supply. A 45° line is used to represent it. The AS curve is represented by the (C+S) curve
because the money received is either spent or saved.

The AD or (C+ I) curve in the graph shows the desired expenditure level by consumers and
businesses at each level of income. At point E where the (C+ I) curve intersects the 45° line, the
economy is in equilibrium.

Equilibrium income level might correspond to full employment, underemployment, or

over-employment of resources.

Inflationary Gap: When demand is more than what is necessary to utilise resources fully, it is
called Excess Demand. In simple terms, when planned aggregate expenditure is more than
aggregate supply at full employment, excess demand arises. It creates an inflationary gap. It is a

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difference between the aggregate demand at full employment equilibrium and the over-full
employment equilibrium.

If the government continues to invest it would lead to an increase in demand and it will cause
inflation.

The determined equality of aggregate demand and supply does not necessarily indicate the full
employment level. It can be below or above also.

The AD intersects the AS at E which is an effective demand point and the national income is OY.

Significance of 45-degree line:

1. The 45-degree line represents the equilibrium point where aggregate supply (AS) equals
aggregate demand (AD) in an economy. This equilibrium level determines the overall
output and price level in the economy.

2. Any point above the 45-degree line indicates excess demand, where aggregate demand
exceeds aggregate supply. This situation leads to inflationary pressure as consumers
compete for limited goods and services.

3. Conversely, any point below the 45-degree line indicates excess supply, where aggregate
supply exceeds aggregate demand. This situation leads to deflationary pressure as
producers reduce prices to clear excess inventories.

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 4. Movements along the 45-degree line represent changes in the price level. For example, if
aggregate demand increases due to increased consumer spending, the economy moves up
along the line, resulting in higher output and prices.

5. Shifts of the 45-degree line represent changes in aggregate demand or aggregate supply.
Factors such as changes in government spending, investment, consumer confidence, or
technological advancements can cause the line to shift. An inward shift indicates a
decrease in overall output, while an outward shift indicates an increase.

Determination of the level of employment in the economy:

1. The equilibrium level of income determined by the equality of aggregate demand and
aggregate supply does not necessarily indicate the full employment level. It can be below
or above as shown in the figure. The AD curve intersects the AS curve at point E which
is an effective demand point and the national income is OY.
2. Let us assume that in the generation of OY level of income. Some of the workers willing
to work have not been absorbed. It means that E is an under-employment equilibrium &
OY is the under-employment level of Income.
3. The workers can be absorbed if the level of output can be increased from Y to Y1 which
means that OY1 is the full employment level of income and E1 is the full employment
equilibrium.
4. With the spending by the government as a result the economy rises from the lower
equilibrium point E to higher equilibrium point E1.
5. With the spending by the government, the aggregate demand curve rises and the OY1 is
the new equilibrium level of income along with full employment.
6. Thus government spending can help to achieve full employment, in case the equilibrium
level of income is above the level of full employment.
7. If the government furthers does the public investment the aggregate demand will increase
leading to a new equilibrium E2. E2 is an over-full employment equilibrium.
8. The Gap between AD1 and AD2 represents the inflationary Gap because the increase in
demand beyond the full employment equilibrium will lead to an increase in prices.

Solutions:

1. Monetary: The central bank can raise interest rates, which would make borrowing more
expensive, discouraging both consumer and business spending. A tight monetary policy
should lower the money available to most consumers, triggering less demand.

24
 2. Fiscal: A government may use fiscal policy to help reduce an inflationary gap by
decreasing the number of funds circulating within the economy.
3. International: If the national currency appreciates, imports become cheaper, which can
reduce domestic prices and ease inflation.

Significance of the Keynesian model:

1. Effective demand determines the level of employment in the country. As it increases

employment also increases.
2. Keynes Falsified Says law: With the concept of effective demand whatever is produced in
the economy is not always consumed it is partly saved. It is based on the psychological
law of consumption which states that when income increases, people tend to spend more
on consumption, but not as much as the increase in income. This is because some of the
income is saved.
3. Role of Investment: According to the principle of effective demand for achieving full
employment level, real investment must be equal to the gap between income and
consumption.
4. The principle of effective demand states that in a rich community, the gap between
income and consumption is high. If investment is not made to fill the gap it will result in
unemployment.

Criticism of the Keynesian theory:

● This theory put more emphasis on the determinants of aggregate demand and to a greater
extent ignored the determinants of aggregate supply.
● This theory applies to developed economies and not very useful for policy purposes in
less developed economies.
● The difficulty of predicting the output Gap and the assumption of Keynesian economics
is that it is possible to know how much demand needs to be increased to deal with the
output gap
● It takes a long time to change aggregate supply corresponding to the change in aggregate
demand. By the time aggregate supply increases, it may be too late and may lead to
inflation.

25
MID-SEM

ENDS HERE

26
 PUBLIC FINANCE

In Public finance “public” is related to public authorities & “finance” is related to the adjustment
of financial resources.

● Public finance is the study of the operation/generation of public income and expenditure.
● Private finance is the study of finance done by the private business or households.

Similarity of Public and Private Finance:

1. They try to gain maximum advantage which is the maximum utility that can be derived
from a purchase.
2. The resources are scarce which means that expenditure cannot be planned in an unlimited
manner.
3. Borrowing is taken up when revenue is less than expenditure.
4. The problem of adjustment of income and Expenditure.

Difference between Public and Private Finance:

1. The government first determines the volume of expenditure that it has to spend on
different heads to perform its obligations and then tries to find the resources to meet its
responsibilities. Meanwhile, in private expenditure, an individual first considers income
and then determines the volume of expenditure.
2. The credit of a private individual has limited sources and can raise credit only within the
economy. They cannot borrow from International financial sources. Whereas the
Government enjoys a very high degree of credit in the market it can borrow a large
amount from its citizens, foreigners, and international sources.
3. The government has the right to print money whereas, the private Individual can't do so.
4. Private Individuals generally have a surplus budget. Whereas, the Government has a
deficit budget in a growing economy.
5. The budget of Private Individuals is secret whereas the government budget is made
public.
6. The government budget is more flexible as the amount of income can be increased by
imposing taxes and likewise it can also change expenditures. Whereas, private
Individuals cannot make a significant change.

27
 7. Expenditure by the public authority takes a long time to show gains. Whereas, private
Individual expenditure leads to a short-term gain.
8. Private finance is for personal benefits whereas public finance is for the benefit of the
public.
9. Private expenditure being small in relation to public policy expenditure has only a
marginal effect & Public expenditure being large in size has a tremendous effect.

Components of Public Finance:

Public Revenue: Resources required by the government to perform its function. They can be
divided into narrow sense(not subject to repayment) and wider sense(all revenue irrespective of
sources).

Sources:

1. Tax sources: The sources of public revenue that are raised by the government from tax in
the economy. They are compulsory contributions levied by the state for meeting expenses
in the common interest of all citizens.

The government derives its power to Tax from the Constitution.

Below is the tax structure of India:

1. Union list: Income Tax other than agricultural income, Corporation Tax, Custom duties,
estate duties other than non-agricultural land, Stamp duties, Tax on sale and purchase of
Newspaper Excise duties, except on alcoholic liquor and opium and other narcotics.
2. State List: Land revenue, Taxes on Agricultural income, Duties in respect of succession
to agricultural land, tax on sale and purchase of goods other than newspapers, toll tax,
entertainment, etc.
3. Local Govt. List: Power to tax is also provided to municipal authorities.

● Direct Tax: Its governing body is the Central Board of Direct Taxes (CBDT)

Income Tax(Governed by IT Act,1961),

Wealth Tax(The simplest calculation of wealth tax is that if it exceeds 30 lakh

then 1 percent of the amount is payable as tax but it was abolished in the 2015
budget and it was replaced with 12% surcharge on individuals who earn more
than 1 crore and for companies 10 crores).

28
 Gift Tax(Abolished in 1998).

Other direct taxes are Securities tax, Corporate tax etc.

● Indirect Tax: Its governing body is the Central Board of Excise and Customs.
(CBEC)

Goods and Services Tax: It was introduced in 2017. It provided 5 tax brackets for
different goods and services(0%. 5%, 8%, 18%, 28%).

Types:

1. CGST: Levied by the Central Government on intra-state (within the same

state) supplies of goods and services.
2. SGST: Levied by the State Government on intra-state supplies of goods
and services.
3. UTGST: Levied by the Union Government on intra-Union Territory
supplies of goods and services, applicable to Union Territories
4. IGST: Levied by the Central Government on inter-state (between different
states or between a state and a Union Territory) and international supplies
of goods and services.

2. Non-tax sources: The sources of public revenue which are raised by the government other
than tax in the economy.
● Administrative revenue

Fees: It includes fees charged by the government for public service. It is not a
voluntary payment it is a compulsory payment.

Special assessment: A compulsory contribution levied in proportion to the special

benefit to defray the cost of special improvement to property undertaken in the
public interest.

Fines and penalties: Punishment imposed for violation of certain laws. It is not an
important source of revenue as the amount cannot be assessed.

29
 Forfeitures: It refers to the penalties imposed by courts for the failure of
individuals to appear in court.

Escheats: These are the claims of the government on the property of an individual
who dies without having an heir.

● Commercial Revenue: The income earned by the public sector enterprises by

selling goods and services to the citizens.
● Other revenue: Gift, Grants, donations, Tributes, Indemnities, National
borrowings and International Borrowings
● Miscellaneous source: Auctioning, Printing of currency, etc.

Public Debt:

Public Expenditure: Expenses incurred by the government authorities for maintaining law and
order, social welfare, and protection of the people of the country.

Types:

1. Revenue and Capital: They are recurring maintenance of facilities like running hospitals,
defense, etc, and non-recurring expenses like establishing schools, hospitals, etc.
2. Functional expenditure:
3. Transfer and Non-Transfer: It refers to payments made by the government where there is
no direct exchange of goods or services. These are often in the form of subsidies
pensions, welfare payments, and direct expenditure by the government in exchange for
goods and services, such as the purchase of equipment, salaries for government
employees, or infrastructure projects respectively.
4. Grants and purchase price: Funds given by the government without expecting a direct
return. These could be grants to states, local bodies, or individuals for specific purposes
like education, healthcare, or rural development. Purchase price refers to expenses
incurred when the government purchases goods or services for public use, such as buying
military equipment or paying for the construction of public infrastructure.
5. Classification according to benefits:

Causes of Increase in Public Expenditure:

1. Rise in population

30
 2. Change in function of state
3. The rising cost of public service
4. Expansion of the public sector
5. Economic development

Planned Expenditure: This refers to the expenditure that is part of the government's
development plans. It is systematically budgeted in the national or state economic plans.

Unplanned Expenditure: Unplanned expenditure is not accounted for in the government’s

developmental plans but is essential for the functioning of the country.

1. Principle of Maximum Social Benefits: This principle advocates that public expenditure
and taxation policies should aim to provide the greatest possible social benefit to the
community. The government's objective should be to maximize the welfare of society as
a whole.

2. Principle of Economy( Minimum waste of resources):

Financial Administration:

Economic Stabilization:

Classification of Expenditure:

Budget: In India, the national budget is an annual financial statement presented by the
government, outlining its expected revenues and expenditures for the upcoming fiscal year,
which runs from 1st April to 31st March. The Union Budget, also known as the Annual Financial
Statement, is presented by the Finance Minister of India in Parliament.

Components of Budget:

1. Revenue Budget:

31
 ● Revenue receipts- These are the incomes received by the government within a
fiscal year that do not create any liabilities. Hence they do not impact assets and
liabilities. Revenue receipts can be classified into two categories:
1. Tax Revenue: This includes taxes collected by the government like
income tax, corporate tax, Goods and Services Tax (GST), customs duties,
excise duties, etc.
2. Non-Tax Revenue: This includes earnings from sources like interest on
loans given by the government, dividends from public sector enterprises,
fees, fines, and grants.
● Revenue expenditure- These are the expenditures incurred by the government for
a purpose other than the creation of physical or financial assets, it does not lead to
the creation of assets or reduction in liabilities. It includes:
1. Interest Payments: Payments for servicing past debt.
2. Salaries and Pensions: Wages of government employees and pensions of
retirees.
3. Subsidies: Support provided by the government in areas like food,
agriculture, fuel, etc.
4. Defense Spending: Operational costs for defence services.
5. Other Welfare Expenditures: Includes spending on social services such
as health, education, and welfare schemes.
2. Capital Budget:
● Capital receipts- These are funds received by the government that are not the part
of regular source of income. They either create liabilities or reduce assets. Capital
receipts are of two types: Debt Creating and Asset reducing.
1. Borrowings: Loans raised by the government from internal (banks,
financial institutions, etc.) and external (foreign countries, international
organisations) sources.(Debt Creating)
2. Recovery of Loans: Money received from the repayment of loans
previously granted by the government.(Asset reducing)
3. Disinvestment: Proceeds from selling government shares in public sector
enterprises.(Asset reducing)

● Capital expenditure- This refers to the expenses incurred by the government to

create assets or reduce liabilities. It includes:
1. Infrastructure Development: Spending on building roads, bridges,
schools, hospitals, and other public infrastructure.

32
 2. Investments: Investments made in public sector undertakings or other
strategic sectors.
3. Loan Disbursements: Loans given by the government to states, union
territories, and other entities.
4. Defence: Purchase of military hardware and strategic assets.

Types of Budget:

1. Deficit Budget: In developing economy, this type of budget can be seen.

Types:

● Budget Deficit- T.R < T.E

Deficiet= T.R-T.E

● Revenue Deficit: Revenue deficit is excess of total revenue expenditure of the

government over its total revenue receipts. It is related to only revenue
expenditure and revenue receipts of the government. Revenue deficit signifies that
government’s own earning is insufficient to meet normal functioning of
government departments.

A high revenue deficit warns the government either to curtail its expenditure or
increase its tax and non-tax receipts.

Revenue deficit = Total Revenue expenditure – Total Revenue receipts and

provision of services.

● Fiscal Deficit: It is defined as excess of total budget expenditure over total budget
receipts excluding borrowings during a fiscal year. It is amount of borrowing the
government has to resort to meet its expenses.

Fiscal deficit = Total expenditure – Total receipts excluding borrowings =

Borrowing

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

33
 Primary deficit = Fiscal deficit – Interest payments

Deficit financing- It is a process of financing deficit in a budget.

Tools of deficit financing:

1. Monetary expansion:
2. Borrowings from public:
3. Disinvestment:
4. Other borrowings:

Balanced Budget:

Surplus Budget:

The objective of the Government Budget:

1. Reallocation of resources in the economy to ensure maximum benefit and social welfare
2. To reduce Inequalities and disparities. Here it includes all kinds of inequalities like-
income, gender, and region.
3. Sustainable development
4. Maintenance of public sector enterprise

34
 MONEY AND BANKING

Money: It is a medium of exchange which is generally accepted and authenticated by the

government.

Evolution of Concept of Money

A barter system refers to the exchange of goods & services with two or more parties without the
use of money. This exchange is also known as “C-C Transactions“( c stands for commodity). It
works on the “double coincidence of wants”.

Double Coincidence of Wants: A double coincidence of wants is a situation where both parties
hold an item needed by the other to fulfill their demand. So, they exchange items without any
monetary medium, which leads to barter trade.

Problems of Barter System:

1. Lack of Double Coincidence of Wants: A barter system is possible only when there is a
situation of “double coincidence of wants“. i.e., when both parties are ready to exchange
each other’s goods. For example, A can exchange goods with B only if A has the goods
needed by B, and B has the goods needed by A. Such a double coincidence of wants is
rare.
2. Lack of Common Measure of Value: In a barter system, all the commodities do not
possess equal value, moreover, there is no common measure of value in which exchange
ratios can be fixed. For example, if A has wheat and B has rice, then it’s difficult to
decide, in exchange for 1 kg of wheat how much rice is needed. In absence of a common
measure of value, the exchange ratio is fixed randomly, hence, one party mostly suffers.
3. Lack of Standard of Deferred Payment: In a barter system, deals consist of future
payments and credits can not be carried out easily, as the borrower may not be able to
provide the same quality goods as promised at the time of repayment, and the value of the
commodity to be exchanged can be increased or decreased at the time of repayment.
There also may be conflicts regarding the type of commodity used for the repayment.
4. Lack of Store of Value: In a barter system, it is very difficult to store the wealth for
future use, as the storage of goods requires time and efforts, and the commodities used for
exchange are wheat, rice, vegetables, etc., are non-durable goods, i.e., their quality falls
with the passage of time.

35
 5. Lack of Divisibility: The barter exchange between divisible and indivisible goods in a
small value is not possible without the loss of a value. For example, if the price of a sheep
is 40kg of rice, then the person with 20kg of rice can not exchange it for sheep, as it is not
possible to cut the sheep into small pieces without destroying its utility.

Evolution of Money:

1. Commodity Money: Commodity money is a physical good that consumers universally

use to trade for other goods. In other words, it is like the money we use today, but has an
actual value.
2. Metallic Money: With the progress of the trade, commodity money was converted into
metallic money. It can be of two types- coined and uncoined. Firstly, uncoined money
was used but because of a problem we shifted to coined money. Metals like silver,
copper, gold, etc., were commonly used as they are easy to use and their quantity can be
easily determined. We faced problems like limited supply.
3. Paper Money: It was very difficult and unsafe to carry gold and silver coins from place
to place, therefore, paper money was invented. The invention of paper money was the
most important stage of money evolution. It had two types of convertible( can be
converted into gold or gold coins. It is also known as full body money) and inconvertible(
cannot be converted into gold or gold coins, here just a percentage of reserve is kept).
4. Fiat Paper Money: It cannot be converted into gold or gold coins but it is accepted
because it is declared as legal tender by the issuing authority. The intrinsic value of this
type of money is nil.
5. Credit Money: Credit money represents a claim on goods and services, allowing
individuals to borrow against their future earnings. It usually comes in the form of bank
credit, loans, and credit cards, facilitating transactions without the immediate exchange of
physical currency.
6. Electronic Money: Electronic money (or e-money) exists in digital form and can be used
for online transactions. It includes digital currencies, bank transfers, and payment systems
like PayPal or cryptocurrencies. E-money has gained popularity due to its convenience
and efficiency in facilitating trade in the digital age.

Functions of money:

Primary Functions-

36
 1. Medium of Exchange: As a medium of exchange, money can be used to make payments
to all the transactions related to goods & services. It is the most important function of
money. As money is universally accepted, therefore all exchanges take place in terms of
money.
2. Measure of Value: As a measure of value money works as a common parameter, in which
the value of every good & service is expressed in monetary terms.

Secondary function:

Standard of Deferred Payments; The Standard of deferred payments states that money act as a
“standard of payment”, which is to make in the present or in near future. On a daily basis,
millions of transactions are made in which payments are not made immediately. Money
encourages such transactions and facilitates capital formation & economic development of the
nation. This function of money is important because:

● It leads to the creation of financial institutions.

● It simplifies the borrowing and lending operations.

Store of Value or Asset Function of Money: Money as a store value can be used to store wealth
in the most economical and convenient way and to transfer the purchasing power from the
present to the future.

Money as a store value has the following advantages:

● It was very difficult to store wealth in terms of goods because of their perishable nature
and high cost. Money provides a solution to this problem as one can store money for as
long as possible.
● Money has the quality of universal acceptability. Therefore, one can at any time use
money in exchange for goods and services.
● Money is easily portable, and saving money is much easier and more secure than saving
goods for future use.

Functions of Money:

1. National Income Distribution: The total output of the country is produced by the factors
of production; therefore, money helps in the ideal distribution of national income
amongst different factors of production by creating factor incomes like interest, profit,
wages, and rent.

37
 2. Increased Satisfaction: Money maximizes the satisfaction of producers and consumers. A
producer maximizes his satisfaction(profit) by equating the price of a factor with its
marginal productivity. Similarly, a consumer maximizes his satisfaction by equating the
price of a commodity(expressed in monetary terms) with its marginal utility.
3. Credit Creation: Commercial banks create credit with the help of demand deposits, which
was not possible before the invention of money. Money as a store value motivates people
to save more in the banks in form of demand deposits.
4. Capital Productivity: Money helps in increasing capital productivity, as it is the most
liquid asset that can be used in anything. The liquidity of money makes it easy and
possible to transfer capital from less productive uses to more productive uses.
5. Bearer of Options: Money provides purchasing power to the person holding it, also
known as the bearer, and he can use it in many ways. The bearer can change his decision
from time to time and place to place regarding the use of money depending on the
situation, priority and urgency.
6. Solvency Guarantee: Money provides a guarantee of solvency for an institution or
individual. If a person has more money than his liabilities, then he can not be declared
bankrupt or insolvent. Due to this reason, firms keep large reserves to meet uncertain
requirements.

Static and Dynamic Functions of Money:

Both static and dynamic functions are required for the proper working of an economy.

Static Functions: Static functions are those functions that facilitate the working of an economy,
and in absence of these functions, an economy can not work properly. For example, functions of
money as a store value, medium of exchange, a measure of value, and a standard of deferred
payments are static functions.

Dynamic Functions: Dynamic functions are those functions that determine the economic trends
and cause movement in the economic activities of a country. For example, the expansion of
credit not only increases the price level, but also increases employment, level of income, and
output in the economy. Money can put idle resources into productive channels to generate more
output.

Liquid preference theory: Liquidity preference theory, developed by John Maynard Keynes,
aims to explain how interest rates are determined. The key premise is that people naturally prefer

38
holding assets in liquid form—that is, in a manner that can be quickly converted into cash at little
cost. The most liquid asset is money.

Liquidity refers to the convenience of holding cash. Everyone in this world likes to have money
with him for a number of purposes. This constitutes his demand for money to hold.

The sum-total of all individual demands forms the demand for money for the economy. On the
other hand, we have got a supply of money consisting of coins plus bank notes plus demand
deposits with banks. The demand and supply of money, between themselves, determine the rate
of interest.

Keynes argued that the desire for liquidity springs from three motives: the transactions,
precautionary, and speculative motives.

● Transactions motive: the need to hold cash for day-to-day transactions like buying
goods and services. This demand for liquidity is fairly predictable and correlates with the
income and expenses of individuals and firms: the demand for liquidity increases with
income. The transaction motive is fundamental and exists regardless of the level of
interest rates, emphasizing the essential role of money as a medium of exchange in daily
economic activities.

T=F(y)

● Precautionary motive: the urge to hold onto cash as a buffer against unexpected
expenses or emergencies. Individuals might hold onto money or easily accessible funds
to cover unexpected medical costs, car repairs, or other financial demands. Similarly,
businesses may maintain a liquidity cushion to weather unexpected operational or market
challenges. The precautionary motive underlines how money is a store of value that
provides a sense of security in the face of uncertainty.

P=P(y)

● Speculative motive: holding onto cash to take advantage of future investment

opportunities not yet available. The speculative motive tends to be more pronounced
among investors and financial institutions, and its intensity can vary with the expectations
regarding the future trajectory of interest rates, economic growth, and market conditions.
When the nominal interest rate is low, people hold onto money, even if it provides no
interest income. But this changes as the interest rate ticks upward. There is an inverse
relationship between the interest rate and the market value of securities, like bonds.

S=S(r)

39
Fisher’s quantitative theory of money:

There is a direct relationship between the quantity of money in an economy and the level of
prices of goods and services.

The theory also states that there is an inverse relationship between the quantity of money in an
economy and the value of money.

Fisher's Equation

The relationship is commonly expressed through the equation:

MV=PT

Where:

● M = Supply of Money
● V = Velocity of money (the average frequency with which a unit of money is spent)
● P = Price level of goods and services
● T = Total amount of goods and services sold

Rearranging the equation to focus on the price level gives:

P=MV/T​

Assumptions:

1. Constant Velocity of Money: According to Fisher, the velocity of money (V) is constant
and is not influenced by the changes in the quantity of money. The velocity of money
depends upon exogenous factors like population, trade activities, habits of the people,
interest rate, etc. These factors are relatively stable and change very slowly over time.
Thus, V tends to remain constant so that any change in supply of money (M) will have no
effect on the velocity of money (V).
2. Constant volume of trade and transaction: Total volume of trade or transactions (T) is
also assumed to be constant and is not affected by changes in the quantity of money. T is
viewed as independently determined by factors like natural resources, technological
development, population, etc., which are outside the equation and change slowly over
time. Thus, any change in the supply of money (M) will have no effect on T. Constancy
of T also means full employment of resources in the economy.
3. Price is a passive factor: According to Fisher the price level (P) is a passive factor
which means that the price level is affected by other factors of equation, but it does not

40
 affect them. P is the effect and not the cause in Fisher‟s equation. An increase in M and
V will raise the price level. Similarly, an increase in T will reduce the price level.
4. Money is only a medium of exchange: The quantity theory of money assumed money
only as a medium of exchange. Money facilitates the transactions. It is not hoarded or
held for speculative purposes..
5. Direct relationship between M and M’: Fisher assumes a proportional relationship
between currency money (M) and bank money (M’). Bank money depends upon the
credit creation by the commercial banks which, in turn, are a function of the currency
money (M). Thus, the ratio of M‟ to M remains constant and the inclusion of M‟ in the
equation does not disturb the quantitative relation between quantity of money (M) and the
price level (P).
6. Long period analysis: The theory is based on the assumption of long period. Over a long
period of time, V and T are considered constant.

Thus, when M’, V, V’ and T in the equation MV + M’Y’ = PT are constant over time and
P is a passive factor, it becomes clear, that a change in the money supply (M) will lead to
a direct and proportionate change in the price level (P).

7. Full employment equilibrium: The theory assumes that the economy is at or near full
employment, meaning all resources are being utilized efficiently.

He further modified his theory and gave an equation of exchange so as to include demand (bank)
deposits (M‟) and their velocity, (V‟) in the total supply of money.

MV=M’V’= PT

Question. Suppose M=1000 Rs. M’=500,V=3, V’=2 AND T=4000. Find P

Fisher’s quantity theory of money can be explained with the help of an example. Suppose M =
Rs. 1000. M’ = Rs. 500, V = 3, V’ = 2, T = 4000 goods.

41
Thus, when money supply is doubled, i.e., increases from Rs. 4000 to 8000, the price level is
doubled. i.e., from Re. 1 per good to Rs. 2 per good and the value of money is halved, i.e., from
1 to 1/2.

Thus, when money supply is halved, i.e., decreases from Rs. 4000 to 2000, the price level is
halved, i.e., from 1 to 1/2, and the value of money is doubled, i.e., from 1 to 2.

Banks- Financial institutions which acccept money from public for lending to others where
money is withdrawable on demand throught demand drafts,cheques etc.

Different types of banks-

● Commercial- Commercial banks engage in a wide array of financial services, acting as

financial intermediaries between depositors and borrowers. These services include
accepting deposits, extending various types of loans, providing checking and savings
accounts, offering credit and loan facilities to businesses, and facilitating international
trade finance. They can be divided into scheduled and non-scheduled banks

42
 ● Rural/Regional- Rural banks specialize in meeting the unique financial needs of rural
communities. They were created to provide rural population access to credit on the
recommendation of narshiman committee in 1975. These banks are governed by the rural
banks act. The area of these banks is regional comprising of some districts
● Co-operative- Cooperative banks stand out as member-owned and member-operated
entities, emphasizing community-based financial services. These banks offer a diverse
range of financial products, including savings and loans, and operate with a cooperative
structure where members are both customers and owners.

Functions of Commercial Bank- It has two types of functions:

Primary- Accepting Deposits and Advancing of Loans are the two primary functions performed
by commercial banks.

● Accepting Deposits- Commercial banks accept deposits from their customers in different
forms based on the requirements of different sections of society. The main types of
deposits include:

1. Current Account Deposits: The deposits which are repayable on demand by the
banks are known as demand deposits or current account deposits. In general, these
kinds of deposits are maintained by businessmen to make transactions with these
deposits. One can get the amount deposited as demand deposits by a cheque
without any restriction. Besides, commercial banks do not pay any interest to the
depositors on these accounts; instead, they charge some amount as a service
charge for running these accounts.
2. Fixed Deposits or Time Deposits: The deposits in which the depositor, deposits
money with the bank for a fixed time period are known as fixed deposits or time
deposits. These deposits do not enjoy a cheque facility and carry a high interest
rate.
3. Saving Deposits: The deposits, which include combined features of demand
deposits and fixed deposits are known as saving deposits. The depositors have the
cheque facility to withdraw money from their accounts, but there are some
restrictions on the number and amount of withdrawals. The restrictions are
imposed to discourage the frequent use of saving deposits. Besides, the interest
rate on saving deposits is less than the interest rate on fixed deposits.

43
 ● Advancing of Loans- The banks are not allowed to keep the amount deposited with
them, idle. Therefore, commercial banks have to keep some amount of the total deposits
as cash reserves and lend the rest of the balance to needy borrowers and charge interest
from them. The interest received by commercial banks from advancing loans is the main
source of their income. Some of the different types of loans and advances made by
commercial banks are:
1. Cash Credit: The loan given to the borrowers against their current assets like
stocks, bonds, shares, etc., is known as cash credit. For this, a credit limit is
sanctioned to the borrower, and money is credited to this account. The borrower
can now withdraw any amount at any time within his credit limit. Interest is
charged from the borrower on the amount actually withdrawn by him.
2. Demand Loans: The loans given by the banks which they can recall at any time
on demand are known as demand loans. The entire amount of the demand loan is
credited to the borrower’s account, and interest is charged on that amount.

● Credit Creation- This is the most Important function of commercial bank. While
sanctioning loan to a coustmer they do not provide cash to borrower instead they open a
deposit account from which the borrower can withdraw money. So the sanctioning of
loans already creates deposit and this is known as credit creation.
● Clearing of Cheques- It is the process of moving the cheque from the bank in which it
was deposited to the bank on which it was drawn.

Secondary- Besides primary functions, commercial banks also perform some secondary
functions.

Agency Functions

● Collection and Payment of Various Items- Commercial banks provide their customers
with the service of collecting bills, interest, subscriptions, rents, and other periodical
receipts on their behalf. They also make payments for insurance premiums, taxes, etc., on
their customer’s standing instructions.
● Trustee and Executor- Banks act as trustee and Executor of property.
● Purchase and Sale of Foreign Exchange: The central bank gives authority to commercial
banks to deal in foreign exchange. Commercial banks, on the behalf of their customers,
buy and sell foreign exchange and also helps in promoting international trade.
● Letter of reference- Banks also give information about economic position of their
customers to domestic and foreign traders and likewise provide information about the
economic position of domestic and foreign traders to their costumers.

44
General utility services

● Locker facility- Banks provide this service to keep valuables of customers safe.
● Travelers cheque- Bank issues traveler's cheque and letter of credit to their customers so
that they may be spared from the risk of carrying cash during their journey.
●

45
 RESERVE BANK OF INDIA

Establishment and Nationalization

Established by: RBI Act, 1934

Started operations: 1st April 1935

Recommendation: Hilton Young Commission, 1926

Nationalized: 1949

Financial Year

Starts: 1st July

Ends: 30th June

Central Board of Directors (21 Members)

Governor – Head of RBI

4 Deputy Governors, 2 Finance Ministry Representatives, 10 Government-nominated Directors

Represent important sectors of India’s economy, 4 Directors to Represent Local Boards(Mumbai,
Kolkata, Chennai, New Delhi)

Functions of RBI

Monetary function

I. Bank of issues- RBI in our country has been given sole right of issues of currency notes
except 1 rupee note and coins.
II. Banker agent advisor to government- It helps the government in times of difficulty.
III. Credit control- Their are two instruments of credit control - qualitative and quantitative.
IV. Lender of last resort- central bank lends to the commercial bank in the time of
emergency. It is responsible directly or indirectly to meet all the reasonable demand for
funds by the commercial bank.

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 V. Custodian of cash and forex reserves

Non Monetary function

● Supervision of banks- RBI is given power to supervise and monitor the working of
commercial bank under the banking regulation act, 1949.
● Promotional and development function- RBI setup bank to promote the development
like nabard. It also setup banks to promote foreign trade.
● Data collection and publication- The RBI collects, collates and publishes all monetary
and banking data regularly in its weekly statements in the RBI Bulletin (monthly) and in
the Report on Currency and Finance (annually).
● Clearance-

Monetary policy- It is the process by which monetary authority of a country, generally a central
bank controls the economy of a country.

Objective of Monetary Policy

● Price stability
● Controlled expansion of bank credit
● Export promotion
● Desired distribution of credit
● Promote efficiency in the financial system by incorporating structural changes like
deregulating Intrest rates.

Tools of monetary policy-

1. Quantitative- These instruments seek to change the total quantity of credit in general.

1. Changing the bank rate and repo rate

2. Undertaking open market operations;
3. Changing the cash reserve ratio.

2. Quantitative- These tools aim at changing the volume of a specific type of credit. In other
words, the selective control methods affect the use of credit for particular purposes.

47
 ● Credit rationing: Credit rationing is a monetary policy tool used by central banks to
control the quantity of credit provided by commercial banks to borrowers. It involves
setting limits on the loans and advances that banks can extend.
● Margin requirements: Margin requirements are regulatory limits on the minimum amount
of a loan that must be backed by the borrower’s own funds. In securities trading, it refers
to the percentage of an asset's value that investors must pay out of their own funds when
purchasing on credit.
● Moral suation: Moral suasion is an informal tool used by central banks to influence the
behaviour of commercial banks and other financial institutions. Instead of enforcing
rules, the central bank may use appeals, advice, or public persuasion to encourage banks
to follow certain practices
● Direct action: Under the banking regulations act the central bank has the authority to take
strict action against any of the commercial banks that refuses to obey the directions given
by RBI.

Bank Rate Policy: Bank rate is the rate of interest charged by RBI for providing funds and loans
to the banking system.

Repo rate: The repo rate is the rate at which the central bank lends money to commercial banks,
typically for short durations, through repurchase agreements.

Cash reserve ratio: The cash reserve ratio is the percentage of a bank's total deposits that must be
maintained with the central bank as reserves

In 1991 CRR was reduced from 15% to 5% and now it ranges between 4-5%. As per the law RBI
can keep it between 3%-15%.

SLR: The statutory liquidity ratio is the minimum percentage of deposits that commercial banks
must maintain in the form of liquid assets, such as cash, gold, or government-approved
securities, before offering credit to customers. SLR helps ensure banks' liquidity and is a
safeguard against sudden financial crises. By adjusting the SLR, the RBI can control the amount
of money banks have available for lending, thereby managing inflation and economic stability.

Legal liquidity ratio: Mandate given by RBI for credit creation for all commercial banks

LLR= CRR+SLR

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Credit creation: It is a important function of commercial banks. It is not a single commercial
bank that can perform this function, all banks are involved.

For example:

Primary Deposit: Suppose you (X) deposit INR 1,000 with Bank A. This amount is called the
primary deposit.

Legal Liquidity Ratio (LLR): If the LLR is set at 20%, the bank is required to keep INR 200 in
reserves and can lend the remaining INR 800.

Credit Cycle: Bank A lends INR 800 to another customer (Y). If Y deposits this INR 800 in
Bank B, Bank B will keep 20% (INR 160) as reserve and lend INR 640 to Mr. Z.

This cycle of lending and depositing continues until there are no excess reserves left for further
lending.

Through this process, the initial deposit of INR 1,000 results in a multiplied effect on the total
deposits, leading to a greater expansion of credit in the economy

The credit multiplier is a factor that represents the total amount of credit that can be created from
an initial deposit, based on the LLR. It is calculated as:

CR= 1/LLR

For an LLR of 20%, or 0.20, the credit multiplier would be:

1/0.2= 5

This means that each INR 1,000 in primary deposits can create a total of INR 5,000 in deposits
through the credit creation process.

Potential Expansion of Credit (PEC)

The Potential Expansion of Credit (PEC) represents the total additional amount of credit that can
be generated from the excess reserve through the multiplier effect. It is calculated as:

49
Potential expansion of credit

Excess reserve× 1/LLR

So, if the excess reserve in the banking system is INR 800 and the LLR is 20%, then:

800×5= 4000

Potential Expansion of Credit (PEC) Formula

The PEC can also be calculated as the difference between the total deposits created and the
primary deposit:

PEC = Total Deposits Created − Primary Deposit

Using this method gives us insight into the incremental amount of credit that banks have added
beyond the initial deposit.

Determinants of credit creation function-

1. Amount of Deposit: Banks can create credit only to the extent of deposits they receive.
A higher level of deposits enables banks to lend more, increasing credit creation, while
lower deposits reduce the lending capacity. Deposits could be primary (deposited by the
public) or secondary (created through lending).
2. LLR: LLR refers to the proportion of a bank's net demand and time liabilities (NDTL)
that must be held in the form of liquid assets like cash or government securities. Higher
LLR restricts credit creation as banks must hold more liquid reserves, reducing the
available funds for lending. If LLR is lowered, banks can lend more, boosting credit
creation.
3. Leakages: Leakages are situations where the entire deposit is not available for credit
creation, such as when: (I) Borrowers keep a portion of their loans in cash, (II) Banks
retain excess reserves beyond the required amount. The more significant the leakages, the
less effective the credit creation process becomes.
4. Avalabily of Borrowers: Even if banks have sufficient funds, credit creation depends on
the demand for loans. A lack of creditworthy borrowers or low demand for loans can
restrict credit creation. Economic conditions, business confidence, and interest rates
influence borrowers' willingness to seek credit.

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Money Supply: Supply of money is in the hands of RBI. India followed the proportional reserve
system whereby, a reserve of gold,silver, government securities and foreign securities were
maintained of which gold and foreign securities were at least 40% of total reserve.

In 1957, India moved to the Fixed Minimum Reserve System due to the growing economy’s
need for more currency in circulation.

Under this system, the RBI must maintain a minimum reserve of ₹200 crores, with at least ₹115
crores in gold and the rest in foreign securities. This shift provided flexibility to issue more
currency without strict proportional constraints.

Measures of Money Supply:

The first and basic measure of the money supply is M1, which is also known as Transaction
Money. It is called transaction money because this measure can be directly used to make
transactions. It is called narrow money.

M1 = Currency and coins with public + Demand deposits of commercial banks + Other deposits
with Reserve Bank of India

The second measure of the money supply is M2, and is a broader concept as compared to M1. It
includes M1 and savings deposits with the post office savings bank. One cannot withdraw
Savings Deposits with Post Office Saving Bank through cheque; therefore, it cannot be included
in demand deposits with the bank, resulting in the evolution of M2.

M2 = M1 + Savings Deposits with Post Office Saving Bank

The third measure of the money supply is M3 and is a broader concept as compared to M1. It
includes M1, Time Deposits with Bank and other deposit with RBI.

M3 = M2 + Time deposits+ Other deposit with RBI(includes everything except banker deposit)

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The last measure of the money supply is M4, and is a broader concept as compared to M1 and
M3. It includes M3 and Total Deposits with Post Office Saving Bank, but does not include NSC
(National Saving Certificate).

M4 = M3 + Total Deposits with Post Office Saving Bank

● All four measures of money supply represent a different level or degree of liquidity. M1
is the most liquid measure of supply, and M4 is the least liquid measure of supply.
● M3 is also known as Aggregate Monetary Resources of the Society and is widely used as
a measure of supply.
● M1 and M2 are usually known as Narrow Money Supply Concepts; however, M3 and M4
are known as Broad Money Supply Concepts.

Bankers deposit with RBI is called reserve money.

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 BUSINESS CYCLE

Business Cycle, also known as the economic cycle or trade cycle, is the fluctuations in
economic activities or rise and fall movement of gross domestic product (GDP) around its
long-term growth trend.

4 Phases of Business Cycle are:

1. Expansion- Expansion is the first phase of a business cycle. It is often referred

to as the growth phase.

In the expansion phase, there is an increase in various economic factors, such as

production, employment, output, wages, profits, demand and supply of products,
and sales. During this phase, the focus of organisations remains on increasing the
demand for their products/services in the market.

The expansion phase is characterised by:

● Increase in demand
● Growth in income
● Rise in competition
● Rise in advertising
● Creation of new policies
● Development of brand loyalty

In this phase, debtors are generally in a good financial condition to repay their
debts; therefore, creditors lend money at higher interest rates. This leads to an
increase in the flow of money.

In the expansion phase, due to increase in investment opportunities, idle funds of

organisations or individuals are utilised for various investment purposes. The
expansion phase continues till economic conditions are favourable.

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2. Peak: Peak is the next phase after expansion. In this phase, a business reaches at
the highest level and the profits are stable. Moreover, organisations make plans
for further expansion.

Peak phase is marked by the following features:

● High demand and supply

● High revenue and market share
● Reduced advertising
● Strong brand image

In the peak phase, the economic factors, such as production, profit, sales, and
employment, are higher but do not increase further.

3. Contraction- An organisation after being at the peak for a period of time begins
to decline and enters the phase of contraction. This phase is also known as a
recession.

Recession-

● Fall in production,profit,inflation
● Banckruptcy and unemployment rate rise

When the growth rate goes below the stedy growth rate depression sets in.

Depression- When recession continues for longer period of time it is called as

depression.

● Economic activity is at its lowest.

● Wages,cost,price are very low.
● Massive unemployment leading to a fall in the aggregate income of the
people.
● This brings down the purchasing power of the community.
● General demand falls faster than production.
● The piled up stock are sold at very high rate of discount leading to heavy
losses to the firm.

54
 An organisation can be in this phase due to various reasons, such as a change in
government policies, rise in the level of competition, unfavourable economic
conditions, and labour problems. Due to these problems, the organisation begins to
experience a loss of market share.

The important features of the contraction phase are:

● Reduced demand
● Loss in sales and revenue
● Reduced market share
● Increased competition

4. Trough- In Trough phase, an organisation suffers heavy losses and falls at the lowest
point. At this stage, both profits and demand reduce. The organisation also loses its
competitive position.

The main features of this phase are:

● Lowest income
● Period if severe strain on the economy
● Economic activities once again register an upward movement
● It enters the phases of recovery
● Adoption of measures for cost-cutting and reduction
● Heavy fall in market share

In this phase, the growth rate of an economy becomes negative. In addition, in trough
phase, there is a rapid decline in national income and expenditure.

5. Recovery-
● Increased economic activity resulting in growth in GDP.
● Rising price of commodity.
● Collection of all or a portion of debt previously considered uncollectable.

Causes of Business cycle-

55
They can be divided into internal and external causes

Internal Causes:

● Fluctuation in effective demand- Effective demand, the total demand for goods and
services in an economy, plays a significant role. When demand increases, businesses
produce more, leading to economic growth. Conversely, a drop in demand leads to
reduced production and potentially a recession.
● Fluctuation in investment- Investment in capital goods by businesses can vary based on
expected profitability and interest rates. When investment rises, it spurs economic
activity, while a decline can lead to downturns.
● Variation in government spending- Changes in government expenditure on
infrastructure, welfare, and services can stimulate or slow down economic activity.
Reduced government spending during austerity measures can trigger a recession, while
increased spending may spur growth.
● Macroeconomic policies- Fiscal and monetary policies have a direct impact on business
cycles. For instance, changes in taxation, government borrowing, and interest rates can
lead to periods of expansion or contraction.
● Money supply- The availability of money in the economy affects business cycles. An
increase in money supply lowers interest rates and boosts investment and spending,
leading to expansion. Conversely, a reduction in money supply can lead to higher interest
rates and reduced spending, which may cause a contraction.
● Psycological factor- Business cycles can be influenced by the collective mood and
expectations of consumers and investors. Optimism can drive spending and investment,
while pessimism can lead to reduced spending and investment, causing economic
downturns.

External causes-

● War- Wars can have a significant impact on economic activity. During a war, economies
often shift resources towards military production, disrupting normal production and
consumption patterns. Post-war economic disruptions can also lead to inflation or
recession, depending on the scale and length of the conflict.
● Post-war reconstruction- After wars, economies often experience a period of
reconstruction, where infrastructure, industries, and housing need to be rebuilt. This can
stimulate economic growth and employment in the short term, but may also lead to
inflationary pressures or debt accumulation depending on the extent of damage and the
cost of rebuilding.

56
 ● Technology shock- Technological advancements or disruptions (such as the invention of
the internet, automation, or artificial intelligence) can dramatically alter production
methods, increase productivity, and create new industries. However, these shifts can also
render some industries obsolete, causing short-term unemployment and economic
restructuring.
● Natural Factor- Natural events like earthquakes, floods, droughts, or pandemics can
disrupt economic activity. For instance, a drought might hurt agricultural output, while a
pandemic (such as COVID-19) can lead to widespread economic slowdowns due to
lockdowns and reduced consumer demand.
● Population growth- Rapid population growth can drive demand for goods and services,
stimulating economic growth. However, it can also strain resources, infrastructure, and
services, leading to potential economic challenges if not managed properly. Conversely,
slowing or declining population growth can lead to labour shortages and reduced
demand, contributing to economic stagnation.

Economic Indicators of business cycle

● Leading indicators: Change in stock prices and New Orders for Manufacturing Goods
● Lagging indicators: Unemployment rate and corporate profit
● Concurrent indicators: Gross domestic product and Inflation

Inflation- It can be defined as rise in the general price level and therefore of fall in the value of
money.

Different types of Inflation

● Creeping Inflation: It is a situation in which prices rise by 3% or less. It is good for

economy because consumer buy goods to beat inflation.
● Walking Inflation: It is a situation in which prices rise between 3%-10%. It is a situation
when economy starts to heat up.
● Gallping Inflation: Galloping inflation is characterised by an extremely high inflation
rate, often between 10% and 50% per year. At this stage, inflation becomes disruptive to
the economy. People may start hoarding goods in anticipation of further price increases,
and the value of money erodes rapidly, reducing consumer and business confidence.

57
 ● Hyper Inflation: Hyperinflation is an extremely rapid and out-of-control inflation,
typically exceeding 50% per month. In this phase, the value of money declines so quickly
that prices of goods and services can increase dramatically in a matter of hours.
Hyperinflation leads to a total collapse in the monetary system, causing severe economic
instability, and it usually requires radical measures to bring it under control. Examples of
hyperinflation can be seen in Venezuela and Zimbabwe.

Effects of Inflation: Inflation has different effects on various groups within an economy, creating
both losers and Gainers.

Losers:

● Lenders- Inflation reduces the value of money that is repaid over time. Lenders receive
repayments in "cheaper" money, effectively reducing the real value of the repayment
compared to when the loan was given.
● Bond Holder- They also get fixed rate of interest that why they are losers in case of
Inflation.
● Pensioners-Pensioners, especially those on fixed pensions, suffer during inflation as their
income remains constant while the cost of living increases. This leads to a reduction in
their purchasing power over time.
● Exporters- If they are selling the product at higher prices, they will become less
competitive and the demand for their goods will decrease.

Gainers:

● Borrowers: Debtors benefit as inflation erodes the real value of their debt, making it
easier to repay in "cheaper" money. Fixed-rate loans become less costly over time in real
terms as wages and prices rise.
● Business man: Businesses that can raise prices in line with inflation (e.g., those with
strong market positions or inelastic demand) may see their revenues increase, allowing
them to maintain profitability even as costs rise.

Different terms used in inflation

Monetary Inflation: Monetary inflation occurs when there is an excessive increase in the money
supply in an economy, often due to central bank actions like printing more currency.

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Profit push Inflation: Profit-push inflation occurs when companies increase their prices to boost
profit margins, often independent of supply and demand pressures.

Open Inflation: Open inflation is a transparent and visible rise in prices across an economy
without any price controls or restrictions. Under open inflation, prices are allowed to adjust
according to supply and demand conditions.

Suppressed inflation: Suppressed inflation occurs when government regulations, such as price
controls or rationing, prevent prices from rising to their natural market levels, even though there
are inflationary pressures in the economy

Shrink inflation: Shrinkflation is a form of inflation where companies reduce the size or quantity
of their products while keeping prices the same, rather than explicitly raising prices.

Inflationary Spiral: An inflationary spiral is a situation where prices and wages increase at a
growing rate, causing the currency to lose value quickly. This occurs when price increases lead
to higher wages, which then causes prices to increase again, and so on.

Greedflation: Greedflation is a term used to describe inflation driven by companies raising prices
more than necessary to cover rising costs.

Deflationary spiral: A deflationary spiral is a cycle where falling prices reduce consumer
spending, leading businesses to cut prices further and lay off workers. This deepens income
losses and spending drops, worsening economic contraction and risking prolonged recession.

Philip curve: It explains the relationship between unemployment and inflation.

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The Phillips curve states that inflation and unemployment have an inverse relationship; higher
inflation is associated with lower unemployment and vice versa. The inverse relationship
between unemployment and inflation is depicted as a downward sloping, convex curve, with
inflation on the Y-axis and unemployment on the X-axis. Increasing inflation decreases
unemployment, and vice versa. Alternatively, a focus on decreasing unemployment also
increases inflation, and vice versa.

Stagflation occurs when an economy experiences stagnant economic growth, high

unemployment, and high price inflation. This scenario, of course, directly contradicts the theory
behind the Phillips curve.

Whole sale price index: The WPI measures the average change in the price of goods at the
wholesale level before they reach consumers.

It includes prices of goods at the first commercial transaction, covering items such as raw
materials, intermediate goods, and wholesale goods. Services are not included.

The WPI is released weekly and monthly, with a base year of 2011–12. Compiled by the Office
of the Economic Adviser, Ministry of Commerce and Industry.

Consumer price index: The CPI tracks the changes in the price level of a basket of consumer
goods and services, directly reflecting what consumers pay.

It includes categories such as food, housing, clothing, medical care, and transport, representing
what urban and rural consumers spend on daily necessities. It’s a broader indicator of the cost of
living. The CPI is published monthly, with a base year of 2012.

Compiled by the Central Statistics Office (CSO) under the Ministry of Statistics and Programme
Implementation.

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Keynesian model of business cycle: According to Keynes the changes in the level of aggregate
effective demand will bring about fluctuations in the level of income, output and employment.

Model starts from the phase of expansion: The aggregate demand consists of consumption
goods and investment good, propensity to consume being more or less stable in the short run,
fluctuations in the aggregate demand depends primarily upon the fluctuations in Investment
Demand.

During the expansion Phase increase in demand of capital goods due to large scale investment
activity leads to rise in prices of capital goods.

Here the price of capital goods increases thereby reducing the marginal efficiency of capital.

High Interest rates makes some potential projects unprofitable. This fall in MEC and the rise in
ROI on the other hand leads to decline in Investment Demand.

Contraction: These two reasons will lead to decline in Investment Demand and Creating
passivism in the economy. Declining trend of investment raises doubts about prospective yield in
capital goods which leads to fall in stock prices.

The crash in stock prices reduces wealth of households. It creates fear leading household to
cutback on expenses, particularly on autonomous Consumption.

With the fall in aggregate demand there will be accumulation of unintended inventories with the
firms this induces firm to cut the production of goods.

A decrease in investment Expenditure causes a decline in income which intern reduces

consumption expenditure and the multiplier process multiplies the effect of this decline and
further depends the depression.

Natural Recovery: The period between the upper turning point and the start of recovery
depends upon two factors:

1. The time necessary for wearing out of durable capital assets.

2. The time required to absorb the excess top of good leftover from the boom.

Explanation: Over-time as depreciation of capital stock occurs without replacement and also
some existing capital equipment becomes obsolete. This with the emergence of scarcity of
capital, marginal efficiency of the capital raises which boots investment.

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Criticism:

● To much emphasis on multiplier: Keynes put forward an important theory of multiplier

which tells us how changes in investment, bring magnified changes in the level of income
and employment.
● But, Kingston’s theory of multiplayer alone does not offer a full and satisfactory
explanation of cycles, a basic feature of the cycles is its cumulative character, both in
upswing and downswing. That is, once economic activity starts rising or falling, It
gathers momentum for a time.
● So, what we have to explain is the cumulative character of economic fluctuations. The
theory of multiplayer alone does not gives adequate explanation for this.

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 INTERNATIONAL TRADE

International Trade: Trade between atleast two countries which is restricted to goods and
services. It can be referred to as the exchange of goods and services between countries. It can
simulate economic growth of countries and canalso stimulate important sectors of the economies
such as the information and communications sector in India.

Globalisation: It is a process of interconnectedness of economies,socities and cultures around

the world. It has gained popularity due to advances in technology,transportation and
communications as well as policies and agreements which favoured free trade and investment.

Importance of International Trade:

1. Range of products are available

2. It promotes competitive prices
3. Standarad of product rises
4. It gives rise to best utilization of resources

In India International trade was restricted till 1991 removed after the LPG reforms.

Theories of international trade

● Comparitive cost advantage: A country should specialise in producing goods where it has
the lowest opportunity cost, even if it does not have an absolute advantage in producing
those goods. Key Idea: Trade can still be mutually beneficial if countries focus on their
comparative advantages.
● Mercantalist theory: Emphasises accumulating wealth, particularly gold and silver,
through a favourable balance of trade (exporting more than importing). Key Idea:
Nations achieve economic strength by maximising exports and minimising imports
through tariffs and trade restrictions.

Adam Smith criticised both of these theories and gave the absolute cost advantage theory.

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Absolute advantage theory: Absolute cost advantage theory refers to the ability of a country to
produce and sell more of a good or service than competetiors using the same amount of
resources. Further, under such circumstances an exchange of goods will take place only if each
of the two countries can produce one commodity at an absolute lower cost of production than
other country.

Assumptions:

● Labour is mobile within the country but immobile between countries.

● The theory assumes that only two countries produce and trade two goods or services.
● Each country specializes in producing the good in which it has an absolute advantage and
trades the surplus with the other country.
● Any trade between two countries only takes place if each country has absolute advantage
in the production.

Criticisms:

● It focus on bilateral trade and ignores multilateral trade

● It advocates for free trade which means no govt intervention which means that domestic
producers are not offered any protection.
● Its mobility assumption is impractical

Comparitive cost advantage theory: The ability of a country to produce a particular good at a
lower marginal cost over another. In this theory, we consider the opportunity cost to decide the
import and export of a country. Ex- China has advantage of electronic good while ireland has
advantage in dairy.

Quantity sacrificed/Quantity Produced= Opportunity cost

Assumptions:

● The theory assumes only two countries are trading and each produces two goods. This
simplifies the model but does not capture the complexity of modern trade involving
multiple countries and goods.

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 ● The country will decide to produce that commodity in which it has the lowest opportunity
cost.
● Labor and other factors of production cannot move across international borders.

Advantage: Instead of absolute cost this theory takes opportunity cost. This is useful since it also
takes in the different factors in the level of development between countries. It demonstrates the
benefits of trade between countries, even when one country has an absolute advantage in
producing all goods.

International Organizations

1. International Monetry Fund

2. WTO
3. World Bank

International Monetary Fund: The International Monetary Fund (IMF) is an international

organization established to promote global monetary cooperation, ensure financial stability,
facilitate international trade, promote high employment and sustainable economic growth, and
reduce poverty worldwide.

Foundation and Headquarters

● Established: July 1944 (at the Bretton Woods Conference)

● Operational Since: December 27, 1945
● Headquarters: Washington, D.C., United States
● Membership: 190 countries (as of 2024)

Objectives of giving Funds:

● Fostering global monetary cooperation

● Securing financial stability
● Facilitaying and promoting international trade, employment and economic growth around
the world.

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Timeline:

● In 1940s it released the fund for post war reconstruction.

● 1950s: Post-War Reconstruction and Stabilization: Supported Europe and Japan's post-war
reconstruction by providing financial assistance to stabilize economies.
● In 1960s decolonisation of africa happened
● In 1970s it managed world saw vietnam war and Helped countries manage economic disruptions
caused by the oil crises. Shifted focus after the collapse of the Bretton Woods system and the
move to floating exchange rates.
● In 1980s Addressed Latin America's debt crises with loans tied to Structural Adjustment
Programs (SAPs).
● In 1990s Supported Eastern European countries transitioning to market economies after the Cold
War.
● In 2000s Launched the Heavily Indebted Poor Countries (HIPC) Initiative for debt relief.
● In 2010s It helped in stablising global economy from fallout of 2008 crisis

Board of Governors:

● Composed of one governor from each member country (usually the finance minister or central
bank head).
● Meets annually to make key decisions.
● Each governor has voting power based on the quota alloted

Executive Board:

● 24 directors represent member countries or groups of countries.

● Responsible for daily operations and decision-making.

Managing Director:

● The chief executive of the IMF, overseeing staff and operations.

● Current (as of 2024): Kristalina Georgieva.

Parameters for quota

● Higher GDP of Member countries

● Economic openness
● Economic Vaiablility
● Foreign reserves

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Based on this India’s Qouta is 2.75%

Special Drawing Rights: It is an International reserve asset created by the IMF in 1969 to supplement the
member countries official reserves. It is denoted by XDR. It cannot be allotted to private companies.

IMF Uses basket of currencies to determine the value of SDR. It includes:

● USD
● Euro
● Chinese Yuan
● Japanese Yen
● Pound Sterling

IMF can created SDR to Inject Liquidity anytime.

Publications of IMF:
World economic outlook
Global financial stability report

World Bank: The World Bank is an international financial institution dedicated to reducing poverty,
promoting sustainable development, and providing financial and technical assistance to developing
countries. It focuses on long-term development projects that improve infrastructure, education, healthcare,
and governance.

Foundation and Headquarters

● Established: July 1944 (at the Bretton Woods Conference)

● Operational Since: June 25, 1946
● Headquarters: Washington, D.C., United States
● Membership: 189 countries (as of 2024)

International Development Association (IDA): 1960s

● Offers concessional loans and grants to the world’s poorest countries.

International Finance Corporation (IFC): 1956

● Focuses on private sector development by providing investments, advice, and asset management
services.

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Multilateral Investment Guarantee Agency (MIGA): 1988

● Provides political risk insurance to encourage foreign investment in developing countries.

International Centre for Settlement of Investment Disputes (ICSID): 1966

● Offers facilities for the arbitration and conciliation of investment disputes between countries and
foreign investors.

World bank comprises of IBRD AND IDA

International Bank for Reconstruction and Development (IBRD)

● Established: 1944 (along with the World Bank)

● Purpose: It was initially established for european economies but now IBRD primarily provides
loans and financial services to middle-income countries and creditworthy low-income
countries.
● Focus Areas:
○ Infrastructure development (e.g., roads, energy, education).
○ Promoting economic growth and poverty reduction.
○ Policy advice and technical assistance to help countries with financial management,
governance, and economic reforms.
● Funding: Raises funds by issuing bonds in international capital markets.
● Interest Rates: IBRD loans are offered at market-based interest rates, though typically with
favorable terms.

International Development Association (IDA)

● Established: 1960 (to focus on poverty reduction for the poorest countries)
● Purpose: IDA offers concessional loans (low-interest loans) and grants to the world's poorest
countries, especially those that do not have access to sufficient capital markets or private finance.
● Focus Areas:
○ Poverty reduction and inclusive development.
○ Basic services like education, healthcare, water supply, and sanitation.
○ Climate resilience, infrastructure, and social protection programs.
● Funding: Funded through member countries' contributions, repayments from previous loans, and
through bond issuance.
● Interest Rates: IDA provides highly concessional loans, often with no or very low interest rates,
with long repayment periods.

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International Finance Corpration(IFC)

It advances loans for development and improves life of people by encouraging the growth of private
sector in developing economies.

It has expanded to more than 100 countries.

Multilateral Investment Guarantee Agency (MIGA): 1988

Its idea was from 1948 onwards and India became its member in 1994. It provides an insurance for
political risk

Publications of world bank:

● Gobal economic prospects

● Ease of doing business
● Universal health Coverage index
● Ease of living

WTO AND GATT

GATT (General Agreement on Tariffs and Trade)

● Established: 1948
● Signatories: 23 countries initially
● Purpose: Facilitate free trade by reducing tariffs and other trade barriers
● Nature: A voluntary, non-binding agreement
● Objectives:
○ Create an international forum for encouraging free trade by regulating and
reducing tariffs on traded goods.
○ Provide a common mechanism for resolving trade disputes.

Key Features

● Agreement Scope: Focused solely on goods, excluding services.

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 ● Negotiations:
○ Eight negotiation rounds were held (most notably the Uruguay Round,
1986-1994), resulting in 123 agreements covering 145,000 tariff items.
● Tariff Types:
○ Ad Valorem: Fixed percentage of the traded value of a commodity.
○ Specific: Fixed sum per unit of traded commodity.
○ Compound: Combination of Ad Valorem and Specific tariffs.

Barriers to Trade

● Tariff Barriers: Direct tariffs on imported goods.

● Non-Tariff Barriers:
○ Technical Barriers: Standards related to technology, safety, health, and labeling.
○ Subsidies:
■ Import Subsidies: Support to local products competing against imports.
■ Export Subsidies: Incentives for producers exporting goods.
○ Government Procurement Policy: Domestic preference in government
purchases.

Transition from GATT to WTO

● As international trade complexities grew, there was a need for a structured international
organization, leading to the creation of the WTO (World Trade Organization).

WTO (World Trade Organization)

● Established: 1995, after the Uruguay Round

● Initial Members: 143 (currently 166 member countries)
● Headquarters: Geneva, Switzerland

Objectives

● Provide flexibility for developing countries, with special priority given to their concerns.
● Facilitate the resolution of trade disputes to maintain global peace and stability.

Functions

1. Administering trade agreements.

2. Settling trade disputes.
3. Reviewing national trade policies.
4. Building trade capacity in developing economies.

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 5. Cooperating with other international organizations.

Structure

● Ministerial Conference: The highest decision-making body.

● Director-General: Heads the WTO.
● Secretariat: Supports daily operations.

WTO Bodies

● Dispute Settlement Body: Resolves trade disputes.

● General Council: Conducts the WTO's day-to-day operations.
● Trade Policy Review Body: Monitors national trade policies.

India and the WTO

● Membership: India has been a member of both GATT and WTO.

● Impact on Indian Economy:
○ Reduction in tariff and non-tariff barriers.
○ Increased investment due to Trade-Related Investment Measures (TRIM) and
Trade-Related Aspects of Intellectual Property Rights (TRIPS) agreements.
○ SPS Agreement: Allows measures to protect human, animal, or plant health.
○ Agreement on Agriculture (AoA): Aims to reduce domestic support and
subsidies, which India finds challenging.

Impact of Trade Barriers

● Positive: Potential protection for domestic industries.

● Negative: Can inhibit trade and increase costs for consumers.

Principles of WTO

1. Non-Discrimination:
○ Most-Favored-Nation (MFN): Equal trading terms for all member nations, with
exceptions for unfairly traded products.
○ National Treatment: Imported and domestic products are treated equally in a
country’s market.
2. Market Access and Free Trade: Aims to remove trade barriers.
3. Fair Competition: Discourages practices like dumping and export subsidies.

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 4. Special Concern for Developing Countries: Includes provisions for flexibility in trade
agreements.

BoP- Balance of Payments

The balance of payment of a country is a systematic record of all economic transactions between
the residents of a country and rest of the world.

This data is prepared by RBI and the IMF prescribed format is used to prepare balance of
payments.

System→ Double entry bookkeeping

It has two components: debit(what goes out during import) and credit(what comes inflow
exports)

Credit Debit

Export of goods Import of Goods

Services Services

Income(Dividend,intrest and profit) Payment(divident,intrest and profit)

Transfer Income Transfer Payment

Conditions of BoP

Favourable

● Current Account- +
● Capital Account - -( Lending To Other Countries)

Unfavorable but controlled

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 ● Current Account- -
● Capital Account- +( FDI and FPI)

In india currently Unfavourable BoP is there before 1991

BoP crisis

Current -

Capital +(loans)

Reasons for Disequilibrium exports

● Short fall in exports- When a country's export sector fails to generate sufficient revenue
and imports rise, it disrupts the trade balance.
● Cyclical fluctuation- Global or domestic economic cycles influence trade flows. During a
recession, demand for exports declines, while during a boom, it may increase. Example:
Reduced demand for luxury goods during global economic downturns.
● Rapid growth in population- A rapidly growing population increases domestic
consumption, leaving fewer goods available for export.
● National calamities - Natural disasters, pandemics, or wars can severely disrupt
production and export capabilities.
● International capital movement- Outflows of capital to foreign markets can strain a
country's foreign reserves, affecting its ability to support exports.
● Structural changes-Long-term shifts in an economy’s industrial structure can affect export
competitiveness.

Measures of control

Monetary

● Monetary policy- Central banks can adjust interest rates and money supply to stabilize
the economy.
○ Higher Interest Rates: Attract foreign capital, strengthen the currency, and
reduce import costs.
○ Lower Interest Rates: Encourage domestic production and export

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 ● Fiscal policy- Governments can adjust taxation and public spending to promote exports
and control imports.
○ Export Incentives: Tax rebates and subsidies to exporters.
○ Import Tariffs: Discourage unnecessary imports to reduce trade deficits.
● Devaluation- Deliberately reducing the value of a country’s currency to make exports
cheaper and imports more expensive.
● Exchange control- Governments regulate foreign exchange transactions to prioritize
essential imports and control currency outflows. In this situation government can ask
exporters to surrender their foreign exchange . Licensing systems, fixed exchange rates, or
restrictions on currency conversion.

Non Monetary

● Export Promotion- Policies aimed at increasing the volume and competitiveness of

exports.

Methods:

● Export subsidies.
● Free trade zones to reduce costs for exporters.
● Diversifying export products and markets.
● Import subsitution- Encourages domestic production of goods to reduce dependency on
imports.

Methods:

● Incentives for local industries.

● Protective tariffs to discourage cheap imports.
● Import control- Direct restrictions on imports to reduce trade deficits.

Methods:

● Quotas on non-essential imports.

● Licensing systems to control the types and quantities of imports.

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 ECONOMIC PLANNING AND NITI AAYOG

The first question after independence was which economic ideology we should follow. At that
time the world was divided into capitalistic and socialists economies. However, the problem was
that we could not opt for both because of our market and socio-economic conditions. Therefore it
was decided that we will follow a system of mixed economy.

In 1950, the Planning Commission was established, with Jawaharlal Nehru serving as the
ex-officio chairman. The first Five-Year Plan spanned from 1951 to 1956 and was based on the
Harrod-Domar model. This model posited that increased savings within the economy would
lead to higher investment, which would, in turn, increase capital stock. The resulting economic
output would lead to a rise in income, ultimately boosting further savings and creating a positive
growth cycle.

In 1952 government formed National development council which approved the plan of
planning commission.

First five year plan 1951-56

During this period India was not food independent therefore the major focus was on agriculture
and irrigation and growth target was 2.1% and actual growth was 3.6%. During this plan PSU’s
were given importance because we decided to have state control.

Second five year plan 1956-61

This plan was based on modeln given by P.C Mahlanobis, a statistician. During this plan
government adopted a top to bottom approach and heavily invested in heavy industries. During
this period government followed inward looking policy embracing protectionism. During this
period target growth was 4.5% and the actual growth was 4.3%.

Industrial policy 1956

Group A industries- State control

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Group B industries- State+ Private but State dominance

Group C industries- Private sector

In this period the country experienced a Minor BoP crisis.

Third Plan 1961-66

This plan focused on a self reliant economy and agriculture was given priority. It is also known
as Gadgil plan. It was a major failure because target growth was 5.6% and the actual growth was
2.8%.

Reason for the failure:

1. Indo-China War of 1962

2. Indo-Pak war of 1965
3. Droughts impacted food supply

1966-67, 1967-68 and 1968-69- In the period we had annual plans and the average growth was
3.9%.

Fourth Plan 1969-74

It targeted growth and stability and self-reliance. In this period green revolution was launched
which made India food secure but it resulted into soil degradation and also widened gap between
big and small farmers. 1971 war played a role in disturbing economy this time.

Fera was enacted during this period to prevent BoP crisis and MRTP was impacted to control
monopoly.

14 Banks were nationalized during this period.

Fifth Plan 1974-79

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During this period focus was given on social justice and one slogan was given by prime minister
“Gareebi hatao”. Targeted growth rate was 4.4% and actual growth was 4.8%.

First population policy was framed nad emergency was imposed during this period.

When the janta party came into power they started rolling plans which continued for 2 years.

Sixth Plan 1980-85

India focused on modernisation of the economy, family planning program were initiated and
introduced a minimum need program for the poor and focus was given to the IT sector.

Seventh Plan 1985-90

It focused on education to girls, telecommunications with computers, use of modern technology

in agriculture and in this period the private sector started getting priority and it helped us move
out from Hindu growth rate. This period the country experienced a BoP crisis and fiscal deficit.

Eighth Plan 1992-97

Focus was on development on human resource development. Mid day meal scheme was
launched to promote education. MPLADS was launched.

Ninth Plan 1977-2002

Target was growth with equality. Target was 7% and actual war 6%

Tenth 2002-07

In the 10th plan Target was 8% and achievement was 7.6%. here the focus was on governance.

Eleventh Plan 2007-12

In this plan term inclusive growth was introduced. Target was 9% and achieved growth was 8%.

Twelfth plan 2012-17

The objective was faster growth, more inclusivity and sustainable growth. Development of
human capabilities was a major focus.

In between this period NITI aayog was announced and it has its different ways.

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Why NITI Aayog?

It was a think tank. It was needed because when plans started situation was very different and at
that time central control was suitable but in the present time central control was not working and
we were not able to have holistic development leading to disparities.

During five year plan Planning commission was very authoritative while niti aayog is more like a
suggestive body.

Objectives of NITI Aayog-

1. Competitive and Cooperative federalism

2. Transparency in terms of planning
3. Women empowerment
4. Equality
5. Proactive

Principles

● Convergence- convergence of center and state scheme

● Collaboration- Collaboration between centre,state and district administration
● Competition- Competition between aspirational districts

Structural composition of NITI Aayog

it can be divided into three parts:

● Governing Council- It consists of chief minister of all the states and Lt. Government of
union territories.
● Regional Council- It is meant for addressing problem of particular region.
● Special invitees- They are experts from the relevant domain and nominated by the prime
minister.

Composition

● Chairperson- Prime minister

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 ● Vice Chairperson- Appointed by Prime minister
● 4 full time members
● 2 part time members(people from leading universities and organizations)
● Ex officio members- Maximum of 4 from the council of minister nominated by PM
● CEO- appointed by prime minister rank equivalent to secretary

Various programmes were started by niti aayog

● Swachh Bharat
● Ayushman Bharat
● Sampann Bharat
● Surakshit Bharat
● Sikshit Bharat

Functions of NITI Aayog

1. Provide critical,directional and strategic input in the process of development.

2. Emergency as a think tank to provide government at the central and state level with
relevant strategic and technical advice.
3. Develop mechanisms to formulate credible plans to the village level and aggregate these
progressively at the higher level.
4. Special attention to the section of the societies that may be at risk of not benefiting
adequately from economic progress.

Sabka sath sabka vikas

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 New economic policy and reforms

Major reasons for New economy policy:

● Poor performance of the Public Sector: The public sector, which dominated the Indian
economy post-independence, was struggling with inefficiency, corruption, and a lack of
competitiveness. Many public enterprises were loss-making and not contributing
effectively to economic growth.
● Deficit in Balance of Payment: India was facing a severe balance of payments crisis in
1991. The country’s imports were exceeding exports, leading to a foreign exchange crisis.
This situation was exacerbated by the Gulf War, which led to a spike in oil prices, further
straining the economy.
● Inflationary pressure: High inflation was a persistent issue, eroding the purchasing
power of the rupee and causing economic instability. The government’s reliance on
subsidies and public spending was contributing to this inflationary pressure.
● Fall in foreign exchange reserves: By 1991, India’s foreign exchange reserves were
critically low, enough to cover only a few weeks of imports. This created a dire situation
where the country could not pay for its imports or service its external debt, threatening its
economic stability.
● Huge burden of Debts: India’s external debt had reached unsustainable levels due to:
Excessive borrowing from international institutions and Poor utilization of borrowed
funds in unproductive sectors. The impact was rising debt servicing costs strained public
finances and widened the fiscal deficit.
● Inefficient management of Economy: Indian economy became inefficient due various
reasons like over-regulation.

New policy- Liberalization, privatization and globalization

Liberalization: It refers to the process of reducing government restrictions on business, trade,

and economic activities. It involves removing barriers to free-market competition, such as tariffs,
quotas, and subsidies, and promoting an open market economy.

Reforms:

● Financial Sector: Reforms in banking sector and capital market reforms

● Foreign Exchange:
● Industrial sector reforms:

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 ● Tax reforms:
● Trade and investment reforms:

Financial sector reforms:

Banking sector reforms: Measures were introduced to enhance the efficiency and
competitiveness of the banking sector, including allowing private sector banks to operate and
improving the functioning of public sector banks.

Capital market reforms: The capital markets were liberalized to attract more investment.
Regulatory bodies like securities and exchange board of India were strengthened to oversee
market operations.

Interest rate deregulation: Interest rates were deregulated, allowing them to be determined by
market forces rather than being setup by the government.

Foreign Exchange Reforms

Shift from a fixed exchange rate regime to a market-determined exchange rate.

Convertibility of the Rupee: Partial convertibility introduced for current account transactions.

Encouraged foreign exchange reserves accumulation.

New Industrial policy, 1992

De-reservation under small scale industries: Reservation was there for public sector but now it is
open to all.

MRTP Act: As a reforms MRTP act was scrapped

Tax Reforms

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Rationalization of direct taxes- Direct taxes refer to taxes levied directly on individuals and
corporations, such as income tax and corporate tax. The reforms addressed high tax rates and a
complicated structure that had led to widespread tax evasion.

● Reduction in Tax Rates:

○ Income tax and corporate tax rates were reduced to encourage compliance and
reduce tax evasion.
○ The aim was to create a fair and predictable tax environment.
● Simplification of Tax Structure:
○ Simplified tax slabs to make the system more understandable for taxpayers.
○ Encouraged voluntary compliance and broadened the tax base.
● Introduction of Self-Assessment:
○ Taxpayers were allowed to assess their tax liability, reducing bureaucratic hurdles.

Reforms in Indirect taxes- Indirect taxes are levied on goods and services, such as excise duty,
customs duty, and sales tax. The reforms aimed to streamline the tax structure and promote ease
of doing business.

● Reduction in Import Duties:

○ High import tariffs were reduced to promote trade liberalization and make raw
materials and capital goods cheaper.
○ This encouraged domestic industries to integrate with global markets.
● Simplification of Excise Duties:
○ Excise duties on goods were simplified, moving towards a uniform rate structure.
○ Reduced cascading effects of taxation on production and distribution.
● Transition Towards GST:
○ The reforms laid the groundwork for the eventual implementation of the Goods
and Services Tax (GST), which replaced the complex multi-tax system with a
unified tax framework.

Simplification of process: Reduction in Bureaucratic Procedures:

○ Eliminated redundant processes and paperwork, making tax compliance easier.

○ Introduced online filing systems to reduce interaction with tax officials.
● Implementation of Technology:
○ Digitalization of tax filing and payment systems.

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 ○ Increased transparency and reduced the scope for corruption.
● Taxpayer-Friendly Policies:
○ Introduction of taxpayer charters to protect the rights of taxpayers.
○ Faster refunds and quicker dispute resolution mechanisms.

Trade and investment:

● Reduction in Import duty- To make imported goods, especially raw materials and capital
goods, cheaper and enhance the competitiveness of domestic industries.
● Removal of export duty- To promote exports and encourage Indian goods to compete
effectively in global markets.
● Relaxation in Import licensing- To reduce bureaucratic hurdles in importing goods and
promote ease of doing business.

Privatization: It is the transfer of ownership of state-owned enterprises (SOEs) to private

individuals or companies. This process is often seen as a way to improve efficiency, increase
competition, and reduce the fiscal burden on governments. It can be achieved in many ways-
selling, franchising, contracting, leasing and other ways.

Merits:

● Increasing competition
● Increase employment
● Reduces political influence in decision making
● Promotes competition

Demerits:

● Encourages monopoly
● Greater disparity in wealth
● Lopsided development in industries
● It may not uphold principle of social justice or public welfare

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Dis-investment: To insure it is effective a committee was formed under C rangrajan. It submitted
report in 1993 and suggested the sector where privatization was needed and also recommended
government to setup an autonomous body to moniter disinvestment.

Globalization: It refers to the process of increased interconnectedness and interdependence of

economies, cultures, and societies across the globe.

It refers to integration of the national economy with the world economy through removal of
barriers on international trade and capital movement.

Advantages:

● Greater access to global markets

● Advanced technology
● Better future prospects for large industries of developing countries
● Better prospect for skilled people across the globe to increase their earnings

Disadvantages:

● It benefits more to developed countries as they are able to expand their markets in other
countries
● Globalization compromises the welfare of the people belonging to poor countries
● Market driven globalization increases the economic disparities among nations and people
● MNC’s have gained strong position in developing countries due to which domestic
companies are forced to face stiff competition

Foreign Direct Investment: Investment into production or business by an individual or company

in a country. It can be done by buying a company or by expanding operations in the other
country.

The department of industrial policy promotion makes announcement on FDI and it is notified by
RBI as an amendment in Foreign exchange regulation act.

FDI was allowed in India in a phased manner and certain sector were completely shutoff. In
defense it started with 26% and now it is 74% with automatic route and 100% with government
route. In insurance it started with 26% now it is 74%. In communication stared with 49% now it
is 100%. In civil aviation we started with 49%.

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Prohibited Sectors

● Lottery business which includes government, private, online etc

● Gambling, betting and casino
● Chit fund
● Real estate
● Tobacco products

Joint ventures

● Tata sons with Singapore airlines

● Jet airways with Etihad Airways
● Walmart
● Starbucks
● Ikea

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SEMESTER

ENDS HERE

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