MACROECONOMICS FOR FINANICAL

MARKETS MODULE

Revised w.e.f. 06 Dec 2023

NCFM Module Examination Details
Fees Allowable access to candidate at test center
Test Pas Certifi (Rs.)
Sr. Durat No. of Maxim
Nega
s cate inclusiv
tive Open
No NAME OF MODULE ion Questio um
Mark
Mar Validit e of
Office
Normal Regular /
Financial
(in ns Marks ks y (in applica Distribu Scientific
. mins)
ing
(%) yrs) ble Sprea
tion Calculato
Calculato
d r
taxes* Table r
Sheet
FOUNDATION
1 Financial Markets: A Beginners' Module 120 60 100 No 50 5 2006 No No Yes No
2 Mutual Funds : A Beginners' Module 120 60 100 No 50 5 2006 No No Yes No
3 Currency Derivatives: A Beginner's Module 120 60 100 No 50 5 2006 No No Yes No
4 Equity Derivatives: A Beginner's Module 120 60 100 No 50 5 2006 No No Yes No
5 Interest Rate Derivatives: A Beginner's Module 120 60 100 No 50 5 2006 No No Yes No
6 Commercial Banking in India: A Beginner's Module 120 60 100 No 50 5 2006 No No Yes No
7 Securities Market (Basic) Module 120 60 100 Yes 60 5 2006 No No Yes No
8 Clearing Settlement and Risk Management Module 60 75 100 No 60 3 2006 Yes No Yes No

INTERMEDIATE
1 Capital Market (Dealers) Module 105 60 100 Yes 50 5 2006 No No Yes No
2 Derivatives Market (Dealers) Module 120 60 100 Yes 60 3 2006 No No Yes No
3 Investment Analysis and Portfolio Management Module 120 60 100 Yes 60 5 2006 No No Yes No
4 Fundamental Analysis Module 120 60 100 Yes 60 5 2006 No No Yes No
5 Options Trading Strategies Module 120 60 100 Yes 60 5 2006 No No Yes No
6 Operations Risk Management Module 120 75 100 Yes 60 5 2006 No No Yes No
7 Banking Sector Module 120 60 100 Yes 60 5 2006 No No Yes No
8 Treasury Management Module 120 60 100 Yes 60 5 2006 Yes No Yes No
9 Insurance Module 120 60 100 Yes 60 5 2006 No No Yes No
10 Macroeconomics for Financial Markets Module 120 60 100 Yes 60 5 2006 No No Yes No
11 NSDL - Depository Operations Module 75 60 100 Yes 60 5 2006 No No Yes No
12 Commodities Market Module 120 60 100 Yes 50 3 2124 No No Yes No
13 Surveillance in Stock Exchanges Module 120 50 100 Yes 60 5 2006 No No Yes No
14 Technical Analysis Module 120 60 100 Yes 60 5 2006 No No Yes No
15 Mergers and Acquisitions Module 120 60 100 Yes 60 5 2006 No No Yes No
16 Back Office Operations Module 120 60 100 Yes 60 5 2006 No No Yes No
17 Wealth Management Module 120 60 100 Yes 60 5 2006 No No Yes No
18 Project Finance Module 120 60 100 Yes 60 5 2006 No No Yes No
19 Venture Capital and Private Equity Module 120 70 100 Yes 60 5 2006 No No Yes No

ADVANCED
1 Financial Markets (Advanced) Module 120 60 100 Yes 60 5 2006 Yes No Yes No
2 Securities Markets (Advanced) Module 120 60 100 Yes 60 5 2006 Yes No Yes No
3 Derivatives (Advanced) Module 120 55 100 Yes 60 5 2006 Yes Yes Yes No
4 Mutual Funds (Advanced) Module 120 60 100 Yes 60 5 2006 Yes No Yes No
5 Options Trading (Advanced) Module 120 35 100 Yes 60 5 2006 Yes Yes Yes Yes
6 Algorithmic Trading Module 120 100 100 Yes 60 3 7080 Yes No Yes No

* Fees are subject to revision

2
 PREFACE
About NSE Academy
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 CONTENTS
Sr No DESCRIPTION PAGE NO
Chapter 1: Introduction to Macro Economics
1.1 Introduction 9
1.2 Microeconomics and Macroeconomics 9
1.3 Why Macroeconomics is important for the financial sector? 11
1.4 The concept of ‘equilibrium’ in economics 11
1.5 Broad outline 12
Chapter 2: Inflation and Interest Rates
2.1 What is inflation? 14
2.2 How to measure inflation? 14
2.3 Types of Inflation 16
2.4 Theories of Inflation 18
2.5 Controlling Inflation 20
2.6 Interest Rates 20
2.7 Factors affecting the level of Interest Rate 20
Chapter 3: Impact of interest rates
3.1 National Income Accounting: Measuring Economic Activity 23
3.1.2 Some other ways to measure National Income 28
3.1.2.1 The Expenditure Approach 28
3.1.2.2 The Income Approach 30
3.2 National Income Accounting and relationship among macroeconomic 31
variables
3.2.1 The Simple Version 30
3.3 Saving and Investment in India 32
3.4 The changing composition of India’s economic environment 35
Chapter 4: Government and Fiscal Policy
4.1 Role of the Government in an Economy 37
4.2 Government Expenditure and Revenue: Understanding the 38
government accounts
4.2.1 Government Receipts 38
4.2.2 Government Expenditure 41
4.2.2.1 Revenue Expenditures 42
4.2.2.2 Capital Expenditures 42
4.2.2.3 Plan and Non-Plan Expenditure 42
4.3 Bringing together the Revenue and the Expenditure side 44
4.3.1 The Deficit Indicators 46
4.4 Financing of the deficit by the government 46
4.5 Fiscal Deficit and Sustainability of Internal Debt 48
4.6 Fiscal policies and their impact on the financial markets 49

4
 CONTENTS
Sr No DESCRIPTION PAGE NO
Chapter 5: Money and Monetary Policy
5.1 What is the role of Money? 52
5.2 Components of Money in India 53
5.3 Demand for Money 54
5.4 Supply of Money 54
5.5 Different Roles of RBI in India 52
5.5.1 How RBI regulates Money Supply in the Economy 55
5.6 What are the roles of Commercial Banks in Money Supply? 56
5.7 Other Instruments of Money Supply 58
5.8 Market Stabilization Scheme 59
5.9 Use of Monetary policy 60
5.10 Use of Fiscal policy 61
Chapter 6: The External Sector: Open Economy Macro Economics
6.1 Why do Countries Trade? 63
6.1.1 Absolute Advantage Theory 64
6.1.2 Comparative Advantage Theory 65
6.2 India and International Trade 66
6.2.1 India’s Merchandise Trade 67
6.2.2 Trade in Services 68
6.2.3 Transfer Payments and net factor Incomes 69
6.3 Balance of Payments 70
6.3.1 Classification of Balance payments accounts 70
6.3.1.1 Current Account 71
6.3.1.2 Capital account 72
6.3.2 Foreign Direct Investment 76
6.3.2.1 Foreign Direct Investment 76
6.3.2.2 Foreign Portfolio Investment 77
6.4 Exchange Rates 80
6.5 Foreign Exchange reserves 82
6.6 Impact of capital flows on money supply 84
6.7 Sterilization of Capital Flows 85
Chapter 7: Financial Markets
7.1 What are the basic roles of the financial market? 86
7.2 Why and how are financial markets different from other markets? 87
7.2.1 Systemic Risk 87
7.2.2 Asymmetric Information 88
7.2.3 Feedback and Amplification 88
7.3 Role of different financial systems: bank based financial systems and 88
capital market based financial systems
7.3.1 Capital market based Financial System 88
7.3.2 Bank based Financial Systems 89

5
 CONTENTS
Sr No DESCRIPTION PAGE NO
Chapter 7: Contd
7.4 Role and Contribution of different segments in India’s Financial 89
market
7.4.1 Commercial banks 89
7.4.2 Non-Banking Financial Companies (NBFCs) 90
7.4.3 Development Financial Institutions 90
7.4.4 Mutual Funds 91
7.4.5 Insurance 92
7.5 The Equity market 93
7.6 Derivatives Market in India 94
7.7 The Debt Market 95
Chapter 8: Regulatory Institutions In India
8.1 Role of Regulatory Institutions in a market-based economy 96
8.2 The Reserve bank of India 96
8.3 The Securities and Exchange Board of India (SEBI) 97
8.4 Insurance Regulatory and development Authority 97
8.5 Pension Fund Regulatory and Development Authority (PFRDA) 98
8.6 Forward Markets Commission (FMC) 99
8.7 Stock Exchanges in India 100
Chapter 8: References 101

6
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7
8
 Chapter 1
INTRODUCTION TO MACRO ECONOMICS
1.1 Introduction:

Understanding of economics is a key to know how the financial markets operate. There are
intricate linkages between various economic factors and financial variables. For example,
any tax rate changes by a government or a decision to change the amount of money in the
system can have both direct and indirect impact on the financial markets. This module
provides in very simple terms various macroeconomic concepts and a glimpse of
macroeconomic behavior with frequent references to the Indian economy. This perspective
forms an integral part of understanding that discerning finance professionals need to
possess, as it would help them identify the causes of different economic developments and
issues as well as anticipate the possible impact of changes in economic policies. A successful
professional is one who applies this understanding to think ahead and formulate strategies
for likely future scenarios.

Macroeconomics is a vast and complex subject. The literature is large, the issues diverse,
and opinion divided on both diagnosis of the problems and prescriptions for solving them. It
is also an evolving subject. Therefore, in preparing a short course material like this module,
the author had to be selective. Further, the author had to strike a balance between theory,
historical experiences and recent developments, while ensuring that the practical aspects of
macroeconomic fundamentals and their impact on the Indian economy are adequately
covered. For more advanced material, interested students are requested to see the
suggested readings at the end of this book.

1.2 Micro economics and Macro economics

It is said that Economics is the social science that studies the production, distribution, and
consumption of goods and services. Resources are scarce, while human wants are
unlimited. Economics is the study of how societies use scarce resources to produce goods
and services and distribute them efficiently among different people to satisfy their
consumption needs. The essence of Economics is to explore ways to optimize the use of
scare resources and to organize the society in a way that leads to the most efficient use of
those resources.

Economic theory can be broadly divided into two categories: Microeconomics and
Macroeconomics. Microeconomics focuses on the individual level of the economy. It studies
the behavior of individual economic agents such as individual consumers or workers or
firms. For example, microeconomics studies how a firm attempts to maximize its profits
under the constraints of its resources or how an individual makes decisions about his
purchases given the income constraint that he or she has. In other words, Microeconomics
analyzes and studies decisions of individual economic agents and how they interact in
specific markets and allocate their limited resources to optimize their own wellbeing.

Macroeconomics, on the other hand, looks at the economy as a whole. It deals with
aggregate economic behavior of a nation, a region or the global economy. In other words,
Macroeconomics deals with economy-wide phenomena such as inflation, unemployment,

9
and economic growth. Macroeconomics tells us about what determines level of output in an
economy, how are employment and prices determined; how money supply affects rate of
interest, how do the monetary and fiscal policies of the government affect the economy etc.
Macroeconomics tries to address some key issues which are of great practical importance
and are being discussed and debated regularly among the press, media and politicians.
Some of the key subjects which are dealt with in macroeconomics include:

Long-term Economic growth: Currently, we see that there is significant divergence of

standard of living among different countries. The main reason for this varying standard of
living among countries is the different levels of economic growth in the past. Over the past
several decades, economies of the currently developed countries have shown moderate to
high growth rates for a sustained period, while the economies of developing countries have
not. The developing countries may have had occasional periods of high growth; but they
have not sustained high growth performance over a long period. In other words, the
developed countries have experienced higher long-term economic growth than the
developing countries. Macroeconomics analyzes how and why different countries are
growing at different rates, and suggests how countries can accelerate their growth rates.

Business Cycles: Growth of most countries—developed as well as developing countries

go through ups and downs. The term business cycle refers to economy-wide fluctuations in
production or economic activity over time between periods of relatively rapid economic
growth, and periods of relative stagnation or decline. The duration of a business cycle can
be several months or even a few years. Despite being termed cycles, these fluctuations in
economic activity usually do not follow a mechanical or predictable periodic pattern.

The downward phase of business cycle, when economic activity contracts, is called
recession. Recession can lead to job losses and other hardships for the population in the
concerned economy. Macroeconomics studies business cycles and suggests policies so that
recession can be avoided as far as possible or made short-lived. The upward phase of the
business cycle is called economic boom. During this period, many new jobs are created and
the unemployment rate in the economy falls.

Inflation: When prices of goods and services increase in an economy, it is said that the
economy is experiencing ‘inflation’. Inflation is thus the rate of increase in general price
level over a period of time. Inflation is usually measured over a year and is expressed in
percentage terms. When we say that annual inflation on April 1, 2020 is 7 percent, it means
that the general price level increased by 7 percent between April 1, 2019 and April 1, 2020.
Inflation can be high, moderate or low. If the general price level falls, inflation turns
negative; this phenomenon is called ‘deflation’. Deflation is a very rare phenomenon. High
inflation and deflation are both not desirable for an economy. High inflation hurts consumers
as it reduces their purchasing power. Suppose during a year, an individual’s income goes up
by 6 percent, but the inflation during the year is 15 percent. Then the purchasing power of
the individual has gone down by 9 percent, even though his income has risen by 6 percent.
On the other hand, deflation leads the producers of goods and services to slow down their
activities, because they get a lower price for their products than they used to earlier. This
reduces their profits or even forces them to incur losses. As a result, the economic growth
slows down. The economy may even get into a recession. Study of Macroeconomics gives
insights into why inflation rises or falls and what policies help avoid periods of high inflation
or deflation.

Global economic linkages: Currently, most countries of the world trade with each
other and experience capital inflows and outflows. Macroeconomics studies the factors which

10
drive movements of goods and services as well as capital across countries. It also studies
the impact of such flows on the rest of the economy. Note that foreign capital flows play a
very important role in the financial markets of developing countries and hence is becoming
an increasingly important aspect of the economy of these countries.

Macroeconomic Policies: Performance of a country’s economy is based on a number of

factors like its endowment of resources, its stock of human capital, its technology and so
on. In addition to all these, one other factor that plays a key role in determining the
economic performance of a country is the economic policy followed by the government of
the country. Governments of different countries use different policies to run the economy as
efficiently as possible. These policies can be broadly divided into two segments: monetary
policy and fiscal policy. Monetary policy involves the use of some monetary tools to
influence the money supply in an economy and thereby influence other aspects on the
economy. Money supply growth is regulated by the central bank of a country. The central
bank of India is called the Reserve Bank of India .Fiscal policy is the use of government
expenditure and taxation to impact the economy. What should be the growth in government
expenditures? How much of it should be on creation of assets? What should be taxed and at
what rates? What should be the direction and magnitude of change in tax rates? These are
some of the questions that fiscal policies, which are part of macroeconomic policies, deal
with. Macroeconomics suggests when and how to use these policies and analyzes how these
policies can be used for a particular economy in a given set of circumstances.

1.3 Why Macroeconomics is important for the financial

sector?
For people in finance, understanding macroeconomics is very important because each of the
major macroeconomic factors mentioned above (such as growth, inflation, business cycles
etc.) have strong impact on the financial markets. Macroeconomic factors can have strong
impact on the financial sector. For example, when the economy gets into downturn, many
firms find it difficult to repay their loans and as a result, the financial health of banks gets
affected. Furthermore, changes in macroeconomic policies influence key variables of
financial markets such as interest rates, liquidity and capital flows.

On the other hand, what is happening in the financial market can have a strong impact on
the rest of the economy. Some examples of such transmission can be observed during the
financial crises. In the United States, weaknesses in the financial sector stemming from a
sudden and substantial decline in the prices of real estate, led to a downturn for the entire
economy. In fact, almost all the countries of the world were affected because of this
problem in the United States. In many countries across the world, this crisis hit not only the
financial markets but also the entire economy, causing major recession and unemployment.
The governments of these countries had to undertake serious coordinated policy measures
to pull their economies out from recession.

1.4 The concept of ‘equilibrium’ in economics

During our subsequent discussion, we will often talk about ‘equilibrium’. It may be
important to understand the basics of equilibrium. In economics, equilibrium is simply a
state of the world where economic forces at work balance each other. In the absence of
external influences the (equilibrium) values of economic variables will not change. Market
equilibrium, for example, refers to a condition where a market price is established through

11
competition such that the amount of goods or services sought by buyers is equal to the
amount of goods or services produced by sellers. This price at which such a balance of
demand and supply occur is often called the equilibrium price or market clearing price and
will tend not to change unless demand or supply change.

Types of Economic Systems

Economic systems may be classified as command economies or as free market economies.

In a command economy, all production and allocation decisions were taken by a central
planning authority. The system, in principle, was expected to work as follows. The planning
authority was supposed to estimate the resource requirements of various economic agents,
and then rank them in order of priority. Production plans and resource allocation decisions
were then required to be made to ensure that resources were directed to users in
descending order of need.

The failure of the command economies was inherent in their structure. To ensure the
desired levels of efficiency, such systems needed to aggregate and process an enormous
amount of information. Not only did this prove to be infeasible in practice, but the quality of
information being also processed was highly suspect in most cases. The output of such
systems was inevitably less than what the grandiose plans promised.

Economic agents in market economies seek to make the most profitable use of the
resources at their disposal. The profit from an economic decision can be determined by
considering the prices of the inputs and outputs that determine the costs of and the
revenues from alternative decisions. The optimal decision is the one that maximizes profit.
Economic agents who generate surpluses of income over expenditure are consequently able
to attract greater and better resources in such a system. Failure, as manifested by
sustained losses, will result in certain economic agents being denied access to the resources
being sought by them.

Decision making in such economies is decentralized. Each agent in order to take a rational
decision examines competing resource needs on the basis of their ability to generate
surpluses. In practice, every agent has a required rate of return on investment. The
threshold return is obviously the cost of funds for the agent. A project is considered to be
worth the investment only if the expected rate of return from it is greater than the cost of
the capital that is being invested.

The informational accuracy of prices ensures efficient allocation of resources in such

economies for the following reasons. If factors of production like labor and capital are
accurately priced, then producers can take optimal production decisions from the standpoint
of the cost of production. On the other hand, if the consumers of goods and services
perceive their prices to be accurate, they will make optimal consumption decisions, which
will obviously have an impact on the revenues generated by the producers. The accuracy of
input costs and output values will show up in the form of profit maximization which is the
motivating factor for agents to engage in economic enterprise.

The informational accuracy of the pricing mechanism is ensured by the fact that such
economies have markets that facilitate the trade of goods and services by agents whose
perception of the value of the asset differs from that of others. If the prevailing price is
perceived to be too low, buyers will seek to buy more than the quantity on offer. The price
will be bid up due to excess demand till it reaches the optimal level. Similarly, if the price is

12
perceived to be too high, sellers will seek to offload more than what is being demanded,
causing prices to decline till supply and demand are equated. Thus, differing perceptions of
value will manifest themselves as supply-demand imbalances. The resulting process of
adjustment that is required to ensure market equilibrium will ensure that the price of an
asset accurately reflects its value.

The key feature of a market economy, that facilitates efficiency, may be stated as follows.
Assume that there is a single producer of a good or a service. If another producer wants to
compete, he must either lower the price, or else improve the quality. In either case it is the
consumer who stands to gain.

Here is an interesting statistic. In 1988 General Motors had sales revenue of 112.53 billion.
In 1990 India had a GDP of 320.98 billion. Thus, India’s GDP was less than 3 times the
sales revenue of General Motors. In 2022 India’s projected GDP is 3,386 billion dollars.
Thus, in 32 years, India’s GDP has grown by more than 10 times, which translates to annual
growth rate of 7.50%.

1.5 Broad Outline

Chapter 2 discusses on two important macroeconomic variables that is inflation and
interest rate. Besides discussing various aspects of inflation and interest rate, the chapter
also analyses their impact on the overall economy.

Chapter 3 discusses how to measure the size of an economy and what are the possible
ways to measure the total income of an economy. It also looks into some key
relationships among macroeconomic variables. In the context of the Indian economy, it
analyzes how some major macroeconomic aggregates have behaved over the years.

Chapter 4 analyses the role of government in the economy. It highlights the revenue and
expenditure pattern of Government of India and tries to analyse the possible impact of
fiscal measures on the economy and on the financial sector.

Chapter 5 focuses on money and the role of the central bank. As money is a key factor in
the financial system, policy implications of some monetary policy instruments are also
discussed.

Chapter 6 analyses how integration with the global economy affects the economy of a
country. An open economy brings forth a new set of challenges and opportunities for an
economy. Economic policies try to maximize the gains and minimize the costs of opening
up the economy. This chapter discusses these issues in the Indian context.

Chapter 7 is devoted to the financial market of India. It discusses how financial markets
are different from other markets. It then goes on to analyse the structure and
components of various financial institutions in India.

Chapter 8 sums up the discussion by analysing the roles of some key financial regulatory
institutions in the Indian economy.

13
 Chapter 2
INFLATION AND INTEREST RATES

2.1 What is Inflation

Inflation denotes a rise in general level of prices. More specifically, inflation refers to the
rate of general price increase over a period of one year. For example, if we say that the
current inflation is 8 percent, it means the general price level has increased by 8 percent
over the last one year.

It has been observed that inflation the world over has generally remained in the positive
territory, implying that the general price level typically rises. There have however been
exceptions, when there have been sustained decline in the price level of goods and services.
This phenomenon is called deflation. For example, if we say that the current deflation rate is
4 percent, it means that the inflation is (–) 4 percent. In other words, the general price level
has fallen by 4 percent over the last one year. Japan suffered from deflation for almost a
decade in 1990s.

2.2 How to measure inflation?

Now, what do we mean by general price level and why do we use general price levels to
measure inflation? Supposing an economy produces 1000 goods. During a given year, the
price of these goods may have changed by different percentages; some may have risen by
5 %, some by 7 %, some by 20 % and there may even be some goods, whose prices may
have actually fallen. No single commodity will give us correct picture of the general price
increase in the economy. So, we must create a price index by taking into account either all
the commodities in the economy or a basket of sufficiently large number of commodities
that broadly represent the economy. Generally, the latter (that is, a given basket of
commodities) is chosen to create a price index. The purpose of a price index is to quantify
the overall increase or decrease in prices of several commodities through a single number.
The price index is measured at regular intervals and changes in price index are an indicator
of the average price movement of a fixed basket of goods and services (that represent the
entire economy). The Inflation at any given time is measured by computing the percentage
changes in the price index at that point of time over the index prevailing one year
previously.

To measure the rate of inflation, the following formula is used:

Rate of Inflation in year X: [( Px – Px-1) / (Px-1 )] * 100 Where:
Px is the price index for the year X.

Px-1 is the price index of the preceding year.

14
The wholesale price index and the wholesale price inflation in India during 1993/94 to
2019/20 are given below:

Table 2.1.: Computation of Inflation through Wholesale Price Index values

Financial Year Wholesale Price Index Inflation Rate (in %)

1993-1994 100 --
1994-1995 112.8 12.8
1995-1996 121.6 7.8
1996-1997 127.2 4.6
1997-1998 132.8 4.4
1998-1999 140.7 5.9
1999-2000 145.3 3.3
2000-2001 155.7 7.2
2001-2002 161.3 3.6
2002-2003 166.8 3.4
2003-2004 175.9 5.5
2004-2005 187.3 6.5
2005-2006 104.5 4.5
2006-2007 111.4 6.6
2007-2008 116.6 4.7
2008-2009 126 8.1
2009-2010 130.8 3.8
2010-11 143.3 9.6
2011-12 156.1 8.9
2012-13 106.9 6.9
2013-14 112.5 5.2
2014-15 113.9 1.2
2015-16 109.7 -3.7
2016-17 111.6 1.7
2017-18 114.9 3
2018-19 119.8 4.3
2019-20 121.8 1.7
2020-21 123.4 1.3
2021-22 139.4 13

Source: Office of the Economic Adviser, Ministry of Commerce and Industry

An important point to note from Table 2.1. is that while the price level increased
consistently over the period (indicated by a consistent increase in index), the inflation rate
fluctuated; that is rose in some years and fell in other years. This is so, because inflation is
the rate of price increase, which can fluctuate both ways even when prices continually
increase.

15
Another point to note from the table is during the year 2015-16, the country faced deflation
which was mainly because of an increase in supply with respect to demand.

2.3 Types of Inflation

Primarily, two types of price indices used are – Wholesale Price Index (WPI) and Consumer
Price Index (CPI). Inflation measured through wholesale price index is called wholesale price
inflation or headline inflation and inflation measured through consumer price index is called
consumer price inflation. The WPI and the CPI as they exist in India are given below.

Wholesale Price Index (WPI) is the index of prices prevailing in the wholesale
market. The concept of wholesale price adopted in practice represents the quoted price of
bulk transaction generally at primary stage. For example, the price pertaining to bulk
transaction of agricultural commodities may be farm harvest prices, or prices at the village
mandi /market. Similarly, for manufactured goods, the wholesale prices are ex- factory gate
level or ex-mine level. In India, wholesale price index is calculated by the Government on
monthly and yearly basis. What you see in Table 1 is the yearly wholesale price index and
yearly wholesale inflation. The wholesale price index and wholesale price inflation are keenly
watched by the observers of the economy and policy makers. The wholesale price inflation
is also called the headline inflation. 1 Please note that it is only since November 2009 that
the WPI has begun to be announced on a monthly basis; earlier, it used to be on a weekly
basis. The switch to monthly inflation from weekly inflation was made to endure that the
policy makers are not misled by the week-to-week fluctuations in inflation to make policy
prescriptions. The WPI is compiled by the Office of Economic Advisor to the Ministry of
Commerce and Industry of the Government of India.

There are three major groups in India’s wholesale price index: 1) Primary Articles 2) Fuel,
Power, Lights & Lubricants and 3) Manufacturing Items. (See Box). Note that the indexes of
the three major groups and each of the subgroups under them are publicly available. So, it
is possible for us to calculate not only general inflation, but also the inflation rate of a
particular group (such as primary articles) or sub-group (such as leather and leather
products).

Box: Major Groups in Wholesale Price Index of India

I. Primary Articles (3 sub-groups)

i. Food Articles
ii. Non-Food Articles
iii. Minerals

II. Fuel, Power, Light & Lubricants (3 sub-groups)

iv. Coal
v. Mineral oils
vi. Electricity

III. Manufactured Products (12 sub-groups)

vii. Food Products
viii. Beverages, Tobacco & Tobacco Products

16
 ix. Textiles
x. Leather & Leather Products
xi. Wood & Wood Products
xii. Paper & Paper Products
xiii. Rubber & Plastic products
xiv. Chemicals & Chemical Products
xv. Non-Metallic Mineral products
xvi. Basic Metals, Alloys & Metal Products
xvii. Machinery & Machine tools Transport Equipment & parts
xviii. Transport Equipment & Parts

The commodity basket for the computation of WPI consists of 435 commodities, of which 98 are
under primary articles, 19 under ‘Fuel, Power, Light and Lubricants’ and 318 under manufactured
products.

1
From the headline inflation if the effect of changes in prices of food and energy (petroleum
etc), which are prone to volatile price movements, are removed, what we get is called Core
inflation. The concept of core inflation rate was introduced by Robert J. Gordon in 1975.
(Robert J. Gordon, 1975. "Alternative Responses of Policy to External Supply Shocks,"
Brookings Papers on Economic Activity, Economic Studies Program, The Brookings
Institution, vol. 6(1975-1), pages 183-206)

The Consumer Price Index is the index of prices prevailing in the retail market. CPI is more
relevant to the consumer, since it measures changes in retail prices. The Consumer Price
Index represents the basket of essential commodities purchased by the average consumer –
food, fuel, lighting, housing, clothing, articles etc. Inflation measured by using CPI is called
consumer price inflation. There are three measures of CPI, which track the cost of living of
three different categories of consumers—industrial workers (IW), agricultural laborers (AL)
and rural laborers (RL). Each category has its own basket of commodities that represent the
consumption pattern of the respective consumer groups. Not only does the basket of
commodities differ, but also the weights assigned to the same commodity may be different
under different CPI series. For example, food gets a weight of only 48 percent under CPI-
IW, but 73 percent under CPI- AL. Among the three, CPI-IW is most popular. In the
organized sector, CPI –IW is used as the cost of living index. Consumer Price Index is
measured on a monthly basis in India. All the three series of CPI are compiled by Labor
Bureau of the Labor Ministry of the Government of India. While wholesale price inflation is
more popular in India, the Consumer Price Index is a popular measure in developed nations
like USA, UK.

However in the year 2014, RBI declared new CPI (combined) as the key measure
of inflation based on recommendations of Urjit R. Patel Committee.

Table 2.2.: Computation of Inflation through Consumer Price Index values

Financial Consumer Price Inflation Rate

Year Index (in %)
2014-15 251 6.3

2015-16 265 5.6

2016-17 276 4.1

17
 2017-18 284 3.1

2018-19 300 5.4

2019-20 323 7.5

2020-21 332 5.13

Source: Office of the Economic Adviser, Ministry of Commerce and Industry

2.4 Theories of Inflation

Various theories have been propounded to explain the cause of inflation. However, in this
book we will limit our explanation to the demand pull and cost push inflation theories.

Aggregate demand pull inflation occurs when the aggregate demand2 for output is in
excess of maximum feasible or potential or full-employment output (at the going price
level). Since the level of output is taken as a given data, the excess demand is supposed to
be generated by the factors influencing only the demand side of the commodities market.
Demand-pull inflation simply means that aggregate demand has been ‘pulled’ above what
the economy is capable of producing in the short run.

Cost push inflation occurs due to an increase in the cost of production. In contrast to the
demand-pull inflation, the cost-push inflation emphasizes increases in some important
component or the other cost as the true source of inflation. It works through some
important cost components in the production process such as wages or materials cost. Note
that according to this theory, the upward push in costs is independent of the demand
conditions of the concerned market; for example, wages could rise because of trade union
activities rather than shortage of labour. The second important aspect to note is that the
higher cost is passed on to the consumers in terms of higher prices and are not absorbed by
the producers.

Impact of Inflation on macroeconomic variables

Exchange Rate: Persistently Higher inflation in a country (say Country A) relative to the
inflation in another country (say Country B) generally leads to depreciation of a currency in
country A. Depreciation of the currency of country A means decrease in the value of the
currency of country A relative to the currencies of country B. In other words, if country A
persistently experiences higher inflation than country B, in exchange for the same number
of units of Currency A, the residents of country A will get fewer units of currency B than
before.

Exports and Imports: As stated in the preceding paragraph, relatively higher inflation in a
country leads to the depreciation of its currency vis-à-vis that of the country with lower
inflation. If the two countries happen to be trading partners, then the commodities produced

18
by the higher inflation country will lose some of their price competitiveness and hence will
experience lesser exports to the country with lower inflation. A currency depreciation
resulting from relatively higher inflation leads not only to lower exports but also to higher
imports.

• The total amount of goods and services demanded in the economy at a given overall
price level and in a given time period.

Interest Rates: When the price level rises, each unit of currency can buy fewer goods
and services than before, implying a reduction in the purchasing power of the currency. So,
people with surplus funds demand higher interest rates, as they want to protect the returns
of their investment against the adverse impact of higher inflation. As a result, with rising
inflation, interest rates tend to rise. The opposite happens when inflation declines.

Unemployment:
There is an inverse relationship between the rate of unemployment and the rate of inflation
in an economy. It has been observed that there is a stable short-term trade-off between
unemployment and inflation. This inverse relationship between unemployment and inflation
is called the Phillip’s Curve (see below).

As shown in the above graph, when an economy is witnessing higher growth rates, unless it
is a case of stagflation, it typically accompanies a higher rate of inflation as well. However,
the surging growth in total output also creates more job opportunities and hence, reduces
the overall unemployment level in the economy. On the flip side, if the headline inflation
breaches the comfort level of the respective economy, then suitable fiscal and monetary
measures follow to douse the surging inflationary pressure.

In such a scenario, a reduction in the inflation level also pushes up the unemployment level
in the economy.

19
2.5 Controlling Inflation
There are broadly two ways of controlling inflation in an economy – Monetary measures and
fiscal measures. The most important and commonly used method to control inflation is
monetary policy of the Central Bank. Most central banks use high interest rates as the
traditional way to fight or prevent inflation. Monetary measures used to control inflation
include (i) bank rate policy (ii) cash reserve ratio and (iii) open market operations. Besides
these monetary policy steps, the fiscal measures to control inflation include taxation,
government expenditure and public borrowings. The government can also take some
protectionist measures (such as banning the export of essential items such as pulses,
cereals and oils to support the domestic consumption, encourage imports by lowering duties
on import items etc.). These monetary and fiscal measures have been discussed in detail in
later chapters of this module.

2.6 Interest Rates

Interest rate is the price demanded by the lender from the borrower for the use of borrowed
money. In other words, interest is a fee paid by the borrower to the lender on borrowed
cash as a compensation for forgoing the opportunity of earning income from other
investments that could have been made with the loaned cash. Thus, from the lender’s
perspective, interest can be thought of as an "opportunity cost’ or "rent of money" and
interest rate as the rate at which interest (or ‘opportunity cost’) accumulates over a period
of time. The longer the period for which money is borrowed, the larger is the interest (or the
opportunity cost). The amount lent is called the principal. Interest rate is typically expressed
as percentage of the principal and in annualized terms. From a borrower’s perspective,
interest rate is the cost of capital. In other words, it is the cost that a borrower has to incur
to have access to funds.

2.7 Factors affecting the level of Interest Rate

Interest rates are typically determined by the supply of and demand for money in the
economy. If at any given interest rate, the demand for funds is higher than supply of funds,
interest rates tend to rise and vice versa. Theoretically speaking, this continues to happen
as interest rates move freely until equilibrium is reached in terms of a match between
demand for and supply of funds. In practice, however, interest rates do not move freely.
The monetary authorities in the country (that is the central bank of the country) tend to
influence interest rates by increasing or reducing the liquidity in the system. This has been
discussed later. Broadly the following factors affect the interest rates in an economy:

Monetary Policy – The central bank of a country controls money supply in the economy
through its monetary policy. In India, the RBI’s monetary policy primarily aims at price
stability and economic growth. If the RBI loosens the monetary policy (i.e., expands money
supply or liquidity in the economy), interest rates tend to get reduced and economic growth
gets spurred; at the same time, it leads to higher inflation. On the other hand, if the RBI
tightens the monetary policy, interest rates rise leading to lower economic growth; but at
the same time, inflation gets curbed. So, the RBI often has to do a balancing act. The key

20
policy rate the RBI uses to inject (or reduce) liquidity from the monetary system is the repo
rates (or reverse repo rates). 3Changes in repo rates influence other interest rates in the
economy too.

Growth in the economy – If the economic growth of an economy picks up momentum,

then the demand for money tends to go up, putting upward pressure on interest rates.

Inflation – Inflation is a rise in the general price level of goods and services in an
economy over a period of time. When the price level rises, each unit of currency can buy
fewer goods and services than before, implying a reduction in the purchasing power of the
currency. So, people with surplus funds demand higher interest rates, as they want to
protect the returns of their investment against the adverse impact of higher inflation. As a
result, with rising inflation, interest rates tend to rise. The opposite happens when inflation
declines.
Global liquidity – If global liquidity is high, then there is a strong chance that the domestic
liquidity of any country will also be high, which would put a downward pressure on interest
rates.

Uncertainty – If the future of economic growth is unpredictable, the lenders tend to cut
down on their lending or demand higher interest rates from individuals or companies
borrowing from them as compensation for the higher default risks that arise at the time of
uncertainties or do both. Thus, interest rates generally tend to rise at times of uncertainty.
of course, if the borrower is the Government of India, then the lenders have little to worry,
as the government of a country can hardly default on its loan taken in domestic currency.

Impact of interest rates

There are individuals, companies, banks and even governments, who must borrow funds
for various investment and consumption purposes. At the same time, there are entities
that have surplus funds. They use their surplus funds to purchase bonds or Money Market
instruments. Alternatively, they can deposit their surplus funds with borrowers in the form
of fixed deposits/ wholesale deposits.
Repo rate is the rate at which the RBI lends money to the commercial banks and reverse
repo rate is the interest rate that commercial banks get for parking their excess funds
with the RBI. These concepts have been discussed later in this module.

Interest rates receive a lot of attention in the media and play an important role in
formulation of Government policy. Changes in the rate of interest can have significant
impact on the way individuals or other entities behave as investors and savers. These
changes in investment and saving behaviour subsequently impact the economic activity in
a country. For example, if interest rates rise, some individuals may stop taking home
loans, while others may take smaller loans than what they would have taken otherwise,
because of the rising cost of servicing the loan. This will negatively impact home prices as
demand for homes will come down. Also, if interest rates rise, a company planning an

21
expansion will have to pay higher amounts on the borrowed funds than otherwise. Thus
the profitability of the company would be affected. So, when interest rates rise,
companies tend to borrow less and invest less. As the demand for investment and
consumption in the economy declines with rising interest, the economic growth slows
down. On the other hand, a decline in interest rates spurs investment spending and
consumption spending activities and the economy tends to grow faster.

Concept of Real Interest Rate

Real interest rate is the interest rate that is adjusted to remove the effects of inflation to
reflect the real cost of funds to the borrower. In simple terms, it is the rate of interest an
investor expects to receive after subtracting inflation. The real interest rate of an
investment is calculated as the amount by which the nominal interest rate is higher than
the inflation rate.

Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)

The concept of real interest rate can be explained with the help of a simple example. If an
individual is earning an interest of 8% per year on the savings in his bank account and
inflation is 4% per year, then the real interest rate that the individual receives is 4% (8% -
4% = 4%). Thus, the real value of savings increases by 1% per year.

22
 Chapter 3
NATIONAL INCOME ACCOUNTING

3.1 National Income: Measuring Economic Activity

Union Finance Minister Nirmala Sitharaman tabled the pre-budget Economic Survey 2020-21
in Parliament on 29-01-2021. According to the survey, India’s economy is likely to rebound
with a 11 per cent growth in the next financial year i.e., 2021-22 as it makes a ‘V-shaped’
recovery after witnessing a pandemic-led carnage. In newspapers and television channels
also, one often finds reference to the GDP growth rate of a country. It is important to
understand what does GDP mean, how it is measured and what does changes in its growth
rate mean for the economy.

The most common measure used to estimate the size of an economy is called the Gross
Domestic Product or GDP. GDP is a comprehensive measure of a country's overall
economic output. GDP is defined as the market value of all final goods and services
produced within an economy in a given period of time, usually in a financial year. Therefore,
India’s GDP in 2018-19 is Rs 13,981,426 crores means that the total value of goods and
services produced in India during 2018-19 is Rs 13,981,426 crores.4

To understand how the GDP is calculated, let us take an example of a very small economy.
Suppose a hypothetical economy produces only three products: wheat, bicycles and cloth.
In year 1, it produces 5 tons of wheat, 100 bicycles and 500 meters of cloth. In Table 3.1,
with the help of the prices and the number of units of different items produced in an
economy, it is shown how the GDP is calculated.

Table 3.1. Calculation of GDP for a hypothetical economy

Item Price in Rs. / unit No of Units Total value of Output (Rs.)

Wheat 5,000 per tones 5 tonnes =25,000
Bicycles 2,000 per unit 100 =2,00,000
Cloth 200 per meter 500 meters =1,00,000
Gross Domestic Product for year 1 Rs. 3,25,000

There are a few things to be noted from Table 3.1. First, as the production of wheat,
bicycles and cloth is measured in different units (for example, production of wheat is
measured in tones, while that of cloth is measured in meters), the production of these three
products cannot be added to find out the size of the economy. If however we find out their
value, all the three products can be expressed in the same unit, (namely rupee). To get the
value of each good in rupee terms, we need to multiply their production volumes by their

23
respective prices. Once that is done, these values can be added up to arrive at the GDP
value.

Secondly, it should be clear from the table that GDP can increase either due to an increase
in production volume of the goods or due to an increase in the prices. These two situations
for the year 2 are shown in Table 3.2. In scenario 1, in our hypothetical economy, the
output of each of the product doubles but prices do not change. In this case, the value of
GDP will be Rs.6,50,000. But suppose as an alternative scenario (Scenario 2), there is no
change in output but only the price of each good doubles. In this case also the value of GDP
will be the same as in the previous case (see Table 3.2).

Table 3.2. Two different Scenarios but same GDP (year 2)

Scenario 1 (same price, output doubles) Scenario 2 (same output, price doubles)

Item Price in Rs./ No of Total value of Item Price in Rs./ No of Total value of
unit Units Output (Rs.) unit Units Output (Rs.)

Wheat 5,000 per 10 50,000 Wheat 10,000 per 5 tonnes 50,000

tonne tonnes tone

Bicycles 2,000 per 200 4,00,000 Bicycles 4,000 per 100 4,00,000
unit unit

Cloth 200 per 1000 2,00,000 Cloth 400 per 500 2,00,000
meter meter

Gross Domestic Product for Rs. 6,50,000 Gross Domestic Product for Rs.6,50,000
year 2 year 2

But obviously, these two situations are completely different. In the first case, there has
been a genuine increase in the level of economic activity in the country, while in the second
case it is only a case of increase in prices. To know whether there has been a genuine
increase in economic activity and by how much, GDP measures need to be taken at constant
prices (that is, the price level of a particular year). For the hypothetical economy, this can
be done by using the prices of a particular year (say year 1, as given in Table 3.1) to
measure GDP for year 2 for both scenarios. If we use prices of year 1 (given in Table 3.1),
Scenario 1 shows a genuine increase in economic activity, while Scenario 2 shows no
increase in GDP. Thus, using GDP estimates at constant prices helps us eliminate the effects
of price level changes on the GDP. When GDP calculations are made using constant prices, it
is called ‘real’ GDP.
When GDP calculations are done using current prices, it is called ‘nominal’ GDP. For
example, in Scenario 1 of Table 3.2, since calculations of GDP in Year 2 have been made
using current prices (that is, prices of year 2), it is called the nominal GDP for year 2,
which is Rs 6,50,000. If instead, in the same Scenario 1, the calculation of GDP for year
2 were made using constant prices (that is prices of Year 1), it would have been called
real GDP for year 2, which would have been Rs 3,25,000.

24
To measure how fast a country’s economy is growing, the rate of growth of real GDP is used.
Annual rate of growth of real GDP is calculated using the following formula

Real GDP growth rate for year (t+1)

= (GDP at constant prices for year (t+1) – GDP at constant prices for year (t)) X 100
GDP at constant prices for year (t)

So, unless otherwise mentioned, the economic growth of a country means growth of its real
GDP. “Real” implies adjusted for inflation. If it is not adjusted for price level, then it is
“nominal”. Table 3.3 shows the real GDP growth rates of India.

Table 3.3. Real GDP Growth Rate:

Source: IMF World Economic Outlook April 2021 New series base 2011-12

• Gross Domestic Product measures the total value of goods and services produced by
an economy, in a period of time.
• Gross Value Added or GVA, is the value added to the product to enhance its value.
• The gross value added is defined as the value of the output, minus intermediate
consumption. Gross national income (GNI) measures, the total income earned by a
country’s people and businesses, including investment income, whether they are

25
 earned within the country or outside. It also covers money received from abroad
such as foreign investment and economic development aid.
• To compute the GNI from the GDP, compensation paid to resident employees by
foreign firms and income from overseas property owned by residents is added.
• On the other hand, compensation paid by resident firms to overseas employees and
income generated by foreign owners of domestic property is subtracted.
• Product and import taxes are added to compute the GNI, while subsidies are
subtracted. Thus, GNI is defined as GDP, plus net receipts from abroad of
compensation of employees, property income and net taxes less subsidies on
production.
• Net National Income or NNI, is the aggregate value of the balances of net primary
incomes summed over all sectors of the economy.
• The difference between the NNI and the Net Domestic Product (NDP), is that the
former is computed using factor costs, whereas the latter is based on market prices.
• Table 3.3 computes the growth rates of GDP, GVA, GNI and NNI, using 2011-12
prices. The growth rate was negative in 2020-21 due to the corona pandemic. There
was also a decline in the growth rates, in 2008-09, due to the global economic crisis.

The GDP deflator is computed by dividing the GDP of a country at current prices, by the
value of the current output as determined using base year prices. Thus, the GDP deflator
may be defined as:

(Nominal GDP ÷ Real GDP) x 100

The GDP deflator is considered to be a better measure of inflation than the Consumer Price
Index (CPI). This because unlike the former, the latter is based on a fixed, static, basket of
goods and services.

In real life, the calculation of GDP is much more complex than the overly simplistic example
given above. This is mainly because of four reasons.

• First, some goods may be produced not for direct consumption, but to be used in
5
the production of other goods. For example, let us assume that a farmer
produces wheat worth Rs 1000 and sells this wheat to a baker. The baker makes
flour and bread and sells the bread at Rs 2000. Therefore, the price of bread now
includes the cost of production of bread (including the cost of wheat) and the
profit of the baker. So, if the values of production of both wheat and bread are
added for GDP calculation, it will lead to double counting and GDP will be
mistakenly shown as high. It is important to avoid such problems.

• Second, a farmer may not sell the entire amount of rice that he produces. Some
amount may be kept for self-consumption. The amount held back for self-
consumption will not be reflected in GDP if one only takes only the value of rice
that is sold in the market for GDP calculation. Hence, in this case, GDP will be
underestimated. In India, particularly, it is important to estimate the self-

26
 consumed amount for calculating GDP. This is because in India, a large share of
the population is engaged in subsistence farming, where the agricultural output
produced is largely used for self-consumption.

Final goods are goods that are subject to direct consumption. If a good is used not for
direct consumption, but for the production of other goods, it is not a final good, but an
intermediate good. Thus, if milk is used for direct consumption, it is called final good; but
if it is used to make curd, it is being used as an intermediate good and not a final good.

• Third, along with intermediate goods, there are other types of goods which are not
final goods, and which are used in the production process. For example, for baking
bread, the baker needs ovens. But unlike wheat, the ovens are not used up during
the production of bread. In other words, while wheat becomes an ingredient for
producing bread, the oven is only a tool to produce it. Such goods are called
Capital Goods. Capital goods are used to produce other goods but unlike
intermediate goods, they are not used up right away during the production of the
final good. It is important to take the value of capital goods in GDP calculation. In
economics, the total value of a country’s capital goods at a given point of time is
called the capital stock at that point of time. Addition to the capital stock during a
certain period is called ‘investment’ during that period. For example, if the baker
had ovens worth Rs 30,000 on April 1, 2019, and had ovens worth Rs 50,000 on
April 1, 2020, then it implies that he bought capital goods worth Rs 20,000 in the
financial year 2019-2020. This amount, which is an addition to his capital stock,
will be taken as his investment in the financial 2019-20. In calculating GDP for a
year, it is very important to incorporate investment during the year (that is the
change in the value of capital stock during the year). Here, it is important to learn
the concept of depreciation (see box 2.1).

• Finally, in a big economy like India there is a significant underground economy or

illegal economy. Incomes are not reported fully; there might be bribery involved.
The underground economy is the part of the economy that people hide from the
government either because they wish to evade taxation or because the activity is
illegal. These activities are not reported in government statistics and therefore these
are not captured in the GDP figures.

Box 3.1: What is depreciation?

Capital goods tend to have a finite lifetime. For example, the oven
bought by the baker might have a lifetime of 10 years and at the end of
the 10th year, the baker will have to replace it. This gradual erosion of
capital goods is called depreciation. The erosion in value of capital goods
during a year is called depreciation during that year. When GDP figures
are adjusted for depreciation, the resultant measure is called Net
Domestic Product or NDP. Therefore, NDP is:

NDP = GDP- depreciation of capital stock

27
3.1.2 Some other ways to measure National Income

Discussion in the previous section shows that national income can be measured as the value
of total output produced, excluding the value of output used in the intermediate stages of
production. This is called the ‘production approach’ for measuring GDP. However, there are
two other ways to measure GDP - the ‘income approach’ and the ‘expenditure approach’.
Whichever approach is adopted, we get the same measure of GDP.

3.1.2.1 The Expenditure Approach

Let us initially assume that there are two sets of economic agents in the system-the firms
and the households. The firms are producers of goods and households are the consumers of
these goods. Firms employ the people from household as workers, pay them wages and
earn their profit by selling their goods and services.

In economics, the resources which are used to produce goods and services are called
“factors of production”. Labour, capital and land are considered to be factors of production.
The factors of production earn a return for their contribution to the production process; for
example, labour earns wage, capital earns interest and dividend, and land earns rent.

Therefore, the economic system will look like the following:

Firms produce and sell goods and services. They hire and use factors of production.

Households buy and consume goods and services. They own and sell factors of
production. (See Figure 3.1)

Figure 3.1. Diagram showing Circular Flow of Income in an Economy

28
Assuming that all goods and services produced during a year are sold during the same year
and there are no unsold goods at the end of the year, we can define the GDP of this
economic system as:

GDP = Consumption expenditure by the household sector (this should equal the total value
of final goods and services produced) + Investment expenditures by the firms (this should
include expenditure on all capital goods by the firms in a certain period)
If we denote GDP as Y; Consumption as C and Investment as I, then the above equation
becomes:

Y=C+I…………………………………………………………………………………….(i)

At this point, it is important to learn the concept of inventory (see Box 3.2).

Box 3.2: What is inventory?

We made a simplifying assumption that all goods and services produced during a period
are completely sold. This is a restrictive assumption. In real life there can be unsold
goods during a period. A firm may produce a quantity of goods in a specific year, but not
sell all of those goods within that same year. These unsold goods are called “inventories”
and are counted as part of investment by the firm.

So far we have assumed that there are only two sets of economic agents in the system:
firms and household. We now introduce a third economic agent, which is the ‘Government’.
The Government plays a very important role in an economy. Government can act as
consumer (while purchasing goods such as stationery or food grains for distribution in ration
shops) or act as a producer (while purchasing capital goods such as machinery). 6

Therefore, if one includes the government in equation (i), the system will become:

Y= C + I + G;……………………………………………………………………………(ii)

Where, government spending is denoted by G

So far, we have assumed a close economy with no foreign trade. Once we relax this
assumption, there are two more important components which should be added to our
equations. Once we open up the economy, it is possible that along with domestic economic
agents, foreign buyers will also be buying goods and services from an economy. The goods
and services that foreign buyers procure from the domestic markets are called ‘Exports’ and
are denoted by X. On the other hand, domestic economic agents can also procure goods
and services from the foreign market. These are ‘Imports’ and are denoted by M. Exports
add to the GDP value because it increases the total expenditure on domestic goods and
services. Imports, on the other hand, have just the opposite effect. Therefore, the new
equation will now look like:

Y = C + I + G + (X-M) ……………………………………………………………………………(iii)

29
The national income accounts divide GDP into four broad categories of spending:
• Consumption (C)
• Investment (I)
• Government spending (G)
• Net Exports (X-M).

The right hand side of equation (iii) actually shows the aggregate demand generated for
the goods and services of the economy.

To raise revenue to finance its purchases, the government imposes taxes on the
household and firms. Taxation lowers the amount of income of households and firms and
thereby reduces their spending.

Equation (iii) is an extremely important accounting equation in economics. It is not only

used to measure GDP but it also has significant relevance in understanding how an
economy works. We will come back to this equation soon.

3.1.2.2 The Income Approach

GDP can be measured from the income side as well. The ‘income approach’ measures
economic activity by adding all the incomes received by all the producers of output. This
includes wages received by workers and profits received by the owners of the firms. To be
more specific, there can be five types of income:

• Compensation of employees: This is the income of workers, including self-

employed workers, and includes salaries, wages, pensions etc.
• Proprietor’s income: These are the profits of partnerships and solely owned
businesses, like a family restaurant.
• Rental income of persons: Income earned by individuals who own land or
structures that they rent to others.
• Corporate profits: Corporate profits are the profits earned by the corporations
and represent the remainder of corporate revenue after wages, rents, interest
payments and other costs.
• Net interest: Net interest is the interest earned by individuals from business and
foreign sources

GDP measurement based on income or expenditure should result in the same GDP
figures7. Therefore, GDP sometimes is also called the total income of the economy.

30
 3.2 National Income Accounting and relationship
among macroeconomic variables

3.2.1 The Simple Version

The basic macroeconomic equation that shows the different components of aggregate
demand is

Y = C + I + G + (X-M) ......................................................................................... (iv)

If we
1) Include government consumption under C and government investment under
I and
(But due to measurement issues, sometimes there can be small differences
among these measures) Assume exports and imports balance each other out
(or X=M), then the equation becomes:

Y= C + I

Rearranging, we get

Y-C = I ............................................. (V)

Now C is consumption and Y is the total income of the economy and savings is defined
as income which has not been spent.

Therefore, Y-C is nothing but the total savings generated in the economy. If we denote

savings by S, then Y- C = S ……………………………………(VI)

From Equation (V) and (VI), I= S or, savings is equal to investment

At one level, this equation will always hold true and it is an identity. This is because of the
way Y, C, S and I are defined, S will always be equal to I. Remember that this happens
when X=M

If we go back to figure 3.1, we can understand that the household sector earns income
through its supply of different factors of production. Some amount of this income is spent
on purchasing goods and services produced by the firms. The residual income is saved.

On the other hand, firms need to buy capital goods to replace their worn out machines
and to add capacity to their production process. Adding capital goods and replacing worn out
machines is nothing but investment. Therefore, firms need funds for their investment.

Therefore, in this economy there is a sector with excess funds and there is another sector
which is requiring funds. It will be mutually beneficial if there is an institution which
channelizes the savings from the household sector to cater to the investment needs of the

31
firms. In fact, this is the main role which the financial sector plays in an economy. A well-
functioning financial sector encourages and mobilizes savings and allocates that to the
most productive uses in the firm sector.

Remember that S = I is only an accounting identity. In reality, even in a very simple

economy, the amount of fund required by the firms for their planned investment and the
amount of actual savings generated by the household sector may not be same. However,
if and when the planned investment by the firm sector matches exactly the actual savings
by the household sector, the economy is said to be in equilibrium. Therefore, the S=I
equation can also be viewed as an equilibrium condition for an economy, provided the
equation is changed to read as.

Savings actual = Investment Planned (Equilibrium condition)

8
As stated earlier Government expenditure includes Government Consumption
Expenditure (such as food subsidy, fertilizer subsidy etc) and Government Investment
Expenditure (government expenditure on plants and machinery).

This also tells us that if an economy does not generate enough savings, then the amount
of investment made by the firms will be low. In other words, investment will be
constrained by the low savings generated in the economy. This is the reason why
governments of developing countries have taken a number of measures to improve the
savings rate of an economy such as giving tax exemptions.

Let us now relax the condition that X= M.

If suppose, X was not equal to M, then it can be shown from Equation (IV) and (V) that I
= S + (M – X)
While S is called domestic savings, (M-X) is called foreign savings.

Note that if in a country in any given year, M exceeds X, the country has positive foreign
savings in that year. In such a case, it is possible for the country to invest more than its
domestic savings in that year.

3.3 Saving and Investment in India

Figure 3.3. Gross Domestic Saving as a percentage of GDP in India
Year Percentage
2015 30.6
2016 30.4
2017 30.5
2018 29.9
2019 28.1
2020 27.1
2021 29.3

Source: World Bank national accounts data, and OECD National Accounts data files.

32
Poor countries tend to have a low saving rate. The reason is not difficult to understand.

A poor person saves a very small fraction of his income because he is compelled to
consume a very high proportion of his low income to meet his basic needs (such as food,
shelter, clothing and security). If the majority of the population is poor (and the income
distribution is not very unequal) then the aggregate saving as a percentage of income for
a poor country is also likely to be low. As income grows, people tend to spend lesser and
lesser fraction of their income and save more and more. While income is an important
factor determining savings, it is not the only one.

Cultural factors also after 2008 as shown in figure 3.3 above. During the year 2019, the
GDS of India as a percentage of GDP was around 28.1% per cent. India is currently
among the countries with the highest saving rates. For a low-income country, this has
been a commendable achievement.

Gross Domestic Savings constitutes savings of (a) public sector, (b) private corporate
sector and (c) household sectors. In India, household sector is the most dominant sector
among these, generating about 70 percent of total savings of the economy in the current
years.

Household savings is composed of both financial and physical savings. About half of the
household savings are in the form of physical assets such as property and gold and the
rest are in the form of financial assets. Among the financial assets of the household
sector, safe and traditional assets such as bank deposits and life insurance funds account
for the bulk. According to RBI data, more than 5 percent of the total household saving in
financial asset is in capital market instruments such as shares and debentures and units
of mutual funds (see Table 3.3).

The primary reasons why the savings rate is declining in India, is inflation, according to
most economists. Due to rising price levels, people tend to spend a larger portion of their
incomes on goods and services, and consequently tend to save less. The household sector
has been spending more, because incomes have not kept pace with the rate of inflation.
This is even more true for low income families, for they tend to be employed in the
informal sector, which has still not fully recovered from the pandemic.

Table 3.3. Components of Household Saving in Financial Assets

(Per cent of Gross National Disposable Income)
2014- 2015- 2016- 2017- 2018- 2019-
Items
15 16 17 18 19 20
A. Gross financial saving of
9.9 10.7 10.4 11.9 10.4 10.5
which:
Currency 1 1.4 -2.1 2.8 1.5 1.4
Deposits 4.8 4.6 6.3 3.1 4.1 3.6
Shares & Debentures 0.2 0.2 1.1 1 0.4 0.4
Claims on Govt. 0 0.5 0.7 0.9 1 0
Insurance Funds 2.4 1.9 2.3 2 1.3 1.7
Provident & Pension Funds 1.5 2.1 2.1 2.1 2.1 2.1

33
B. Financial Liabilities 3 2.7 3 4.3 4 2.9
C. Net Financial Savings (A-B) 6.9 7.9 7.3 7.6 6.4 7.6
#As per the preliminary estimate of the Reserve Bank

Source: Reserve Bank of India

Among the other sectors which generate savings in India, the private corporate sector
is becoming important. It has increased from 1.0 per cent of GDP in the 1950s to

1.7 per cent of GDP in the 1980s, to 3.8 per cent of GDP in the 1990s and further to 7.8
per cent of GDP in 2006-07. In fiscal year 2018, gross domestic savings in the
private corporate savings was over 11 percent of the GDP in India.

As regards the public sector (comprising government and its enterprises), the contribution
of public sector in total savings has been the lowest and in some years it was negative.
Negative savings mean that the sector consumed more than its income. However, since
2003-04, it has made a positive contribution to the GDS (see figure 3.4).

3.4. Sectoral breakup of Gross Domestic Saving in India till 2020-21 as a percent
of GDP at current market prices

The house-hold sector continues to contribute the bulk of savings in India, as is to be

expected. Post liberalization in 1991, the role of the private sector in the economy has
increased tremendously, and savings by the private corporate sector has been steadily

34
increasing over the years, as is to be expected. There is a decline in 2020-21, which is
due to the pandemic. The role of the public sector has declined steadily over the years,
and the economy has been opened up to the private sector. Significant privatization of
key sectors has also happened. Consequently, this sector now contributes very little by
way of savings.

3.4 The changing composition of India’s economic

environment
There are three broad sectors in a country’s economy. They are (a) agriculture and allied
activities, (b) industry and manufacturing sector and (c) the services sector. The structure
of Indian economy has gone through some remarkable changes over the years. At the
time of independence, agriculture accounted for more than 50 percent of the country’s
GDP. But since India started liberalizing during the 1980s, the economy has gone through
a major structural shift. The contribution of agriculture has gone down drastically over the
years and the share of services sector has increased sharply. The contribution of industry
has largely remained stagnant (Figure 3.5 and subsequent table below).

Figure 3.5. Sectorial Contribution to India’s GDP from 2018-2021

(% contribution to GDP in recent years)

The percentage share of agriculture and allied activities to the total economy is steadily
increasing. In India, agriculture is state subject. The central government supplements the
efforts of the state governments through various programmes. Agriculture has received
tremendous support in recent years, by way of higher allocation in the Union budget. The
minimum support price (MSP) for agricultural products, has been fixed at 150% of the
cost of production. Farmers are getting support by way of various government schemes.
These include:
• Income support to farmers through PM KISAN
• Pradhan Mantri Fasal Bima Yojana (PMFBY)
• National Bee and Honey Mission (NBHM)
• Pradhan Mantri Krishi Sinchai Yojana (PMKSY)
• Long Term Irrigation Fund (LTIF)
• Micro Irrigation Fund

The central government has taken several steps for increasing investment in agriculture
sector such as greater institutional credit; scientific warehousing infrastructure for

35
increasing the shelf life of agricultural products; an Agri-tech Infrastructure Fund for
farming; focus on developing commercial organic farming etc. The government is also
implementing various schemes for supply of farm inputs, like seeds, fertilizers,
agricultural machinery and equipment, irrigation facilities, and institutional credit at
subsidized rates.

The Agriculture Infrastructure Fund has been set up to support to post harvest
management and community farming assets. The Rashtriya Krishi Vikas Yojana (RKVY),
grants aid to state governments for approved projects. States can also take up agriculture
projects in the Public Private Partnership (PPP) mode. The Mission for Integrated
Development of Horticulture (MIDH), provides financial assistance to eligible projects, in
the form of credit for creation of post-harvest management infrastructure like Pack
Houses, Pre-cooling units, Integrated pack houses, Refrigerator van, Primary/mobile
Processing unit, Cold Storage etc.

The Pradhan Mantri Kisan Samman Nidhi (PM-KISAN) Scheme is being implemented to
provide income support to all landholding farmer families, to enable them to take care of
expenses related to agriculture and allied activities. The government has also launched
the Aatmanirbhar Bharat Abhiyan (ABA) to strengthen Infrastructure, Logistics, Capacity
Building, Governance and Administrative Reforms for agriculture.

Most countries go through such a transition during their phase of development, where the
share of agriculture comes down and the share of industry and services goes up. What is
worrying for India is that, though the contributions of these sectors have changed, more
than 60 per cent of the population continues to depend on agriculture for its livelihood.

GDP versus GNP

The output of a country may be measured as the Gross Domestic Product (GDP) or as the
Gross National Product (GNP). The GDP measures the total output within a country, whether
generated by its nationals or by foreign nationals. The GNP, on the other hand, measures
the total output of its nationals, whether within its borders or overseas.

Consider India’s case. Assume Indian nationals generate 2,500 billion USD of output, within
its borders, while foreign nationals generate 800 billion dollars of output, within its borders.
We would say that India’s GDP is 3,300 billion dollars. Let’s suppose that Indian’s based
abroad generate 1,600 billion dollars of output in that year. If so, India’s GNP for the year
will be 2,500 + 1,600 = 4,100 billion dollars. Hence, a country’s GDP may be greater than
or less than its GNP. If we assume that out of the 1,600 billion of output generated by
Indians abroad, 800 billion was generated in the UK, then that 800 billion would be a part of
UK’s GDP for the year.

36
 Chapter 4
GOVERNMENT AND FISCAL POLICY

4.1 Role of the Government in an Economy

The government plays many important roles in the overall economic system of a country.
Though India is slowly moving towards a market based economic system, there is hardly
any sector in the economy which is not touched by the government. In fact, even in most
developed countries with highly developed markets, the role of the government continues to
be important, as can be seen below.

1. Providing a platform for improving economic efficiency: A well-functioning legal and a

stable political system is essential for markets to operate efficiently. A basic role of
the government is to provide these facilities. For example, a strong defense is
required to protect the country from any external and internal threat. Maintaining an
efficient police force and ensuring a good legal system assures domestic and foreign
economic agents of a safe and predictable economic environment.

Secondly, there are many sectors which fail to attract any major private investment
as they may not be profitable in the short and medium run. Examples of such sectors
include education and healthcare services. It is the role of the government to invest
in these sectors. Similarly, development of roads, ports, telecommunication network
in economically backward areas is also a responsibility of the government. In many
of these areas, investment is usually below the desired level if investment decisions
are left completely to the private sector which is typically driven by profit maximizing
motives.

The government also plays a regulatory role. For certain industries such as drugs
and pharmaceuticals, it is important for governments to spell out technical standards
for companies to follow, to protect the interests of the consumers. Sometimes the
government also sets up regulatory bodies to protect consumer interest. For
example, the Indian government has set up regulatory bodies to supervise the
telecom sector. By facilitating increasing competition in the sector, the telecom
regulator has played a key role in developing the telecom industry tremendously.

2. Ensuring an equitable distribution of income: Distribution of income arising out of

completely market driven economic forces can potentially lead to serious imbalances
in an economy. If income inequality becomes too large in an economy, it creates
both social and economic tension in the system. The government uses its taxation
powers to deal with this situation. For example, by taxing the income of the rich at a
much higher rate than the income of the poor, the government attempts to reduce
income inequality. Further, some of the tax revenue is used to subsidize the poor in
different ways. Taxation thus gives the government a chance to transfer income from
the relatively better-off class to the needy segment of the society.

37
 3. Stabilizing the Economy through economic policies: When the economy slows down
or faces a major economic crisis, most often it is the government which comes to the
rescue. By proper use of monetary and fiscal policies. Governments can stabilize the
economy to a certain extent. This is explained in detail later. For example, during the
recent financial crisis, most governments gave massive stimulus packages to boost
the demand in the economy.

4. Conducting International Economic Policies: As the economy of a country gradually

becomes more integrated with the global economy, the government plays a key role
in facilitating and monitoring this integration, so as to maximize the potential
benefits for the country. This requires a number of coordinated policy responses,
including gradual removal of trade barriers, introducing measures to attract foreign
capital into the country, work with other nations to protect the global environment
and so on.

To sum up, even when countries move toward more open and market-based economy, the
government needs to guide the economy based on a long term strategic vision and decide
on the priorities of the nation. In this respect, India has been no exception. To understand
the way the Government plays a role in the economic development of a country, it is
important to understand government finances. Following is an attempt to explain the
concepts necessary to understand government finances in the Indian context.

4.2 Government Expenditure and Revenue: Understanding

the government accounts
To fulfill the aforementioned roles, it is important for a government to generate or raise
resources and then spend those resources in the most efficient possible manner.
Governments raise resources mostly using taxes and spend that money according to the
priorities of the society. The use of taxes and government expenditure for attaining policy
objectives constitutes the core of fiscal policy.

4.2.1 Government Receipts

Government’s total receipt is divided under two heads such as, Revenue Receipt and Capital
Receipts. Revenue receipts include tax and non-tax revenue received by the government.
On the other hand, capital receipts include recoveries of loans and borrowing and other
liabilities.

Revenue Receipts

Taxes

A tax can be defined as a compulsory contribution imposed by a public authority. The public
authority can be the central or state government or a local public authority like a
municipality.

38
Taxes can be broadly divided into direct taxes and indirect taxes. A direct tax is imposed
and collected directly from an individual (or a legal entity like a company). Examples of
direct taxes are income tax, capital gains tax, gift tax, wealth tax etc. These taxes are borne
directly by the entity it is levied on. For example, personal income tax, which is levied on
the salary earner, has to be borne directly by the salary earner. The salary earners cannot
pass on their tax liability to others.

Indirect taxes include customs (a tax on imports) and excise (a tax on production). Such a
tax is called ‘Indirect tax’ because; it is a tax which is collected by an intermediary. The
person on whom the tax is levied passes on the tax burden to some other persons. He acts
as an intermediary between the government and the ultimate taxpayer. Thus, while a direct
tax cannot be shifted to others, an indirect tax can be passed over by the taxpayer to
someone else.

Here it is pertinent to mention that the year 2017 will forever be etched in Indian history as
the year that saw the implementation of the biggest and most important economic reform
since Independence - the Goods and Services Tax (GST). The goods and services tax (GST),
introduced in India on 1 July 2017, and replaced a host of indirect taxes being levied by the
central and state governments, which has changed the taxation landscape. The underlying
theme was to have a ‘one nation one tax’ which would improve ease of doing business for
taxpayers, bring in transparency, ensure timely compliance and ultimately reduce the tax
burden for the common man. The single GST subsumed several taxes and levies, which
included central excise duty, services tax, additional customs duty, surcharges, state-level
value added tax and Octroi. For inter- state transactions and imported goods or services, an
Integrated GST (IGST) are levied by the Central Government.

Figure 4.1 shows the composition of India’s tax revenue in the year 2019-20, while the
Figure 4.2 shows the contribution of direct and indirect taxes of the Central Government
from 1980/81. Please note that although the government finances in India include the
finances of the Central, State and Municipal Governments, we have focused here only on
the Central Government finances.

Figure 4.1. Percentage Breakup of Government of India’s Tax Revenue

GST - 27%
Corporate Tax -
31% Excise - 12%
Customs - 6%
Other Taxes - 24%

39
 Figure 4.2. Direct and Indirect Tax Revenue of the Central Government
(Rs Crores)
DIRECT AND INDIRECT TAX REVENUES OF CENTRAL AND STATE GOVERNMENTS
(₹ Crore)
Year Centre (gross) States Centre & States combined
Direct Indirect Total Direct Indirect Total Direct Indirect Total
1 2 3 4 5 6 7 8 9 10
2015-16 741945 708013 1449958 88176 758967 847143 830121 1466981 2297101
2016-17 849713 866109 1715822 109914 796409 906325 959627 1662518 2622145
2017-18 1002037 913456 1915494 119152 943488 1062640 1121189 1856945 2978134
2018-19 1136615 942050 2078665 109468 1090814 1200282 1246083 2032864 3278947
2019-20 1049549 958030 2007579 166654 1057348 1224002 1216203 2015379 3231582
2020-21 905000 989460 1894460 166552 1114582 1281134 1071552 2104042 3175594
2021-22 1108000 1102959 2210959 203449 1415481 1618930 1311449 2518440 3829889
Notes : 1. Data for 2020-21 are Revised Estimates and data for 2021-22 are Budget Estimates.
2. States direct taxes, indirect taxes and total taxes exclude States' share in Central taxes as reported in Central Government Budget
documents.
Also see Notes on Tables.
Source : Budget documents of the Government of India and the State Governments.
The share of indirect taxes, in total tax revenues garnered, has been steadily increasing,
ever since the Goods and Services Tax (GST), was implemented in 2017. More goods and
services have been brought into the tax net, and compliance, both voluntary and
involuntary has improved. The lion’s share of direct taxes has been collected by the central
government, since in India, unlike in the US, states are not empowered to collect income
tax. Thus, direct and indirect taxes are fairly balanced from the centre’s perspective, while
in the case of the states, indirect tax collections are much higher.

Source: PIB and Handbook of Statistics on Indian Economy

40
Non-tax Revenue

Besides the revenue collection from taxes, government also collects non-tax revenue. The
non-tax revenue of the Union Government includes administrative receipts, net contribution
of public sector undertakings including railways, posts, currency and mint and other
revenues which include revenue from auction of telecom spectrum. In 2018- 19, the total
non-tax revenue collection was about 27.7% percent of the total tax revenue.

Capital Receipts

Capital receipts do not occur during the normal course of business. These arise when the
government sells some of its assets or when it borrows from external or internal sources.
Capital receipts can be non-debt receipts or debt receipts. Recoveries of loans and advances
and receipts due to sale of government assets and PSUs are classified as non- debt capital
receipts. On the other hand, government borrowing from different sources makes up most
of the debt-creating capital receipts.

Non-debt Capital receipts mainly consist of recovery of loans and advances, and
disinvestment receipts. Over the last few years, the contributions of Non-debt Capital
receipts have improved in the total pool of Non-debt receipts. They have been pegged at Rs.
1.20 lakh crore, 0.6 per cent of GDP, in 2019-20 (Budget Estimates) owing to an envisaged
growth of 6.3 per cent over 2018-19 (Provisional). The receipts from recovery of loans and
advances have been declining over the years and are pegged at 12.4 per cent of Non-debt
Capital receipts in 2019-20 (Budget Estimates). The major component of Non-debt Capital
receipts is disinvestment receipts that accrue to the government on sale of public sector
enterprises owned by the government (including sale of strategic assets). Government
aimed at mobilising Rs. 1.05 lakh crore on account of disinvestment proceeds as per 2019-
20 (Budget Estimates).

It is important to be conceptually clear that receipts of the Government include tax and
non-tax revenue, non-debt creating capital receipts and debt creating capital receipts. The
government needs to raise debt creating capital receipts (for example, by taking market
loans) because it cannot fund all of its expenditures from the revenue (tax and non-tax) and
non-debt capital receipts. The next section deals with government expenditures.

4.2.2 Government Expenditure

All revenue received and loans raised by the Government are credited to the Consolidated
Fund of India and all expenditure of the Government are incurred from this fund. Money can
be spent through this fund only after getting approval from the Parliament. The
Consolidated Fund has further been divided into ‘Revenue’ and ‘Capital’ divisions.

41
4.2.2.1 Revenue Expenditures

Revenue expenditure is involves routine government expenditure, which does not create
any asset for the government. In other words, revenue expenditure is incurred by the
government for the normal running of government departments and various services.
Examples of revenue expenditure are salaries and pensions of government employees,
subsidy payments for food fertilizers etc, goods and services consumed within the
accounting period, interest charges on debt incurred by government etc.

4.2.2.2 Capital Expenditures

Capital expenditure can be defined as an expenditure which leads to addition of material

assets for the economy. One feature of capital expenditure is that the benefits from capital
expenditure are reaped over a period of time. Capital expenditure does not include
operating expenditure. Examples of capital expenditure are building infrastructure projects
like roads and ports, buying land, making buildings, purchase of machinery and equipment
etc.

To sum up, while revenue expenditure is for the normal running of government departments
and various services; capital expenditure results in creation of assets in the economy.

4.2.2.3 Plan and Non-Plan Expenditures

Since the country follows a plan based model of an economy, the total expenditure of the
government is divided under plan and non-plan expenditures. The plan expenditure is
directly related to expenditure on schemes and programmes budgeted in the government’s
plans. The non-plan expenditure is the expenditure incurred on establishment and
maintenance activities. Non-plan capital expenditure mainly includes defence, loans to
public enterprises, loans to States, Union Territories and foreign governments. On the other
hand, non-plan revenue expenditure includes expenses on interest payments, subsidies
(mainly on food and fertilizers), wage and salary payments to government employees,
grants to governments of States and Union Territories, pensions, police services, economic
services in various sectors, other general services such as tax collection, social services, and
grants to foreign governments.

In India, revenue expenditure tends to be much higher than capital expenditures under both
plan and non-plan heads (figure 4.4). Low capital expenditure can be a problem for a
country like India because it suffers from weak infrastructure such as road, electricity, water
etc. Low investment in these areas can impede the pace of economic growth.

42
Figure 4.4. Revenue and Capital Expenditures

5.6
5.0
4.7
4.8 4.4
4.7
3.9

3.8 3.2

2.1

1.7

2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21

RE BE

Revenue expenditure per unit of capital expenditure has declined since 2019-19. The
revised estimate for 2020-21 was 2.1 and the budgeted estimate for 2021-22 was 1.7. The
estimated revenue expenditure was 68,804 crore rupees, while the estimated capital
expenditure was 39,817 crores. The ratio is 68804 ÷ 39817 = 1.7280. The bulk of revenue
expenditure was on account of salaries, which amounted to 30,131 crores, and pension
which amounted to 8589 crores. Of the capital expenditure, 15336 crores was on account of
centrally sponsored schemes (CSS). These are schemes which are funded by the Union
Government but are implemented by the state governments.

Plan Versus Non-Plan expenditure a Clarification

In India the practice was to classify the expenditure incurred by a government as plan and
non-plan. It should be remembered that India used to follow a system of preparing 5-year
plans. Planned expenditure was a term used for expenses incurred in relation to plan related
activities. Non plan expenditure on the other hand, refers to expenditure incurred in
connection with the routine activities of the government. After the report submitted by the
C. Rangarajan Committee, it was decided to replace the terms plan and non-plan, with the
term’s capital and revenue expenditure.

The Planning Commission and NITI Aayog

India was a planned or command economy until 1991. The Planning Commission formulated
five-year plans for the country. It had the authority to prescribe policies to the states and
had the power to distribute funds to state governments, and certain central government
ministries. This system was based on what in management parlance is called the top-down
approach. That is, polices were framed centrally, and then executed by the states and other
government entities.

43
On August 17, 2014, the Planning Commission was abolished. It was replaced by the NITI
Ayog, where NITI stands for National Institution for Transforming India. Unlike the Planning
Commission the NITI Ayog is a think tank that works as an advisory body. It cannot dictate
policies to state governments, and nor does it have the power to allocate funds to the
states. The power to allocate funds in today’s system, is vested with the Ministry of Finance.
Like corporations, the NITI Ayog has a Chief Executive Officer (CEO), who is appointed by
the Prime Minister. The NITI Ayog follows a bottom-up approach. It takes extensive inputs
from the states and other stakeholders, before drawing up policy frameworks.

4.3 Bringing together the Revenue and the Expenditure

side
As the revenue and expenditure of the government depends on a number of variables, there
is no guarantee that these will exactly match each other. For most years, Indian
government’s expenditure has exceeded its revenue. Figure 4.5 shows the gap between
total plan and non-plan expenditure by the government in the last few years and the total
non-debt creating revenue of the government. The figure shows that there is a significant
gap between these two. The government finances this deficit either by borrowing from the
open market through sale of government bonds or by printing money. However, each of
these measures has their own limitations which will be discussed in more detail in Chapter-
5. But before we discuss that, it will be important to understand the different deficit
indicators that are associated with the budget.

Table. 4.5. Income and Expenditure of government of India (Rs crores)

(Amount in Rs. Crores)

2019-20
2017-18 2018-19
(Budgeted)
Revenue Expenditure 18,78,833 21,40,612 24,47,780
Capital Expenditure 2,63,140 3,16,623 3,38,569
Total Expenditure 21,41,973 24,57,235 27,86,349
Revenue Receipts 14,35,233 17,29,682 19,62,761
Capital Receipts 1,15,678 93,155 1,19,828
Total Receipts without
15,50,911 18,22,837 20,82,589
Borrowings
Revenue Deficit 4,43,600 4,10,930 4,85,019
Source: Union Budget, 2019-20

44
 2019-20
Items 2020-21 2020-21 2021-22
(Pre-
(BE) RE (BE)
Actuals)
A. Revenue Receipts 52618 91100 75903 97141

B. Revenue Expenditure 52964 62664 62486 68804

Revenue Surplus (A-B) -346 28436 13417 28337

C. Capital Receipts 12411 10328 16438 11480

D. Capital Expenditure 12065 38764 29855 39817

Capital A/C Deficit
346 -28436 -13417 -28337
(C-D)

E. Total Expenditure 65029 101428 92341 108621

F. Total Receipts 65029 101428 92341 108621

G. Fiscal Deficit 10679 10240 15710 10647

H. Unfunded/Additional 0 0 0 0
resources required

The revenue account consists of expenditures incurred in connection with routine items such
as salaries, wages, maintenance and repairs. Revenue receipts are all those incomes which
do not incur repayment liability. Capital account expenditures are those expenditures
corresponding to investment outlay and disbursements, including repayment of public debt.

The revised estimate of revenue receipts for 2020-21 was lower than the budget estimate
on account of the pandemic. However, the revised revenue expenditure is virtually the
same as the budgeted expenditure, indicating that expenditure was not significantly
impacted. The capital receipts in 2020-21 was higher than budgeted, and the capital
expenditure was lower. The fiscal deficit for 2020-21 was higher than budgeted. However, in
the following year, 2021-22, the budgeted fiscal deficit was back to pre-pandemic levels.

45
4.3.1 The Deficit Indicators

Government uses several deficit indicators to ascertain the state of government finances
and each of these has its own implication and importance in government finances.

Revenue Deficit: Revenue Deficit refers to the excess of revenue expenditure over revenue
receipts.

In other words, Revenue Deficit (RD) = Revenue Receipts (RR) – Revenue Expenditure (RE)

Gross Fiscal Deficit is the excess of total expenditure over the sum total of revenue receipts,
recovery of loans. This indicates the total borrowing requirements of government from all
sources.

In other words, Fiscal Deficit (FD) = {Total Expenditure – (Revenue receipts + recovery of
loans)}

Net fiscal deficit is the gross fiscal deficit less net lending of the Central Government.

Primary deficit is measured by deducting interest payments from gross fiscal deficit.

To understand the calculation, Table 4A.1 in the appendix shows the actual calculation of
different deficits in the union budget 2010-11.

4.4 Financing of the deficit by the government

India’s fiscal deficit was projected 3.5% of GDP for the current year 2020-21. However, it is
estimated to cross 7% as revenue collections suffered from lockdown and restrictions due to
covid-19 pandemic. Figure 3.6 shows how different deficit indicators have moved during the
last few years.

Source: Reserve Bank of India

It is noteworthy that historically both revenue and fiscal deficit have been at elevated levels
in India. Figure 4.7 below shows fiscal deficit performance of India. While both high revenue
and fiscal deficits are detrimental to the economy, higher revenue deficit is a matter of

46
greater concern. because revenue deficit essentially implies that the government is living
beyond its means and is borrowing money to fund current consumption. This reduces the
country’s capacity to incur capital expenditure, which is basically used to build productive
assets in the country,. On the other hand, fiscal deficit involves borrowing money to finance
capital expenditure. This might not be a bad thing as long as long-run returns from the
investment projects (or assets that are being built) generate resources to offset the initial
borrowing. Therefore, it is important to understand what type of deficit a country is running.

Figure 4.7: Fiscal Deficit of India as % of GDP:

For 2019-20, it is budget estimate.

Source: Reserve Bank of India

High deficits incurred by the government are detrimental for the economy, because they
lead to not only higher inflation, but also higher interest rates. Financing huge deficits is a
difficult task for any government. The government can finance the fiscal deficit by borrowing
from the central bank or it can borrow from the domestic market by selling government
bonds in the open market. If the government borrows money from the central bank, it is
essentially financing deficit by printing money. If too much money gets into the system
without any potential increase in output, then this increase in money supply can become
inflationary.

Secondly, it is also argued that if an economy is operating close to full employment level,
that is if there is no excess production capacity among the major sectors of the economy,
then an increase in fiscal deficit may lead to inflationary pressures. This is so, because high
fiscal deficit means high aggregate domestic demand and since the production cannot adjust
to match the higher demand (because of lack of extra production capacity), then it results in
higher inflation. For example, if the government plans to build a stadium in a country where

47
the cement and steel industry is operating close to their optimum capacity, a sudden
increase in demand from steel and cement might lead to a rise in prices of cement and
steel. Consequently, this may push up the rate of inflation in the country.

Finally, if the government raises money from the domestic market, which is typically done
by selling government bonds to the banks, the supply of bonds increases in the market and
as a result of which rate of interest goes up. Increase in the rate of interest increases the
cost of capital for the private sector and dampens the flow of private investment which is
known as ‘crowding out’ of private investment. However, in developing countries like India,
if fiscal deficit is increasing because of high capital expenditure on building domestic
infrastructure, then it can actually attract more private capital in spite of the increase in rate
of interest.

In recent years, financing of deficit in India has been done by market borrowings to a large
extent. It has often been argued that high fiscal and revenue deficits are affecting capital
formation in the Indian economy by reducing private investment through an increase in
interest rate (’crowding out’) and at the same time reduced government expenditure as a
significant portion of its resources are channelized to fund consumption expenditure or
revenue deficit. Such a trend can pose as a major impediment to the sustainability of India’s
high economic growth rate.

4.5 Fiscal Deficit and Sustainability of Internal Debt

Financing of persistent fiscal deficit creates another set of problems for policymakers. If the
government uses domestic debt to finance the fiscal deficit, the debt obligation of the
government increases. Also, debt service requirements increase. This may lead to a
situation where a major part of the revenue earned by the government is spent on debt
service requirements. This will limit the ability of the government to develop capital stock
and physical infrastructure for the economy which is crucial to enhance and sustain a high
level of economic growth. How much domestic debt a government can handle, is a difficult
question to answer as the debt sustainability depends on a number of economic parameters.

As high fiscal deficit can lead to a number of problems including debt sustainability, inflation
(under certain circumstances) and crowding-out, the government of India has been trying
to maintain fiscal prudence by containing fiscal deficit level. Toward this end, in 2003, the
government enacted the Fiscal Reforms and Budget Management Act (FRBMA) for medium-
term management of the fiscal deficit. The FRBMA imposes some constraints on the
expenditure pattern of the government. It requires that the government to reduce the
revenue deficit gradually, so that it eventually disappears and also to reduce the fiscal
deficit gradually to a level below 3 percent of GDP by March 31, 2021 and central
government debt to 40 per cent of GDP by 2024-25. However, government has failed to
achieve these targets, and further due to covid -19 pandemic in the year 2020, the fiscal
consolidation goal of achieving 3 per cent in 2020-21 was shifted to 2022-23.

48
4.6 Fiscal policies and their impact on the financial
markets
The most direct impact of fiscal policies on the financial market is through taxation. In our
discussion on government revenue, we have seen that tax revenue plays a very important
role in government finances. The government can alter tax rates in a bid to influence tax
revenue generation. The government can try to change the tax rates, it can impose new
taxes or abolish existing ones or can use measures to broaden the tax base. In each of
these cases, it will affect the income and consumption pattern of a large number of people.
Depending upon the tax measure, it will have a positive or a negative impact on the
financial market. For example, if personal income tax rate is lowered then it is likely to
increase the disposable income of people and can have a positive impact on the financial
markets through an enhanced level of financial savings. On the other hand, introduction of a
long-term capital gains tax10 may have the adverse impact on the market.

If any Capital Asset is sold or transferred, the profits arising out of such sale are
taxable as capital gains in the year in which the transfer takes place.

Table 4A.1. Calculation of Deficits as done in the budget documents

49
Expenses which bring a change to the government’s assets or liabilities (such as
construction of roads or recovery of loans) are capital expenses, and all other expenses are
revenue expenses, such as payment of salaries or interest payments. In 2022-23, capital
expenditure is expected to increase by 24.5% over the revised estimates of 2021-22, and
revenue expenditure is expected to increase by 0.9% over the revised estimates of 2021-
22. Disinvestment is the proceeds realized by the government for selling its stakes in Public
Sector Undertakings (PSUs). In 2021-22, the government is estimated to meet 45% of its
disinvestment target. The disinvestment target for 2022-23 is Rs 65,000 crore.

Receipts may be analysed as follows. The total indirect tax collections are estimated to be
Rs 13,30,000 crore in 2022-23 of which Rs 7,80,000 crore will be raised by way of GST.
The collection from corporate income tax is expected to increase by 13% in 2022-23 to Rs
7,20,000 crore. Non-tax revenue consists of interest receipts on loans given by the centre,
dividends and profits, external grants, and receipts from general, economic, and social
services. In 2022-23, non-tax revenue is expected to decrease by 14% over the revised
estimates of 2021-22. This is due to a decline of 14% in interest receipts and a decline of
23% in dividend and profits. The disinvestment target for 2022-23 is Rs 65,000 crore, which
is 17% lower than the revised estimate of 2021-22.
The total expenditure in 2022-23 is expected to be Rs 39,44,909 crore, which is an increase
of 4.6% over than the revised estimate of 2021-22. Out of this, Rs 11,81,084 crore is
proposed to be spent on central sector schemes, and Rs 4,42,781 crore is proposed to be
spent on centrally sponsored schemes. The government has estimated to spend Rs
2,07,132 crore on pension in 2022-23, which is 4.1% higher than the revised estimate of
2021-22. In addition, expenditure on interest payment in 2022-23 is estimated to be Rs
9,40,651 crore, which is 23.8% of the government’s expenditure.

Thirteen ministries with the highest allocations account for 53% of the estimated total
expenditure in 2022-23. Of these, the Ministry of Defence has the highest allocation in
2022-23, at Rs 5,25,166 crore, which accounts for 13.3% of the total budgeted expenditure
of the central government. Other Ministries with high allocation include Consumer Affairs,
Food and Public Distribution, Road Transport and Highways, and Home Affairs.

Subsidies
In 2022-23, the total expenditure on subsidies is estimated to be Rs 3,55,639 crore, a
decrease of 27.1% from the revised estimate of 2021-22. Allocation to food subsidy is
estimated at Rs 2,06,831 crore in 2022-23, which represents a 27.8% decrease over the
revised estimate of 2021-22. A higher level of food subsidy was budgeted in 2020-21 and
2021-22 mainly on account of: the Pradhan Mantri Garib Kalyan Ann Yojana, which provides
for free foodgrains to the poor to mitigate the impact of COVID-19, and for clearing the
loans of the Food Corporation of India. Expenditure on fertiliser subsidy is estimated at Rs
1,05,222 crore in 2022-23. This is a decrease of Rs 34,900 crore from the revised estimate
of 2021-22. Fertiliser subsidy for 2021-22 was increased substantially, in response to a
sharp increase in international prices of raw materials used in the manufacturing of
fertilisers. Petroleum subsidy consists of subsidy for LPG and Kerosene. No kerosene
subsidy has been budgeted for either 2021-22 or 2022-23. Expenditure on LPG subsidy is
estimated to decrease by 10.8% to Rs 5,813 crore in 2022-23. Expenditure on other
subsidies includes interest subsidies for various government schemes, subsidies for the
price support scheme for agricultural produce, and assistance to state agencies for
procurement, among others. In 2022-23, the expenditure on these other subsidies is
estimated to decrease by 31% over the revised estimate of 2021-22.

50
Scheme-wise Allocation
The Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) has the
highest allocation in 2022-23 at Rs 73,000 crore. This is a decrease of 25.5% over the
revised estimate of 2021-22. In 2021-22, the expenditure had increased by 34.2%
compared to the budgeted figure, to mitigate the impact of second wave of COVID-19. The
PM-KISAN scheme (income support to farmers) has the second highest allocation in 2022-
23 at Rs 68,000 crore. Key schemes with a comparatively higher increase in allocation in
2022-23 include the Pradhan Mantri Gram Sadak Yojana (35.7%), the Jal Jeevan Mission
(33.3%), and the National Education Mission (28.4%).

The fiscal deficit is an indicator of borrowings by the government for financing its
expenditure. The estimated fiscal deficit for 2022-23 is 6.4% of GDP. The revenue deficit is
the excess of revenue expenditure over revenue receipts. Such a deficit implies the
government’s need to borrow funds to meet expenses which may not provide future
returns. The estimated revenue deficit for 2022-23 is 3.8% of GDP. In 2021-22, the
government had set a budget estimate of 6.8% of GDP for fiscal deficit, and 5.1% of GDP
for revenue deficit. As per the revised estimates, the fiscal deficit is expected to marginally
exceed the budget estimate to 6.9% while revenue deficit is estimated to be lower at 4.7%.
The primary deficit is the difference between the fiscal deficit and interest payments. It is
estimated to be 2.8% of GDP in 2022-23.

51
 Chapter 5
MONEY AND MONETARY POLICY

This chapter will talk about the role of money in an economy. It will also introduce the
concept of demand for and supply of money. Understanding the functioning of the monetary
system is important because money market constitutes an important segment of the
financial market.

5.1 What is the role of Money?

Money plays a number of extremely important roles in a modern economy. The most
obvious role of money is as a medium of exchange. During the early days of human
civilization, it was realized that the barter system suffers from the problem of “double
coincidence of wants”. This means that a barter system will only work only if two persons
can be found whose disposable possessions mutually suit each other's wants. In a country
or in an economy, there may be many people wanting a particular good and there may be
many people who possess those things wanted, but to allow a barter or a direct exchange of
goods to happen, there has to be a double coincidence of wants. For example, to have his
food, a hungry tailor will have to find a farmer who needs a shirt. This is unlikely to happen.

The second problem with a pure barter system is that it must have a rate of exchange,
where each commodity is quoted in terms of every other commodity. This complication can
be avoided if any one commodity be chosen, and its ratio of exchange with each other
commodity is known. Such a commodity can be used as a unit of account or a numeracies.

To overcome these problems of barter, use of a commonly accepted medium of exchange

started. This medium also acted as a measure of value. Different civilizations used different
commodities as the medium of exchange. In some African countries, the medium of
exchange was decorative metallic objects called Manillas. The Fijians used whales’ teeth for
the same purpose. In some parts of India, cowry or sea shells were used as the medium of
exchange and measure of value. Such usages of commodities as the medium of exchange
and measure of value correspond to what we presently call ‘Money’. By the 19th century,
commodity money narrowed down to usages of precious metals like silver and gold11. This
however limits the amount of money in the economy as it is constrained by the availability
of precious metals which are exhaustible resources. Since then, we have moved to an era of
paper money.
The use of paper money has become widespread because it is a convenient medium of
exchange, is easy to carry and store and is also a measure of value for the large number
of goods and services produced in a modern economy.
The value of money stems from the fact that private individuals cannot legally create

52
money. Only designated authorities are allowed to supply money. This limitation in the
supply of money ensures that money retains its value. This also means that money can
also be viewed as a store of wealth.
Therefore, to summarize, money has three broad roles in an economy:

a) It is a medium of exchange.

b) It is a measure of value.

c) It can be used as a store of wealth.

It is worth pointing out here that modern currencies are not backed by any equivalent
gold or silver reserves. Based on a host of macroeconomic factors, the government or the
central bank decides the amount of money to be supplied to an economy.

5.2 Components of Money in India

In general terms, it can be said that money consists of coins, paper money and withdrawal
bank deposits. Bank deposits are part of money supply because one can write cheques on
these accounts and the cheque possesses the essential qualities of money. Moreover,
increasingly credit cards and electronic cash are becoming an important component of the
payment system. Continuing financial innovations are causing widening of the definition of
money. The Reserve Bank of India (RBI) publishes 4 measures of monetary aggregates in
India. These measures define money based on progressive liquidity or spend ability 12.

a. M1 = currency held by the public (currency notes and coins) + Demand deposits
with the banking system (on current and saving bank accounts) + Other demand deposits
with RBI.

b. M2 = M1 + saving deposits with Post office savings banks.

c. M3 = M1 + time deposits with the banking system.

d. M4 = M3 + total deposits with the post office savings organization (excluding

National Savings Certificates).

These definitions are based on RBI’s Third Working Group on Money Supply. The formal
report of this group is published as “Report of the Working Group on Money Supply:
Analytics and Methodology of Compilation”, Reserve Bank of India, 1998, Mumbai.

M1 represents the most liquid form of money among the four money stock measures
adopted by RBI. As we proceed from M1 to M4, the liquidity gets reduced. In other words,
M4 possesses the lowest liquidity among all these measures. The importance of all these
four money stock measures varies from the point of view of monetary policy.

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5.3 Demands for Money

There are three motives underlying the demand for money i.e. transaction demand for
money, speculative demand for money and precautionary demand for money. These three
motives are explained below.

First, the transaction motive of demand for money (also called transaction demand for
money) means that money is demanded to carry out certain transactions. It is likely to be
positively related with income. This is simply because higher the income of an economic
agent, higher is the expected volume of economic transaction. To facilitate higher volume of
economic transactions, more money is required. However, the transaction demand for
money is influenced by the prevailing rates of interest and the expected rate of return on
alternative assets like shares. This is because money held in the form of idle cash provides
liquidity and facilitates economic transactions but it does not give a positive return.
Therefore, the economic agents will be facing a tradeoff between the utility they derive from
the liquidity of the available cash and the expected return they are forgoing on alternative
assets. So, they will try to economize on their money holding, when the expected returns on
alternative assets go up.

The second motive to demand money is called speculative motive. The demand for money
arising out of speculative motive is called speculative demand for money. The speculative
demand for money depends on people’s expectation of the future interest rate movements.
John Maynard Keynes, in laying out speculative reasons for holding money, stressed the
choice between money and bonds. If agents expect the future nominal interest rate (the
return on bonds) to be lower than the current rate they will then reduce their holdings of
money and increase their holdings of bonds. If the future interest rate does fall, then the
price of bonds will increase and the agents will have realized a capital gain on the bonds
they purchased. This means that the demand for money in any period will depend on both
the current nominal interest rate and the expected future interest rate. The speculative
demand for money is low when people expect interest rates to fall in future and vice versa.

Thirdly, the precautionary demand for money arises because of uncertainty regarding future
income. For example, one does not know when one would fall sick or have accident or need
money for some unforeseen requirement. The money demanded to cover these expenses is
called precautionary demand.

5.4 Supply of Money

The world has transited from commodity money to paper money. A ‘commodity money’ like
gold, silver or copper has some intrinsic value. That means that even if the commodity is
not used as money, it will have some value of its own. However, the same cannot be told
about paper currencies. A paper currency note does not have any intrinsic value or value of
its own. Such type of money is called “fiat money”. A ‘fiat’ is an order and fiat money is
established as money by government order. When an economy relies on fiat money, some
agency is required to regulate and support fiat money. In most countries, a ‘Central Bank’
has been created to support fiat money, oversee the banking system and regulate the

54
quantity of money supply in the economy. In India, the Reserve bank of India (RBI) is the
central bank. Other examples of central banks are Federal Reserve or Fed in the USA, the
Bank of England in UK and the European Central Bank in the Euro area.

5.5 Different Roles of RBI in India

The Reserve Bank, established through the Reserve Bank of India Act, 1934 commenced its
operations in 1935. It draws its powers and responsibilities through other legislations also
such as the Banking Regulation Act, 1949. The important roles RBI undertakes in the Indian
economy are as follows:

1. Issuer of Currency: it issues coins and currency notes in adequate quantity,

2. Supervisor of the Financial System: it prescribes regulations for sound functioning of

banks and financial institutions, including non-banking finance companies. It
promotes best practices in risk management and corporate governance to protect
depositors' interest and to enhance public confidence in the financial system of the
country.

3. Banker to the Government: It maintains accounts of central and state governments.

It performs merchant banking function for the central and the state governments.

4. Bankers' Bank: It ensures adequate liquidity in the financial system and in individual
banks, on a daily basis. When a financially troubled bank look for funds, the RBI also
performs the ‘lender of the last resort’ function for such banks.

5. It conducts monetary policy in India with a view of price and exchange rate
management.

5.5.1 How RBI regulates Money Supply in the Economy

Like other central banks of the world, one of the most important responsibilities of RBI is to
control the amount of money that is available to the Indian economy. This is called money
supply management. The decisions regarding the supply of money in the economy come
under the purview of ‘Monetary Policy’. Monetary Policy is the process by which the central
bank regulates the supply of money in the economy and influences the cost of liquidity in
the financial system. The RBI announces changes in the monetary policy periodically
depending on its assessment of the macroeconomic and monetary developments in the
economy. The next few sections will discuss how money supply is regulated in the Indian
economy.

In the era of gold standard, money supply by each central bank of the world was
constrained by the amount of gold it possessed. As we are currently in a fiat money system,
the supply of money is no longer constrained by the availability of gold. In other words, a
central bank can print as much money as it wants to put in the system. What determines
the volume of banknotes in a certain period? According to the RBI,

“The Reserve Bank decides the volume and value of banknotes to be printed each year. The

55
quantum of banknotes that needs to be printed, broadly depends on the requirement for
meeting the demand for banknotes due to inflation, GDP growth, replacement of soiled
banknotes and reserve stock requirements”.

The most usual way for a central bank to change money supply is through open market
operations (OMOs). OMOs are sales and purchases of government securities or bonds. If a
central bank buys bonds from the public in the nation’s bond markets, then it is increasing
money supply in the economy. Conversely, when the central bank is selling bonds, it is
withdrawing money from the system and reducing the money supply.

5.6 What are the roles of Commercial Banks in Money

Supply?
Commercial banks play a very important supplementary role in the creation of money in the
economy. Banking systems in India, like most other countries, work on the principle of
fractional reserve system. In this system, banks are required to keep a certain fraction of its
total deposits in reserves with the central bank (this is called Cash Reserve Requirement or
CRR) and lend out the rest of the money to their borrowers. The reserve requirements play
a very important role in ‘creating’ money in a modern economy.

To see how a fractional reserve system can create money, let us first consider the case
where all deposits are held as reserves with the central bank: banks accept deposits, place
the money as reserve with the central bank, and leave the money there until the depositor
makes a withdrawal or writes a check against the balance. Therefore, if an economic agent
is depositing x amount of money in a bank, the amount of total currency available with the
public goes down by x and amount of demand deposits goes up by x. So money supply will
not change. To summarize one can say that in a 100% CRR system, all deposits are held in
reserve and thus the commercial banking system does not affect the supply of money.

Now, suppose the reserve requirement tells the banks that they need to keep only 10
percent of their deposits as reserves. Assume that the RBI has bought a Rs 1,000
government bond from a person Mr. A.

Mr. A now deposits that Rs. 1,000 in his account at Bank 1. Bank 1, will not want to keep
the entire Rs 1,000 as reserves as it will hardly earn any interests on the reserves. So Bank
1, keeps Rs. 100 as reserves and lends out Rs 900 to Mr. B. Therefore, the total money
supply is now Rs.1,000 (Mr. A’s deposit with Bank 1)+Rs. 900 (Cash with Mr. B) = Rs 1,900

Mr. B buys a book with that amount and the book seller again deposits Rs 900 in his bank
account in Bank 2. Bank 2 will again keep Rs 90 as reserves and will lend out the rest to Mr
C. So the total money supply now becomes Rs 1,900 + Rs 900 (bookseller’s deposit with
Bank 2) + Rs 810 (cash with Mr C) = Rs 2,710.
(http://www.rbi.org.in/scripts/FAQView.aspx?Id=39)

56
Table 5.1. Creation of Money through Fractional Reserve System
Total Money Supply=
Currency + Deposits with the
banks

Stage 1. RBI buys Releases Rs 1,000 1000

bond
Bank 1 Keeps Rs 100 as reserve 1000 + 900 = 1900
Lends out Rs 900
Bank 2 Keeps 10% of 900 as 1900+810= 2710
reserve Lends out Rs 810

Therefore, between the Bank 1 and Bank 2, it has been possible to increase the original
supply of Rs 1,000 from RBI to Rs 2710 (check Table 5.1 for a summarized version). This
process can go on. If rr is the reserve requirement, then in mathematical terms it can be
shown that the total money supply will be:
Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …] Rs 1000

= (1/rr) Rs 1000
= (1/.1) Rs 1000 (since rr is 10 percent or 0.1)

= Rs 10,000
This shows how commercial banks under the fractional reserve system can create money and
liquidity in the system. The ratio (1/rr) is called the money multiplier. In other words, Money
multiplier is a measure of the extent to which the creation of money in the banking system
causes the growth in the money supply to exceed growth in the monetary base.

Note that there might be numerous leakages in real life so that the actual value of money
multiplier might be less than what the reserve requirement figure may indicate. For example,
economic agents may not deposit the entire amount of money they receive to a commercial
bank. Similarly, commercial banks might also have excess reserves with the central bank
(that is, reserves which are above the reserve requirement). It should also be apparent from
the above exercise that the central bank can alter the money supply in the economy by
changing the reserve requirements. For example, using the above example, total amount of
money created through the banking system will be Rs 10,000 if the reserve requirement is 10
percent. However, total money created would have only been Rs 5,000 if the reserve
requirement is made 20 percent.

In India, the reserve requirement is called the Cash Reserve Ratio (CRR). CRR refers to the
liquid cash that banks have to maintain with the Reserve Bank of India (RBI) as a certain
percentage of their net demand and time liabilities. The homepage of RBI website provides

57
latest information about the CRR rates. At present CRR is 3%. Figure 5.1 shows how the CRR
has changed over the years, while Figure 5.2 shows how the value of the money multiplier
has changed during the last few years.

Figure 5.1. The CRR and SLR over the years (in percentage)

Source: Reserve Bank of India

Figure 5.2. Value of the Money Multiplier in India

Source: Reserve Bank of India

5.7 Other Instruments of Money Supply

Besides CRR, RBI also uses some ‘policy’ interest rates as instruments for controlling money
supply such as bank rate, repo rate, reverse repo rate etc. Bank rate is the rate at which

58
the central bank offers refinance to the commercial banks. An increase in the ‘bank rate’
leads to an increase in the cost of borrowing by the commercial banks from the central bank
and thereby discourages bank borrowing from central bank. Further, as banks’ cost of
borrowing goes up, they are forced to raise their lending rates. This leads to a reduction in
the growth of money supply. The opposite occurs when the Bank rate is reduced. However,
RBI has not depended much on the ‘Bank Rate’ to influence the growth in money supply
lately and it is increasingly depending upon open market operations (OMOs) for sterilizing
capital flows and managing liquidity in the system. In the last few years, RBI has developed
the Liquidity Adjustment Facility (LAF) as an effective instrument for its OMOs.

The LAF is used as a system of sterilization and liquidity management by RBI. Two rates of
interest viz. repo and reverse repo rate constitutes the LAF system. Repo (Repurchase
Agreement) instruments enable commercial banks to make short-term borrowing from the
central bank through the selling of debt instruments. Thus, the repo rate is the rate at
which the commercial banks borrow money from RBI against a collateral of government
securities. In other words, repo denotes injection of liquidity by the central bank into the
economy (through the commercial banks) against eligible collateral. On the other hand, the
reverse repo rate represents the opposite. It is the rate at which commercial banks park
their surplus liquidity with the central bank. In other words, reverse repo denotes the rate
at which RBI absorbs liquidity from the system.

Between repo and reverse repo, reverse repo is the lower rate. The rationale for this can be
explained from two angles. First, under the reverse repo transactions, commercial banks
park their funds with the RBI. Therefore, this transaction has the lowest possible risk. As
rate of interest and risk are positively related, the rate of interest should be lowest in
reverse repo.

Secondly, it can also be argued that if reverse repo rate is higher than the repo rate, then it
is opening up arbitrage possibility for the commercial banks. This will happen because the
commercial banks will be able to borrow money at repo rate and then they will be able to
park the money with the central bank at the reverse repo rate (the assumption here being
repo rate<reverse repo rate). This is absurd. Therefore, reverse repo is the lower rate. The
gap between the reverse repo rate and the repo rate is called the LAF corridor (Figure 5.3).

The Reserve Bank of India can influence the borrowing and lending rates of commercial
banks by changing the repo and the reverse repo rates. Any increase or decrease in these
rates result in similar movements in borrowing and lending rates of commercial banks.

The LAF corridor also influences the call money rate in the system. Call Money rate is the
overnight inter-bank borrowing rate. The Call Money Market is the most active and sensitive
part of the organized money market in the country because it registers very quickly the
pressures of demand and supply for funds operating in the money market. The LAF corridor
provides a theoretical floor and ceiling for the call money rates because of the reasons
stated below.

59
If the call money rate determined freely by the demand for and supply of short-term funds
at any given time is lower than the reverse repo level, then commercial banks with surplus
liquidity would prefer to park their money with RBI at the reverse repo rate (rather than
with other banks in need for short-term funds) to ensure enhanced safety and better return
from such transactions. So the call money rates will have to be higher than or equal to
reverse repo rates. On the other hand, if the call money rates determined freely by the
demand for and supply of short-term funds at any given time become higher than the repo
rate, then banks which are in need of funds, have the option of borrowing it from the RBI at
a cheaper rate. Therefore, in theory, call money rates should stay within the LAF corridor.
However, in practice, the overnight inter-bank lending rates do not always stay within the
LAF corridor. Introduction of LAF has helped to stabilize the call money rates to a great
extent.

Figure 5.3. The LAF Corridor

5.8 Market Stabilization Scheme:

LAF is an ideal tool for managing short-term liquidity problems. Keeping in view of the
surging capital inflows and the resultant excess liquidity in the system, RBI felt the need for
other instruments besides LAF to fulfill the objective of absorbing liquidity of a more
enduring nature. With an aim to absorb more ‘long-term’ liquidity, RBI introduced a new
instrument called the Market Stabilization Scheme (MSS) in 2004. Under this arrangement,
in addition to the normal borrowing requirements, the Government issues Treasury Bills
and/or dated securities for the purpose of absorbing excess liquidity from the system. The
MSS proceeds are held in a separate identifiable cash account by the Government and are
appropriated only for the purpose of redemption and/or buyback of the Treasury Bills and/
or dated securities issued under the MSS. To sum up, while LAF is used for more short-term
liquidity management, MSS is for managing liquidity which is more long-term in nature.

5.9 Use of Monetary policy

RBI is the apex institution in administering the monetary policy measures in the Indian
economy. RBI’s conduct of monetary policy has been guided by the twin objectives of
maintaining price stability and enhancing economic growth. The prevalent phase of business

60
cycle determines RBI’s direction of monetary policy. In case of high inflationary situation,
which typically happens when the economic growth is robust, RBI takes contractionary
monetary policy measures by raising key policy rates like CRR, repo and reverse repo rates
to absorb excess liquidity from the system. By resorting to such measures, RBI essentially
tries to reduce the money supply in the economy which leads to a rise in the interest rates.
Rising interest rates reduce aggregate demand and thereby contain inflationary pressure.
However, the pace of economic growth would be affected under such policy framework.
Since we are talking about a phase of business cycle, when the GDP growth is already very
high, the RBI does not mind if the growth rate gets reduced somewhat, as long as it is able
to bring inflation rate down to what it is comfortable with.

On the other hand, think of a situation when the economy gets into a recessionary phase
and the economic growth slows down. Note that during the recessionary phase, inflation
rate is typically very low. What does the RBI do in this case? RBI resorts to expansionary
monetary policy measures by reducing key policy rates. This results in reducing the market
interest rates. Reduced interest rates augment the investment activity and thereby increase
the total output and employment in the economy. This may however lead to some increase
in inflation. But the RBI does not mind that.

Thus, the RBI uses monetary policy instruments differently at different times, depending on
what is the most pressing concern of the economy: high inflation or low GDP growth. When
inflation is the major concern, it tightens monetary policy (that is, it reduces growth in
money supply) and when sluggish economic growth is the major concern, it loosens
monetary policy (that is, it attempts to increase growth rate of money supply).

5.10 Use of Fiscal policy

The kind of policy objectives that can be achieved through the use of monetary policy, can
also be achieved by fiscal policy instruments (see below). While the RBI determines the
monetary policy, it is the government that determines a country’s fiscal policy. Many times,
appropriate monetary policies are combined with fiscal policies to have the desired impact
on the economy. When an economy gets into a recessionary phase, the government can use
fiscal policy to boost the economic activity in the country. Tax rate and public expenditure
are the main instruments of fiscal policy. To revive growth during recessionary phase,
government resorts to expansionary fiscal policy measures which means that it reduces the
tax rates and/or increases the public expenditure. A cut in direct taxes, for example, raises
the disposable income of people. This will encourage many people to raise their spending,
which will boost the aggregate demand in the economy. Similarly, a reduction in indirect
taxes makes the goods cheaper and more affordable, leading to higher spending by people.

Now what impact does increase in government expenditure have at times of recession? An increase in
public expenditure raises the aggregate demand in the country. This works very well when the
economy passes through recessionary phase. During normal times, however, there are problems
associated with raising public expenditure beyond a certain level or lowering tax rates beyond a point.
Higher public expenditure and/or lower tax revenue would push up the fiscal deficit of the
government. In order to finance the fiscal deficit, government would have to (i) borrow
money from open markets or (ii) monetize the deficit (that is, print more money). In the

61
former case, it would crowd out private investment. In other words, higher market
borrowing by the government would mean less investible resources for the private sector.
Since private investment is typically more productive than public expenditure, part of which
are for non-productive purposes such as subsidies, the economy suffers when fiscal deficit
rises to very high level. Persistence of such huge fiscal deficit would also affect the country’s
image in foreign countries which may make it difficult for the domestic country to borrow
abroad funds. To the extent, government finances the deficit by printing money, it would
increase money supply in the economy which will push up the rate of inflation. Hence, there
are limits on the extent to which the government can use expansionary fiscal policy to raise
economic growth rate.

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 Chapter 6
THE EXTERNAL SECTOR: OPEN ECONOMY
MACROECONOMICS

The discussion so far was based on the assumption that the economy is a closed one; that
is, there is no international trade and no inflow or outflow of capital to the economy. As
India is getting increasingly integrated with the global economy, to gain insights into the
macroeconomic issues in India, we need to understand how the macro scenario changes
when we move from a closed economy to an open economy. But before doing that, it will be
useful to understand some basic concepts of open economy macroeconomics.

6.1 Why do Countries Trade?

One of the fundamental ways in which a country integrates with the economic system of the
rest of the world is through international flow of goods and services. This happens through
exports and imports of goods and services. When a country sells its domestically produced
goods and services abroad, the country is said to be ‘exporting’. Conversely, ‘importing’
means that the country is buying goods and services that have been produced abroad.

International trade and gains from trade have received considerable attention in economics
and policy making. Different schools of economic thoughts have propagated different
reasons for why countries trade.

Mercantilism is an economic theory, thought to be a form of economic nationalism, that

holds that the prosperity of a nation is dependent upon its supply of capital and that capital
is represented by bullion (gold, silver, and trade value) held by the state, which is best
increased through a positive balance of trade with other nations. The Mercantilists of 16th to
18th Century believed that international trade leads to a situation, where the country with
positive trade balance improves its national wealth at the expense of the country which is
running a trade deficit. It was believed that a country can promote its self-interest by
discouraging imports and encouraging exports to increase its wealth. This position
essentially called for a protectionist trade policy. Not surprisingly, tariffs and quotas were
used to restrict imports and subsidies were used to boost exports to cause a “favorable
trade balance”.

However, Adam Smith and David Ricardo challenged this perception and showed that
international trade can be beneficial for all the countries. They showed that trade is not a
zero-sum game (that is, one country’s gain from trade is equal to its trading partner’s loss)
and that free trade increases the global wealth. According to these models, differences in
productivity of factors of production (factor productivity) across nations open up possibilities
of trade.If the factor productivities among countries are different, then using a two country-

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two good framework, it can be shown that trade leads to increase in income of both the
countries compared to autarky (see below). 19 The gains from trade come from each
country specializing and exporting the good in whose production it has an advantage over
the other.

Similar results can also be derived from these models if the framework is extended to multi-
country, multi commodity setup. The policy implications of these theories strongly advocate
free trade. This marks a complete departure from the protectionist policy measures
suggested by the mercantilist school.

6.1.1 Absolute advantage theory

When one nation is more efficient than (or has an absolute advantage over) another in the
production of one commodity but is less efficient than (or has an absolute disadvantage with
respect to) the other nation in producing a second commodity, then both nations can gain
by each specializing in the production of the commodity of its absolute advantage and
exchanging part of its output with the other nation. This will pave the way for most efficient
use of resources.

A country is said to be running a positive trade balance when its exports exceed its imports
and a negative trade balance when the opposite occurs.
A protectionist trade policy implies the policy measures taken to protect the domestic
producers of goods and services to some degree from competition from abroad and
boosting exports through subsidies.
Protectionist policy measures include import tariff (where a tariff is imposed on the goods
and services imported) and quotas (where restrictions are imposed on how much of
goods and services can be imported in a year) and export subsidies.

• An Inquiry into the Nature and Causes of The Wealth of Nations, by Adam Smith in
1776
• Principles of Political Economy and Taxation, by David Ricardo in 1817
• The three major factors of production are land, labour and capital.
• economies with no trade

For example: table 6.1 shows that country-A has an absolute advantage over country-B in
the production of wheat for one hour of labour time produces 12 bushels of wheat in
country A as compared to 2 bushels of wheat in Country B. On the other hand, country- B is
having an absolute advantage over country-A in the production of cloth as one hour of
labour time produces 10 yards of cloth in Country B as compared to 8 yards of cloth in
Country A. With trade, country-A can specialize in the production of wheat and country-B
can specialize in the production of cloth. In other words, they specialize in commodities in
which they have absolute advantage over one another.

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Table 6.1: Absolute advantage
Country- Country-
A B
Wheat (bushels/man-hour) 12 2

Cloth (yards/man-hour) 8 10

Let us see how both countries gain by exporting the commodity in which they have absolute
advantage. Let us suppose Country-A exchanges 12 bushels of wheat against 12 yards of
cloth with country-B. Here, country-A gains 4 yards of cloth or saves ½ man- hour or 30
minutes of labor time (Country A can only exchange 12 bushels of wheat for 8 yards of cloth
domestically). Similarly, the 12 bushels of wheat that country-B receives in trade would
have required 6 hour of labor time to produce the same in Country B. These six hours can
instead be used for the production of cloth which would produce 60 yards of cloth in
country-B. After having earlier exchanged 12 yards of cloth with country-A, country-B
retains or gains 48 yards of cloth or saves around 5 hours of labour time.

The fact that Country B gains much more than Country A, is not important at this time.
What is important is that both nations gain from specialization in production and trade.

Absolute advantage can only explain a very small part of world trade today, especially some
trade between developed and developing countries. However, trade among developed
countries could not be explained by absolute advantage. To explain this, David Ricardo
propounded the law of comparative advantage. In a sense, absolute advantage is seen as a
special case of the more general theory of comparative advantage.

6.1.2 Comparative advantage theory

The law of comparative advantage advocates that even if one of the countries has an
absolute disadvantage in the production of both commodities with respect to the other
nation, there is still a basis for mutually beneficial trade. The first country should specialize
in the production of and export the commodity in which its absolute disadvantage is smaller
(the commodity of its comparative advantage) and import the commodity in which its
absolute disadvantage is greater (the commodity of its comparative disadvantage).

For example: Table 6.2 shows that country-B has absolute disadvantage in the production
of both the commodities. However, since country-B’s labour is half as productive in cloth but
six times less productive in wheat with respect to country-A, country-B has a comparative
advantage in the production of cloth. On the other hand, country-A has an absolute
advantage in both the commodities, but it is greater in wheat. So, country-A has
comparative advantage in the production of wheat over country-B. With trade, both
countries can gain if country-A specializes in the production of wheat and export some of it to
country-B in exchange of cloth. Similarly, country-B would specialize in the production of
cloth and export some of it to country-A in exchange of wheat.

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Table 6.2: Comparative advantage

Country-A Country-B

Wheat (bushels/man-hour) 12 2

Cloth (yards/man-hour) 8 4

Suppose that country-A could exchange 12 bushels of wheat for 12 yards of cloth with
country-B, it would save 30 minutes of labor time for country-A or it will gain 4 yards of
cloth. On the other hand, the 12 bushels of wheat that country-B receives from its
counterpart would require six hours of labor time to produce the same quantity in country-
B. These six hours can be used for the production of cloth by country-B which will be able to
produce 24 yards of cloth. Out of this, country-B needs to give up only 12 yards of cloth to
country-A in exchange for 12 bushels of wheat. Thus, country-B would gain 12 yards of
cloth or save three hours of labor time. Hence, both countries benefit from such a trade,
albeit country-A gains more than country-B. However, it is important to note that both
countries can gain from trade even if one of them is less efficient than the other in the
production of both commodities.

6.2 India and International Trade

Interestingly, India has been involved in international trade since the early days of
civilization. Archeologists and historians have discovered that South Asia has been involved
in international trade at least since the 4th Millennium BC, when the sea-faring Indus Valley
civilization used to trade with the Sumerians. This is one of the first regular maritime
international trade routes known in history. Historians tend to indicate that the Indus valley
civilization had a fairly well-developed network and logistics facility for international trade.
India continued to be actively involved in international trade throughout its history,
including in the British period. Only after India’s independence in 1947, policymakers
decided that India should focus more on developing its domestic industrial base and follow a
more inward-looking economic development strategy, which did not see external trade as
an important source of growth. Since the 1980s, India is again opening up and consequently
India’s trade with the rest of the world has increased significantly—not only in absolute
terms but also as a percentage of GDP. Figure 6.1 and Table below the figure 6.1 shows
India’s trade (that is, exports plus imports) to GDP ratio.

Figure 6.1. India’s Trade to GDP Ratio (in percentage)

2015 2016 2017 2018 2019 2020

Trade to GDP Ratio 38.20% 31.70% 29.40% 29.30% 31.50% 27.80%

Source: Handbook of Statistics on Indian Economy and Statista Research

Department

66
When a country exports its goods or services, it receives foreign exchange. For example, if
an Indian garment manufacturer sells his product to a garment shop in USA, he receives the
payment in US dollars. Similarly, if an Indian importer needs to buy something from the US
market, say a book from amazon.com, he will have to use US dollars for that transaction.
When we look at these export and import figures in aggregate for a country, we can
understand whether a country is exporting more or it is importing more. In other words, we
have to see whether the country has positive or negative net exports. Net exports are
defined as:

Net exports in a year = Total exports of goods and services in that year –
total imports of goods and services in the same year

If the net exports of a country are greater than zero in a given year, then that country is
called a ‘trade surplus’ country in that year. On the other hand, if a country imports more
than its exports in a year, that is, if the net export of the country is negative, then that
country is called a ‘trade deficit’ country for that year. Note that when we talk about trade
surplus or trade deficit, we talk about trade in both goods and services put together. India
has generally been a trade deficit country as it imports more than it exports. 20 China, on
the other hand, has emerged as a country with large trade surplus.

6.2.1 India’s Merchandise Trade

International trade in goods alone is called ‘merchandise trade’. Thus there is a difference
between ‘trade balance’ and ‘merchant trade balance’. The former refers to the trade
balance in goods and services together, while the latter refers to the balance in goods
alone. The official trade statistics released by the Government, however, refer to
merchandise trade (or trade in goods), unless otherwise mentioned. In India,
merchandise trade data is compiled by Directorate General of Commercial Intelligence and
Statistics (DGCIS, website: http://www.dgciskol.nic.in/). DGCIS collects merchandise
trade data from land, sea and rail ports of India. As far as merchandise trade is
concerned, India has been persistently running a trade deficit (i.e. Imports are greater
than Exports). This is shown in Figure 6.2
There have, however, been some exceptional years, when India had a trade surplus.

Figure 6.2 India’s Merchandise Trade from FY 2018-19 to 2021-22 (in

billion US$)

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6.2.2 Trade in Services

Trade in services refer to the sale and delivery of an intangible product called services.
‘Services’ is a very diverse category and it can range from architecture services to voice-
mail telecommunications services to software services.

The basic difference between trade in goods and trade in services is that while in
merchandise trade, the goods physically cross the international border, the same may not
be true in case of services. For example, when a tourist from Japan comes to India and
stays in an Indian hotel, India is essentially exporting its hospitality services to a
customer in Japan. But while India is selling its services overseas, the service is not
crossing the international border. This is unlike merchandise trade, where there is a
visible movement of goods across international borders. Same will be true for services
imports. Similarly, when a legal expert from Switzerland is advising his Indian client and
is being paid for it, India is importing the service but there will be no visible cross-border
movement of the service. For these reasons, data for trade in services is not collected in
the same way as data for trade in goods. Trade in services is classified under the category
called ‘invisibles’ in a country’s statistical reporting system.

As stated earlier, in India, service sector accounts for around 60 percent of the GDP.
However, the size of annual exports of services in case of India is smaller than the size of
annual exports in merchandise goods, although exports of services in India is growing
much faster than trade in merchandise goods. If the current trend continues, the exports
of services may overtake India’s merchandise exports in another few years. It is
interesting to note that that while India was ranked 16th in the world in merchandise
exports in 2018, in case of exports of services, India was ranked 11th.

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Merchandise exports were lower in 2020-21, as compared to 2019-20, on account of the
pandemic. However, they rebounded sharply in 2021-22. Imports too, declined in 2020-
21, but rose sharply in 2021-22. The bulk of imports are energy related. Thus, the trade
deficit, declined from 2019-20 to 2020-21, but rose sharply in 2021-22. Services exports,
which are primarily IT related in the case of India, declined marginally from 2019-20 to
2020-21. However, they rose in 2021-22. In all the years, the net services exports were
positive. The trade overall trade deficit, declined sharply in 2020-21, as compared to
2019-20, but rose significantly once again in 2021-22.

6.2.3 Transfer payments and net factor incomes

Along with trade in services, the ‘invisibles’ category also contain data on two other
important forms of payments. These are ‘Transfer payments’ (or ‘transfers’) and ‘net
factor incomes. Transfers are gifts or payments which are not in return for any economic
activity. In case of India, ‘transfers’ comprise primarily remittances from Indians working
overseas. According to World Bank data, India was the top recipient of remittances in
2018. During that year, India received remittances to the tune of US dollar 79 billion. 22
China and Mexico are other developing countries which have historically received high
remittance flows.
Net factor income means income paid to Indians from overseas sources which can be
earnings on investment i.e. income (rent, profits, dividends), royalties and interest. On the
debit side, it will be similar types of income that foreigners get from India.

69
In India’s international trade, merchandise is gradually losing it dominant position to
services and other transfer income components. However, the Make in India initiative was
launched by Prime Minister in September 2014. The primary objective of this initiative is to
attract investments from across the globe and strengthen India’s manufacturing sector. It is
being led by the Department for Promotion of Industry and Internal Trade (DPIIT), Ministry
of Commerce and Industry, Government of India. Keeping in view of these changing
dimensions of India’s trade basket, it is pertinent to discuss India’s evolving trade scenario
through the Balance of Payments mechanism.

• ‘Invisibles’ contain not only trade in services, but also other items (see below).
• According to the methodology adopted by RBI, ‘Remittances’ include repatriation of
funds by migrant workers for family maintenance and local withdrawals from the
non-resident Indian (NRI) deposits.

6.3 Balance of Payments

Balance of payments (BoP) is a summary statement in which all the transactions of the
residents of a nation with the residents of all other nations are recorded during a particular
period of time, typically a calendar year. Thus, BoP is a much wider term in its coverage as
compared to balance of trade.

• In case of India, although BoP data is measured and published every quarter, annual
BoP data refers to data for the financial year.

An important purpose of measuring the balance of payments is to inform the government

regarding the international position of the nation and to help it in its formulation of
monetary, fiscal and trade policies. Moreover, the information contained in the BoP is
indispensable to banks, firms and individuals who are directly or indirectly involved in
international trade and finance.

International transactions are classified as credits or debits. Credit transactions involve the
receipt of payments from foreigners and are entered with a positive sign in the BoP
statement. The export of goods and services, unilateral transfers from foreigners and capital
inflows are credits as they involve the receipt of payments from foreigners. On the other
hand, debit transactions involve the making of payments to foreigners and entered with a
negative sign. Import of goods and services, unilateral transfers to foreigners and capital
outflows are debits as they involve payments to foreigners.

6.3.1 Classification of Balance of Payments accounts

The Balance of Payments has two main components:

(i) current account

(ii) capital account.

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6.3.1.1 Current Account

The Current Account records the transactions in merchandise and invisibles with the rest of
the world. Merchandise covers exports and imports of all movable goods, where the
ownership of goods changes from residents to non-residents and vice versa. Invisibles, as
stated earlier, has three components: trade in services, transfer payments and factor
incomes. In other words, the current account in the balance of payments covers all cross-
border transactions relating to goods and services trade, receipt or payment of income from
investments (primary income), and unilateral transfers (secondary income). Historically,
India’s current account balance is largely driven by movements in the goods trade account.
In 2018-19 also, higher deficit in goods trade mainly widened the current account deficit.
Thus, Current Account captures the effect of trade link between the economy and rest of the
world. This is shown is Table 6.3.

Table 6.3. Constituents of Current Account of a Country

Credit Items Debit Items

Merchandise Trade Exports Imports
Invisibles: Services Export Imports
trade
Invisibles: Transfers Inflows of payments Outflows of payments
Invisibles: factor Inflows of factor Outflows of factor income
incomes income

The current account of a country is in surplus if receipts from exports of goods and services
and from transfers and factor incomes exceed payments on account of imports of goods and
services, transfers and factor incomes, the country is said to have a current account
surplus. On the other hand, if payments on this account exceed receipts from trade in goods
and services and transfer payments, the country is said to have a current account deficit. In
spite of a significant increase in India’s exports and high remittance flows, India has
remained a current account deficit country. Table 6.4 shows the components of current
account in India.

Table 6.4. Components of India’s Current Account (in US $ billion)

2017-18 2018-19
Credit Debit Net Credit Debit Net
I. Goods & Services 504.1 586.5 -82.5 545.2 643.6 -98.3
Ia. Goods 309 469 -160 337.2 517.5 -180.3
Ib. Services 195.1 117.5 77.6 208 126.1 81.9
II Primary Income 18.9 47.5 -28.7 21.8 50.7 -28.9
III Secondary Income 69.4 6.9 62.5 76.6 6.6 70
Total Current Account 592.4 641 -48.7 643.7 700.9 -57.2
(I+II+III)

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Source: RBI Bulletin, Nov 11 2019.

Table 6.4 tells us that India has received about 545.2 US $ billion through exports of goods
(US $ 337.2 billion) and services (US $ 208.0 billion) in 2018-19. However, imports of
goods and services in the same year were around US $ 643.6 billion (these are figures in
italics in the table 6.4). Though there have been positive net transfers on account of high
private transfers (flow of remittances from migrant workers) and positive balance in trade in
services, it has an overall current account deficit mainly due to a large deficit in
merchandise trade. Traditionally India has been a current account deficit country for almost
all years since it liberalized in 1991.

However, it is pertinent to note that in Q4 (Jan-March) of FY 2019-20, India recorded a

current account surplus of $0.6 billion, or 0.1 per cent of GDP, for the January-March
period, this is the first quarterly surplus in 13 years.

The surplus in the current account in the March quarter was primarily on account of a lower
trade deficit and a sharp rise in net invisible receipts. Also, India’s current account balance
(CAB) recorded a surplus of US$ 19.8 billion (3.9 per cent of GDP) in Q1 of 2020-21 on top
of a surplus of US$ 0.6 billion (0.1 per cent of GDP) in the preceding quarter, i.e., Q4 of
2019-20 on account of a sharp contraction in the trade deficit to US$ 10.0 billion due to
steeper decline in merchandise imports relative to exports on a year-on-year basis. So, the
question is, how does India pay for this deficit?

To elaborate, when we talk about international transactions like export, import and
remittances, these transactions are carried out using foreign exchange. Though trade can
be done using the currency of the trade partner, most countries tend to use US dollars for
international transactions. Credit items in current account like exports and inward flow of
remittances give a country the required foreign exchange. This money then can be spent to
buy goods and services from abroad and also to pay for other invisible outflows from the
country. Therefore, if a country like India persistently runs a current account deficit, it must
procure foreign exchange to cover for that deficit. The answer to this question lies in
something called the ‘Capital Account’.

6.3.1.2 Capital Account

The capital account records purchases and sales of assets, such as stocks, bonds and land.
In other words, the capital account shows all the inflows and outflows of capital. Capital
account transactions reflect net change in the national ownership of assets. For example,
when foreign investors acquire shares listed in India from Indian shareholders, it results in a
change in the ownership of those shares by the Indian nationals. This represents a capital
account transaction. This will become clear later in the chapter. No such thing however
occurs in case of current account transactions.

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Capital account tracks the movement of funds for investments and loans into and out of a
country. Some of the components of capital account are foreign direct investment (FDI),
foreign portfolio investment (FPI) and external commercial borrowing (ECB).

Note that a country may incur a deficit of a surplus in both (i) the current account
transactions and (ii) capital account transactions. The overall Balance of Payments for a
country in a given year is the sum of the surplus/ deficits of current and capital accounts. A
surplus in one account can offset the deficit in the other.

In India, with significant changes in liberalization of foreign investment rules in 1991, the
country has been generally running a surplus in its capital account. The surplus generated in
the capital account allows India to pay for its current account deficit. In fact in several
recent years, the surplus in the capital account exceeds the deficit in the current account
(the year 2008/09 was a notable exception). This is shown in Figure 6.3. This means that
India has been in recent years generally been running an overall balance of payments
surplus. This surplus results in net addition to the country’s foreign exchange reserves.
Consequent to the improvement in current account and higher capital flows into the
country, the Balance of Payments (BoP) position of the country has improved from foreign
exchange reserves of US$ 302 billion in end March, 2019 to US$ 461.2 billion as on 10th
January 2020. In 2019-20, there was an accretion of US$59.5 billion to foreign exchange
reserves (on a BoP basis).

Figure 6.3. India’s Current Account and Capital Account (% of GDP)

Since India liberalized its capital account in 1991, non-debt creating flows have become
much more important component in India’s capital account. Among the non-debt creating
flows, the two most important types of capital flows are Foreign Direct Investment (FDI)
and Foreign Portfolio Investment (FPI). India has been receiving high FDI and FPI inflows
since 2000. These are shown in Figure 6.4.

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Figure 6.4. FDI and FPI Inflows to India (in US$ billion)

Source: Economic Survey 2019-20

Examples of Current Account and Capital Account Transactions

A party in Australia has exported goods worth 100,000 AUD to Singapore. The payment will
be credited to the exporter's account in Singapore. This transaction will be shown as follows
in the:

Credit Export of Goods 100,000

Export of goods is like a sale. And sales revenue for a company, increases with credits.
Debit Foreign Assets 100,000
Assets increase with debits.

A party in Australia has bought Singapore Treasury Bonds worth 100,000 AUD and has paid
for it by issuing a cheque on its bank account held in Singapore. This transaction will be
shown as follows:

Credit Foreign Bank Deposits 100,000

Debit Foreign Bond Holdings 100,000
One asset is declining while another is increasing.
Financial asset holdings increase with debits and decline with credits.
Impact of Current Account and Capital Account Changes on a Country’s Reserves

If a country has a current account surplus, it can either use the surplus to retire some of its
external debt, or make external investments, or else its central bank can add to the
country’s reserves. On the other hand, if there is a current account deficit, it will require the
country to borrow more from foreign sources, or liquidate some of its external assets, or
else lead to a depletion of its reserves. Thus, a current account surplus must lead to a
deficit in the capital account, or else an increase in the reserves. On the other hand, a
current account deficit, must lead to a capital account surplus, or else a decline in the
reserves.

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To give an analogy from the corporate sector, if the net income for the company for a
financial year is positive, there are two options. If the size of the balance sheet is to be
retained at its current level, it can either acquire more assets, or buyback some of its
equity, or else it can retire some of its debt in the form of bank loans or bonds and
debentures issued. Unlike a company, a country does not have shareholders. Consequently,
a current account surplus, can be utilized only by repaying external debt, or acquiring
assets in the form of reserves. Similarly, if a company has a loss in a financial year, there
are once again two options. If the size of the balance sheet has to be maintained at its
current level, it can either raise additional capital by way of debt or equity, or else sell off
some of its assets. In the case of a country, it can borrow more abroad, or else dip into its
reserves. It should be remembered that the term ‘reserves’ connotes an asset for a country,
but a liability for a company.

The Current Account and a Country’s Net Foreign Assets

The net foreign assets of a country may be defined as its foreign assets minus its foreign
liabilities. If the net foreign assets are positive then the nation may be deemed to be a
creditor nation, else it is a debtor nation. The change in the current account is equal to the
change in net foreign assets.

Δ Current Account = Δ Net Foreign Assets = Δ Foreign Assets – Δ Foreign Liabilities

If a country has a current account surplus either its foreign assets will increase or else its
foreign liabilities will decline. On the contrary if a country has a current account deficit,
either its foreign assets will decline or else its foreign liabilities will increase.

International Reserves

International reserves mainly consist of gold and convertible foreign currencies. The stock of
gold depends on new discoveries of deposits, and additions due to mining of new gold net of
its uses. The value of gold would depend on supply and demand forces in the market. The
U.S. dollar is the other major component of foreign exchange reserves. Its stock would
obviously depend on the balance of payment deficits of the U.S.

Special Drawing Rights (SDRs)

In the 1960s, discussions began as to whether it was possible to create a new asset, whose
stock could be monitored and controlled by a world agency, and which would become the
primary reserve asset. It was felt that the stock of this asset could be based on the liquidity
needs of the world financial system, that is, its supply could be made a function of
international trade and capital flows. This, it was felt, was more desirable than depending on
gold or the U.S dollar to provide liquidity.

In 1967 the International Monetary Fund (IMF) decided to create such an asset known as
Special Drawing Rights (SDRs). It was proposed that the IMF would open an account for
each member country and credit it with a certain amount of SDRs . The total volume of SDRs
created was to be approved by the governing board of the IMF, an d its allocation among

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member nations was to be proportional to their respective quotas. Member countries were
permitted to use SDRs for settling payments among themselves as well as for transactions
with the IMF. The value of the SDR was originally fixed in terms of gold. In 1974, the SDR
became equivalent to a basket of 16 currencies, and in 1981 it was made equivalent to a
basket of 5 currencies. The SDR is currently equivalent to a basket of five currencies: the
US Dollar, the Euro; the Pound Sterling, the Japanese Yen, and the Chinese Yuan. In order
to make transactions in SDRs attractive, the Fund pays interest on SDR holdings in excess
of the amount allocated to a country. However, it also charges interest on any shortfalls .

Reserves at the IMF

A country's reserve at the IMF represents the amount that a country can draw automatically
from the IMF, that is, unconditionally and without prior permission. Each member country
has a quota at the IMF, It is required to contribute 25% of its quota in the form of foreign
currencies and SDRs and the balance 75% in its own currency. The 25% that has been
contributed in the form of SDRs and foreign currencies is called the Reserve Tranche.

A country can obviously borrow the reserve tranche. However, it may so happen that some
other country has purchased some of its currency from the IMF. If so, then it can borrow
more than its reserve tranche. However, if it has purchased some other country's currency
from the IMF, then it can only borrow less than its reserve tranche. We will clarify this with
the help of an example.

Example

Assume that Australia's quota is 1000 AUD, of which it has contributed 250 in the form of
SDRs and 750 in the form of AUD. Now suppose that Singapore has borrowed 300 AUD from
the IMF. If so, Australia's reserve position at the IMF = 250 + 300 = 550 AUD.

6.3.2 Foreign Direct Investment

6.3.2.1 Foreign Direct Investment

The International Monetary Fund (IMF) defines FDI as an investment made to acquire
lasting interest in enterprises operating outside of the economy of the investor. In other
words, FDI comprises activities that are controlled and organized by firms (or groups of
firms) outside of the nation in which they are headquartered and where their principal
decision makers are located. In the context of the manufacturing sector, FDI is
conventionally thought of in terms of branch plant or subsidiary company operations that
are controlled by parent companies based in another country. The most important
characteristic of FDI, which distinguishes it from foreign portfolio investment, is that it is
undertaken with the intention of exercising control over an enterprise.

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In other words, FDI is a category of cross border investment made by a resident in one
economy (the direct investor) with the objective of establishing a ‘lasting interest’ in an
enterprise (the direct investment enterprise) in an economy other than that of the direct
investor. The motivation of the direct investor is a strategic long term relationship with the
direct investment enterprise to ensure a significant degree of influence by the direct
investor in the management of the direct investment enterprise. In India the ‘lasting
interest’ is not evinced by any minimum holding of percentage of equity
capital/shares/voting rights in the investment enterprise. The objectives of direct
investment are different from those of portfolio investment, whereby investors do not
generally expect to influence the management of the enterprise.

FDI can be of two broad types, viz. (a) greenfield investments and (b) through merger and
acquisition activities. Greenfield investment is defined as the establishment of a completely
new operation in a foreign country. Greenfield FDI refers to investment projects that entail
the establishment of new production facilities such as offices, buildings, plants and factories.
In Greenfield Investment, the investor uses the capital flows to purchase fixed assets,
materials, goods and services, and to hire workers for production in the host country.
Greenfield FDI thus directly adds to production capacity in the host country and, other
things remaining the same, contributes to capital formation and employment generation in
the host country.

Secondly, FDI can also be through Merger and Acquisitions with existing firms in the
destination country (FDI through M&A). Such cross-border M&As involve the partial or full
takeover or the merging of capital, assets and liabilities of existing enterprises in a country
by a firm from other countries. The target company that is being sold and acquired is
affected by a change in owners of the company. There is no immediate augmentation or
reduction in the amount of capital invested in the target enterprise at the time of the
acquisition. If for example, an Indian company is acquired by an US company, capital would
flow into India from the USA to the owners of the company, but not to the company itself.
So, there is no immediate addition to the productive capacity. However, there can be
efficiency gains in the medium term through transfer of technology, better management,
better market access etc.

To calculate FDI flows, RBI includes equity capital, reinvested earnings (retained earnings of
FDI companies) and ‘other direct capital’ (inter-corporate debt transactions between related
entities). FDI flow to India has been increasing over the years. Since April 2000, cumulative
amount of FDI inflows to India have crossed US$ 721,783 million (up to September 2020).
Detailed statistics about FDI inflows to India, including monthly flows and sectoral breakups
are available on the website of Department of Industrial Policy and Promotion
(www.dipp.nic.in). This website also contains a manual of FDI which gives the detailed
procedural information about investing in India through the FDI route.

6.3.2.2 Foreign Portfolio Investment

Foreigners’ investment in a country’s capital market is known as foreign portfolio

investment. The basic difference between FDI and FPI is that in case of FDI, the investor

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acquires lasting interest in the company where it has invested. But in case of FPI, the
investor does not have any managerial representation in the board of directors of the
company. In other words, foreign direct investors have the management of the firms under
their control; but this is not the case for foreign portfolio investors.

To invest in the Indian stock market, a foreign investor has to fulfill a number of criteria laid
out by the market regulator, the Securities and Exchange Board of India (SEBI). These
investors will also have to be registered with SEBI. These registered foreign investors are
called the Foreign Institutional Investors (FIIs). Along with FIIs, Non- Resident Indians
(NRIs) are also eligible to purchase shares and convertible debentures under the Portfolio
Investment Scheme. FIIs include Asset Management Companies, Pension Funds, Mutual
Funds, Investment Trusts as Nominee Companies, Incorporated/Institutional Portfolio
Managers or their Power of Attorney holders, University Funds, Endowment Foundations,
Charitable Trusts and Charitable Societies.

FIIs are also allowed to invest on behalf of their sub-account. A sub account of an FII is
generally the underlying fund on whose behalf the FIIs invests. The following entities are
eligible to be registered as sub-accounts, viz. partnership firms, private company, public
company, pension fund, investment trust, and individuals.

A similar but more complex system is investment by FIIs through the Participatory Notes
(PN) route. Participatory notes (PNs) are instruments used by foreign investors not
registered with the Indian regulators for taking an exposure in the domestic market. PNs
are like contract notes and are issued by FIIs registered in India to their overseas clients
who may not be eligible to invest in the Indian stock markets. There have been some
controversies about the use of PNs by FIIs. Concerns have been expressed that undesirable
elements may have been investing money in India through this route and accordingly
certain restrictions have been imposed.

Indian companies are also allowed to raise equity capital in the international market through
the Global Depository Receipt (GDR) and American Depository Receipt (ADR) route. Let us
understand how this works. To raise capital through public issues, a company has to be
listed and traded on various stock exchanges. Thus, companies in India issue shares which
are traded on Indian stock exchanges (such as National Stock Exchange).

These shares are sometimes also listed and traded on foreign stock exchanges like NYSE
(New York Stock Exchange) or NASDAQ (National Association of Securities Dealers
Automated Quotation), if the intention to raise capital abroad. But to list on a foreign stock
exchange, the company has to comply with the policies of those stock exchanges, which are
much more stringent than the policies of the exchanges in India. This is especially so for the
exchanges in the USA and Europe. This deters these companies from listing on foreign stock
exchanges directly.

But many companies get listed on these stock exchanges indirectly – using ADRs and GDRs.
How does this work? The company deposits a large number of its shares with a bank located
in the country where it wants to list indirectly. The bank issues receipts against these

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shares, each receipt having a fixed number of shares as an underlying (usually 2 or 4).
These receipts are then sold to the people of this foreign country. This is how the company
raises capital abroad. These receipts are listed on the stock exchanges. They behave exactly
like regular stocks and their prices fluctuate depending on their demand and supply, and
depending on the fundamentals of the underlying company.

These receipts, which are traded like ordinary stocks, are called Depository Receipts. Each
receipt amounts to a claim on the predefined number of shares of that company. The
issuing bank acts as a depository for these shares – that is, it stores the shares on behalf of
the receipt holders.

Both ADR and GDR are depository receipts, and represent a claim on the underlying shares.
The only difference is the location where they are traded. If the depository receipt is traded
in the United States of America (USA), it is called an American Depository Receipt, or an
ADR. If the depository receipt is traded in a country other than USA, it is called a Global
Depository Receipt, or a GDR. This allows retail investors of other countries to invest in
shares of Indian companies.

Foreign companies have the option of listing on Indian exchanges, in the form of IDRs or
Indian Depository Receipts, which are the Indian equivalent of ADRs and GDRs. The first
company to list IDRs on the Indian exchanges, was Standard Chartered bank.

Therefore, foreign portfolio investment comes to India broadly through two sources. First
and the more dominant source of FPI are the FIIs. FIIs invest money in Indian capital
markets. They invest in both debt and equity segments of the markets. The second source
of FPI is through the ADR and GDR route. If one looks at the period 1992-93 to 2020-21 (till
26-01-2021), India has received FPI worth Rs. 14,65,191 crores.

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6.4 Exchange Rates
So far, we have discussed various aspects of international trade and capital flows without
any discussion on exchange rates. It will be important now to introduce the concept of an
exchange rate. The exchange rate is formally defined as the value of one currency in terms
of another. There are different ways in which the exchange rates can be managed.
Exchange rates may be fixed, floating, or with limited flexibility. A nominal exchange rate
denotes the price of foreign country’s currency in terms of the domestic currency. For
example, price of 1 US dollar in terms of Indian rupees (INR) is currently around 82. An
exchange rate helps each country to have its own currency, which is different from its
trading partners and yet carry out trade freely in the international market.

If the exchange rate changes in a way that 1 US dollar can buy more INR, then it is said
that INR has depreciated. In other words, if tomorrow 1 US dollar can buy 85 INR (instead
of 82), then one can say that INR has depreciated. In economic jargon of financial press,
this is also called weakening of INR. This is because 1 INR is now worth less number of US$.
Conversely if 1 US dollar becomes equivalent to say 78 INR (rather than 82), then it will be
said that INR has appreciated or strengthened.

The determination of the exchange rate of a country is influenced by a number of factors.

One of the most important determinants is the concept that the exchange rate should
ensure purchasing power parity across countries. According to this theory, a currency
should have the same purchasing power in all countries. That is, the exchange rate (say
between US dollar and Indian rupee) should be adjusted in a way that 1 US dollar should be
able to buy the same good in equal quantity, both in USA and in India. This theory
essentially tells that exchange rate should be dependent upon the price level of both the
countries. For example, if a sandwich costs Rs 25 in India and US$ 1 in USA, then the
exchange rate should be 1 US$ = 25 INR. This will ensure purchasing power parity between
INR and US$. More formally, if the price of a basket of goods in India is P, the price of the
same basket of goods in USA is P*, then the exchange rate e (expressed in terms of INR
per dollar), should be determined by the following equation:

e. P*= P

or e = P/P*

Though this theory looks elegant and simply, in real life, the purchasing power parity is not
achieved through exchange rates. In addition to purchasing power parity, Several other
factors may influence the determination of the exchange rates. The most important factor
that determines exchange rates in real life is the relative demand for and supply of domestic
currency vis-à-vis the foreign currency. Let us take two examples:

In situation 1, India needs to import huge amount of oil in a certain month. It is going to
buy this oil from the international market. Therefore, to pay for this oil import, Indian
importers will have to procure dollars in the foreign exchange market. If the demand for
dollar increases in Indian markets relative to the supply of dollars, the price of dollar will go

80
up. Because, to induce more people to sell dollars, more INR will have to be given per US
dollar. This means an appreciation of dollar and depreciation of rupee.

In situation 2, India has received huge amount of FDI and FPI flow in a certain month. Now
foreign investors will need rupees for their investment in India and not dollars. Therefore,
they will need INR in exchange of their dollar bills. If this supply of US dollars exceeds the
demand for dollars in that month, the price of the dollar would go down to induce more
people to buy dollars in exchange for rupees. This will be elaborated later in this chapter.

Currency appreciation and depreciation can have significant impact on an economy. For
example, if there is a depreciation of INR, then the value of imports become costlier. For
example, if the initial exchange rate is 80 INR/US$ and India buys oil at the rate of
100$/barrel, then the rupee price of 1 barrel oil will be 8000 INR. If the rupee depreciates
to 85INR/US$, then the same consignment will cost India 8500 INR. Therefore, a
depreciation will raise the prices of all its imported products, thereby raising inflationary
pressure in the economy.

On the other hand, if rupee appreciates from 80INR/US$ to say, 75 INR/US$, then it will
hurt the exporters of the country. Suppose it takes Rs 120 to produce a toy in India. In the
first case, the exporter can sell his product at US$ 1.5 in the international market. However,
after the appreciation, the same product will have to be sold at US$ 1.6 in the same market.
This is likely to affect the competitiveness of the export sector in India. In other words, the
exporters now cannot sell their toys as easily as they could earlier it was US$ 1.5.

The role of the Central Bank of the country is to manage the exchange rate in such a way
that the following four broad objectives are satisfied (Reddy 1997, Mohan 2006). They are:

1. To ensure that economic fundamentals are reflected in the external value of the
rupee.
2. To reduce excess volatility in exchange rates and ensure that market correction of
overvalued or undervalued exchange rate is orderly and calibrated.
3. To help maintain an adequate level of foreign exchange reserves.
4. To develop a healthy foreign exchange market.

With these objectives, RBI tries to manage the exchange rate in India. Officially it is said
that RBI does not have a fixed or pre-announced target or band while monitoring the
exchange rate. The International Monetary Fund (IMF) classifies the Indian exchange rate
regime as a “managed float with no predetermined path for the exchange rate”. In the
words of the present RBI governor:

“The exchange rate policy in recent years has been guided by the broad principles of careful
monitoring and management of exchange rates with flexibility, without a fixed target or a
pre-announced target or a band, coupled with the ability to intervene, if and when
necessary.”

However, although the exchange rate is allowed to be determined by the demand for and
supply of foreign exchange the exchange rate in India, it does not enjoy complete flexibility.

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The RBI does intervene at times in the foreign exchange market and tries to keep INR at a
stable level. The exchange rate INR/US$ reached an all-time high of 76.168 in Apr 2020 and
a record low of 4.762 in May 1966. Figure 6.6 shows the INR/US$ exchange rate for the
period of 60 days i.e. Nov 2020 to Jan 2021 (till 21st).

Figure 6.6. Nominal INR/US$ Exchange Rate

The Big-Mac Index and Purchasing Power Parity

To compute exchange rates on the basis of purchasing power parity, we need a product that
is homogeneous or identical across countries. It has been argued that McDonald burgers are
ideal for this. Assume a burger that costs 1.25 USD in the US costs 75 INR in India and 1.50
SGD in Singapore. The implied exchange rates are:

1 USD = 60 INR; 1 USD = 1.20 SGD; and 1 SGD = 50 INR

6.5 Foreign Exchange reserves

During our discussion on Current Account (CA) and capital account (KA) in India, it was
shown that the overall balance (the sum of CA and KA) has remained positive for India for
the last few years. This means that the country is receiving net positive payments from
abroad. The excess foreign exchange that is flowing in the country means that there is an
upward pressure on INR. In other words, given the excess supply of foreign exchange in
comparison to demand, the INR would tend to appreciate. If the RBI does not want INR to
appreciate, then it should buy the excess dollars (which are the result of positive overall
balance in India) from the foreign exchange market. This is what the RBI has been doing.
To keep the value of INR within a narrow band, it is actively intervening in the foreign
exchange market and mopping up excess supply of dollars. This has kept the value of INR in
check and has allowed RBI to amass huge amount of foreign exchange reserves. (Note that
it is the central bank of a country, which in India’s case is the RBI, which maintains the

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foreign exchange reserves of a country.) As per RBI’s latest available reports on foreign
exchange reserves, reserves followed an increasing trend from USD 477.81 billion as at
end-March 2020 to USD 544.69 billion as at end- September 2020. Table 6.5 shows the
various components of Current Account and Capital account which have contributed to this
buildup of foreign exchange reserves in India. Figure 6.6 shows movements in foreign
exchange reserves from March 2020 to September 2020.

Table 6.5. Sources of Accretion of Foreign Exchange Reserves for April to June 2020 period
in USD billion.

Sr.No Items Amount

in USD
Billion
1 Current Account Balance 19.8
2 Capital Account (a to f) 0.1
A Foreign Investment 0.2
a.1 Foreign Direct Investment -0.4
a.2 Portfolio Investment of which 0.6
a.2.1 FII 1.1
B Banking Capital of which 2.2
b.1 NRI Deposits 3
Sr.No Items Amount
in USD
Billion
C Short Term Credit -0.2
D External Assistance 4.1
E External Commercial Borrowings -1.6
F Other items in capital account -4.7
3 Valuation Change 8
Total (1+2+3) @ Increase in reserves 27.9
(+)
/ Decrease in reserves (-)

Source: Half Yearly Report on Management of Foreign Exchange Reserves,

Reserve Bank of India, December 2020

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Figure 6.6 Movement in Foreign Exchange Reserves

Source: Reserve Bank of India

Foreign exchange reserves play a number of important roles for the economy. According to
Y.V. Reddy, former governor of Reserve Bank of India, high amount of foreign exchange
reserve is necessary for:

– maintaining confidence in monetary and exchange rate policies,

– enhancing capacity to intervene in foreign exchange markets,

– limiting external vulnerability by maintaining foreign currency liquidity to absorb

shocks during times of crisis including national disasters or emergencies;

– providing confidence to the markets especially international credit rating agencies

that external obligations can always be met, thus reducing the overall costs at which foreign
exchange resources are available to all the market participants, and

– incidentally adding to the comfort of the market participants, by demonstrating the

backing of domestic currency by external assets.

However, amassing huge foreign exchange reserves also creates some other
macroeconomic management problems for the economy, which will be discussed next.

6.6 Impact of capital flows on money supply

As we have discussed, in a scenario, when there is a positive capital account balance and
such balance exceeds the foreign exchange requirements to finance the current account
deficit, as in the case of India. there is an excess supply of foreign exchange (say dollars) as
compared to demand. As a result, the Indian rupee would tend to appreciate. If this
happens for a sustained period of time, the Indian exports would lose their competitiveness.
To counter this problem, the central bank of the country has the option to check the
appreciation of the domestic currency by buying up some foreign currency (say US dollar) in
the Indian foreign exchange market. However, by doing that, the central bank may lose
control over the money supply, because the RBI buys the foreign currency in the market in
exchange for Indian rupees. As a result, the supply of Indian rupees (money supply)
increases. Sometimes, this increase in money supply may lead to a money supply growth
that exceeds the RBI’s desired money supply growth.

In India, RBI has actively intervened in the foreign exchange market to ward off the
appreciating pressures on INR. A look at the RBI balance sheet shows that since 1993- 94,
there has been a sharp increase in the Net Foreign Assets (NFA), which predominantly
constitutes foreign exchange reserves. It also shows that net foreign exchange asset
accretion by the banking system has become the most important source of expansion of
money supply in India.

The central bank does not want the money supply to spin out of control. Maintaining price
stability is considered to be one of the most important roles of RBI. Historical experiences

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have also shown that sustained episodes of high credit growth have often been followed by
price instability. Thus the RBI faces conflicting objectives. If in the situation of excessive
capital inflows, it intervenes by purchasing excess dollars, it can maintain the
competitiveness of Indian exports, but may lose control over money supply. On the other
hand, if in such a situation, it does not intervene, it would have greater control over money
supply, but the competitiveness of Indian exports would go down. There are a couple of
alternatives to deal with these conflicts. First, the central bank can moderate some of the
pressure on the rupee to appreciate by encouraging private investment overseas by Indian
businessmen or by allowing foreigners to borrow from the local market. This way the excess
supply of dollars can be reduced without any need for RBI intervention. The second
alternative is to sterilize the capital inflows, which is elaborated below.

6.7 Sterilization of Capital Flows

During a sustained period of net capital inflow, when the central bank buys foreign
exchange from the market in exchange for rupees to keep the nominal exchange rate ofthe
domestic currency from appreciating, it creates excess supply of rupees (relative to
demand) in the market. Subsequently, the central bank mops up the excess supply of
rupees by selling government securities in open market operations. When the central bank
sells government bonds in the market, it implies that economic agents (like commercial
banks, financial institutions, retail investors etc.) are buying these papers by paying money
to RBI from the existing supply of money. This reduces money supply in the economy. This
whole exercise of mopping up excess supply of rupees from the market is called sterilization
of capital flows. Sterilization can keep the growth in money supply under control, thereby
avoiding the undesirable expansionary effects on money supply of capital inflows.
Intervention in the foreign exchange market followed by sterilization allows the monetary
authority (RBI) to build foreign exchange reserves (that will help to withstand future shocks,
and provide comfort and confidence to market participants), while keeping the money
supply growth under control.

However, there are some problems with sterilization. In a theoretical world with completely
free capital flows, sterilization is self-defeating. In theory, capital is attracted to a country A,
if the risk adjusted rate of interest in country A is higher than the same in the home country
of the capital. If a central bank sterilizes the capital flow by selling securities, it will have to
offer attractive interest rates those papers to attract buyers. This will push up the rate of
interest in country A and it will attract more capital inflow. Therefore, the sterilization
process will exacerbate the problem of excess liquidity that it tried to tackle. However, in a
practical world, capital inflows depend on a host of other factors apart from risk-adjusted
rate of interest. Therefore, in real life, many central banks of the world, including RBI, have
partially managed to sterilize the effects of excessive capital inflow .

The second problem is more pertinent. There are certain fiscal costs associated with
sterilization. This is because during sterilization, the central bank is essentially selling
government securities to mop up excess liquidity. The government would have to pay
interest to those who come to acquire government securities due to the sterilization
process. This is called the fiscal cost of sterilization .

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 Chapter 7
FINANCIAL MARKETS

7.1 What are the basic roles of the financial market?

In a very simple economy, there are two sets of economic agents: households and firms.
Households save and the firms invest. It is the role of the financial sector to ensure that the
savings of the household sector reaches the firms, which need the resources for investment.
In reality the economy is of course much more complex than this overly simplified system.
In a real economy, savers include not only households but also firms and government.
Similarly, investments can be made by not only firms, but also households and the
government. However, even in a more complex economy, the main function of the financial
system essentially involves the mobilization of resources from those who have surplus and
allocation of these resources to those who face deficit. In other words, the financial sector
plays the role of an intermediary by ensuring smooth flow of resources from those who have
surplus funds to those who have a shortage of funds.

Let us look at the savers’ side. People differ from each other in their risk appetite as well as
their expectations of return and liquidity of their savings. The financing system provides a
menu of saving vehicles with differing risk, return and liquidity characteristics. A more
efficient financing system, catering better to the needs of those with surplus funds, can
generate higher savings. Now, let us look at the investors’ side. The financing system also
helps in allocation of savings to those in need of funds (namely, investors). Investors have
differing needs too. An efficient financial system allocates savings efficiently and increases
the productivity of investment. In other words, for a given level of saving, more efficient
financial intermediation increases the productivity of investment. It thus seems obvious that
the more efficient the financial system, the more rapid the growth rate.

The second important role of the financial system is that of risk management. Every
business enterprise involves risk. The financial institutions provide a framework for
evaluating these risks. The financial market allows sharing, trading and transferring of risk
among different economic agents. For example, when an innovative high-technology firm
sells its equity in the financial market, it is sharing the risk of the new technology with its
shareholders. In absence of a financial market, such firms will tend to go for projects which
are safer and may be less innovative. Financial markets, by allowing the sharing of risk,
encourage future structural changes essential for maintaining a country's long-term growth
potential. Given rapid technological progress and increased role of innovation in growth
performance, the role of financial market becomes crucial.

The third role of the financial markets is to pool and communicate information efficiently, so
that market prices reflect available information.

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All these roles put the financial system at the centre of modern macroeconomics. As Stiglitz
et al (1993) suggest, “the financial system can be thought of as the "brain" of the entire
economic system, the central locus of decision making: if they fail, not only will the sector's
profits be lower than they would otherwise have been, but the performance of the entire
economic system may be impaired”.

7.2 Why and how are financial markets different from

other markets?
Financial markets are different from other markets in the economy. They are much more
complex and have a number of special characteristics, which make them rather unique.
Because of the special nature and characteristics of the financial markets, they require a
special set of rules and regulations. This section will discuss some of these characteristics in
more detail.

7.2.1 Systemic Risk

Financial markets are characterized by a complex and dynamic network of inter-relations

among major intermediaries like banks, financial institutions and securities markets. Also, a
large number of borrowers and lenders are dependent on the financial system. One of the
important characteristics of the financial markets is that it is a source of systemic risk.

Systemic risk is the risk of collapse of an entire financial system or entire market, as
opposed to risk associated with any one individual entity, group or component of a system.
It refers to the risks imposed by inter linkages and interdependencies in a system or
market, where the failure of a single entity or cluster of entities can cause a cascading
failure, which could potentially bring down the entire financial system and even severely
affect the real sector in the economy. This phenomenon is very special to the financial
market.

Over the years, systemic risks of the global financial markets have increased. Innovation in
financial tools have continued to foster the growth of risk transfer instruments, such as
derivatives and structured products, while deregulation and technological improvement have
helped to further increase the growth of cross-border activity and the entry of new market
participants. All these have increased the systemic risk of the system. Banks and financial
institutions of the world are now more dependent on each other and any shock happening to
one of the bigger financial centers of the world is likely to affect the entire global financial
system. This was evident during the housing market crisis in USA. A collapse of house prices
in USA affected the banking system and eventually snowballed into a full-fledged economic
crisis in the developed world. Most developing countries were also affected, in spite of
having little exposure to the US mortgage market.

Another thing which has contributed to this increase in systemic risk is increased ‘leverage’
in the financial system. “Leverage” typically refers to the use of borrowed funds to increase
returns on any given investment. If asset prices are rising and the cost of borrowing is low,

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then banks try to maximize their profit by increasing their exposure to rising asset prices by
borrowing as much as they can. While borrowed funds are central to the concept of
“leverage,” leveraging can be done through any instrument through which a bank can
magnify its exposure to a given asset. The ‘Leverage ratio’ is generally defined as debt-to-
equity ratio. A bank with a high debt to equity ratio is said to be more leveraged than a
bank with low debt to equity ratio. Excessive leverage by banks makes them vulnerable to
failure in the event of a sudden and substantial fall in the prices of assets they have been
financing. This increases the systemic risk in the economy. After the recent financial crisis, it
was found that banks and financial institutions had increased their leverage ratios
significantly in the recent years. Systemic risk is difficult to manage because it is greater
than the sum of individual risks facing the components of the system.

7.2.2 Asymmetric Information

Information asymmetry is a situation in which one party in a transaction has more or

superior information compared to another. This often happens in transactions where the
seller knows more than the buyer, although the reverse can happen as well. This could
potentially be a harmful situation because one party can take advantage of the other party’s
lack of knowledge.

Asymmetric information is an important characteristic aspect of the financial market.

Although asymmetric information is not something exclusive to the financial market, the
extent of this problem is relatively deeper in this market than in other markets. Asymmetric
information has received significant attention in Economics in recent times. Three Nobel
laureates George Akerlof, Michael Spence and Joseph Stiglitz have made pioneering
contributions to this field.

In financial markets, information asymmetry can happen because of a number of reasons.

For example, a borrower has much better information about his financial state than the
lender. The lender has difficulty knowing whether it is likely that the borrower will default.
To some extent, the lender will try to overcome this by looking at past credit history and
evidence of salary. However, this only gives limited information. The consequence is that
lenders will charge higher rates to compensate for the risk. If there was perfect information,
banks wouldn't need to charge this risk premium.

7.2.3 Feedback and Amplification

Information asymmetry is present not only in financial sector but in some other economic
sectors as well, but the presence of systemic risk together with information asymmetry
result in another problem in the financial system: that is, a much stronger. feedback and
amplification mechanisms than in other sectors. For example, because of the presence of
systemic risk and information asymmetry, even a rumor about a bank run can create panic
in the financial market 26. There are also issues of ‘herd behavior’ and ‘contagion’ in the
financial markets. Herd behavior is a tendency for a group of individual to mimic the actions
(rational or irrational) of a larger group. Herd behavior can be observed during stock market
bubbles/crash when there are periods of frenzied buying/selling. In India, FIIs tend to have
a disproportionately high level of influence on market sentiments and price trends. This is so
because other market participants perceive the FIIs to be infallible in their assessment of

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the market and tend to follow the decisions taken by FIIs. This ‘herd instinct’ displayed by
other market participants amplifies the importance of FIIs in the domestic stock market in
India.

These special characteristics and features of financial markets imply that these markets are
to be regulated and governed by specialized institutions. This is the reason why there are so
many different forms of financial institutions in the economy. Each of these institutions has
a role to play in either promoting the basic roles of finance or to tackle some of the
problems, which are specific to the financial markets. The roles of different financial
regulators have been discussed in Chapter 8.

7.3 Role of different financial systems: bank based financial

systems and capital market based financial systems

While all countries have both banks and capital markets acting as financial intermediaries,
their relative importance varies from country to country. Based on the relative importance
of banks and capital markets in financial intermediation, financial systems of most countries
can be categorized as either bank based or capital market-based systems.

7.3.1 Capital Market Based Financial System

In capital market-based systems, securities markets share centre stage with banks in
getting society’s savings to firms, exerting corporate control and easing risk management.
Countries with a common law tradition, strong protection for shareholder rights, good
accounting standards and low levels of corruption tend to be more market- based. The USA
and UK are the prime examples of market based financial system.

7.3.2 Bank based Financial Systems

On the other hand, bank-based economies are characterized by predominant financing of

the investment activities by banks, who are far fewer in number than shareholders in a
capital market-based economy. In bank-based systems banks play a leading role in
mobilizing savings, allocating capital, overseeing the investment decisions of corporate
managers, and providing risk management vehicles. The banks are the primary source of
long-term funds and in most bank-based economies, there is relatively little secondary
trading of financial assets.

A bank run refers to a situation when an unusually large number of depositors rush in to
withdraw their deposits, fearing that the bank may fail.

India’s financial system has traditionally been characterized as a bank-based one. However,
since the financial sector reforms initiated in 1991, stock markets have become increasingly
more important than before, in India’s economic system and the predominance of the
banking system has been somewhat reduced, although banks continue to be a dominant
source of financial intermediation.

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The next section will briefly discuss the role and contribution of different sets of financial
intermediaries in the Indian financial system.

7.4 Role and contribution of different segments in India’s

Financial Market:
7.4.1 Commercial Banks

Banks are traditional financial institutions that do the job of financial intermediation
between the savers and investors. Acceptance of deposit from the public and lending to the
investor has remained the core activity of the banking system. Apart from the core activities
of the commercial banks, many of these banks are now increasing their footprint in the
market for financial intermediation by providing services such as dematerialization,
underwriting of financial instruments (shares and debentures). In India, many banks are
offering value added services like foreign exchange transactions, merchant bank and
remittance services. As it was discussed in a previous chapter, commercial banks through
their fractional reserve system also help create liquidity in the economy.

7.4.2 Non-Banking Financial Companies (NBFCs)

Besides the commercial banking segment, another segment in the financial system, known
as Non-Banking Financial Companies plays a crucial role in facilitating transfer of funds from
the surplus to the deficit segment in the economy. According to RBI, a Non- Banking
Financial Company (NBFC) is a company registered under the Companies Act, 1956 and is
engaged in the business of loans and advances, acquisition of
shares/stock/bonds/debentures/securities issued by Government or local authority or other
securities like marketable nature, leasing, hire-purchase, insurance business and chit
business.

In India, the NBFCs are mainly equipment leasing companies, hire-purchase companies,
housing finance companies, insurance companies and merchant banking companies. Nidhi’s
and chit fund companies are also part of NBFCs in India. The role of NBFCs in both
manufacturing and services sector is significant. They play the role of an intermediary by
facilitating the flow of credit to end consumers particularly in transportation, SMEs and other
unorganized sectors. NBFCs are in a better position to cater to these segments because of
their inherent strengths in the areas of fast and easy access to market information for credit
appraisal, a well-trained collection machinery, close monitoring of individual borrowers and
personalized attention to each client as well as minimum overhead costs.

Difference between NBFCs and Commercial Banks

NBFCs are different from banks in three respects, First, an NBFC cannot accept demand
deposits; secondly, an NBFC is not a part of the payment and settlement system and as
such an NBFC cannot issue cheques drawn on itself; and finally, deposit insurance
facility of Deposit Insurance and Credit Guarantee Corporation (DICGC) is not available
for NBFC depositors unlike in case of banks.

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7.4.3 Development Financial Institutions

Development financial institutions are specialized institutions and are narrower in their
coverage as compared to commercial banks. Development financial institutions consist of
development banks, which provide medium- and long-term financial assistance to different
sectors of the economy like industry, agriculture and services. Important roles of such
financial institutions include providing adequate and timely credit to the private sector for
promoting industrialization, help the private sector to develop entrepreneurial skills,
promote development of rural areas and finance housing, small scale industries and
infrastructure development.

Examples of development financial institutions are: Industrial Development Bank of India

(IDBI), National Bank for Agricultural and Rural Development (NABARD), EXIM Bank, Small
Industries Development Bank of India (SIDBI) etc. These banks often have specialized
roles. For example, SIDBI is focused on small scale industrial units (Units in which the
investment in plant and machinery does not exceed Rs.1.00 crore). EXIM bank, on the other
hand, is focused more on international trade finance and related issues. The role of NABARD
is to facilitate credit flow for the promotion and development of agriculture, and support
allied economic activities in rural areas .

7.4.4 Mutual Funds

Mutual Funds are essentially investment vehicles where people with similar investment
objective come together to pool their money and then invest accordingly. A mutual fund as
a financial intermediary combines or pools investors' savings for collective investment in a
diversified portfolio made up of equities, debts, short-term money market instruments,
and/or other securities. A mutual fund will have a fund manager who trades the pooled
money on a regular basis. The net proceeds or losses are then typically distributed to the
investors periodically. Mutual funds play a significant role in channelizing the saving of
millions of individuals into the investment in equity and debt instruments.

Mutual funds are meant to serve the interest of several small investors who may not have
the time, experience, expertise or means of managing their investment portfolio directly on
a regular basis. They are useful for investors because they get advantage of a professional
fund manager, better diversification of portfolio, improved liquidity of their assets and
convenience. Mutual funds are also popular among retail investors because they offer the
investors a range of investment avenues with varying risk–return profile. Returns on
investment in Mutual Funds are also exempt from long term capital gains taxes.

Exchange Traded Funds (ETFs)

Mutual funds, have certain shortcomings. First, the shares of an open-end fund are priced
at, and can be transacted only at, the NAV as calculated at the end of the day. Thus,
transactions at intra-day prices are ruled out. Also, if there is a large redemption of shares
by investors, the fund may have to liquidate a substantial chunk of its portfolio. This could
trigger of tax liabilities for shareholders who continue to stay invested with the fund. In
response to these drawbacks, exchange-traded funds (ETFs) were introduced in the 1990s.
These are open-ended in structure but are traded on stock exchanges just like conventional

91
stocks. Most ETFs are based on popular stock indices. The exchange- traded feature of an
ETF offers many advantages to the investors. Because ETFs are quoted on stock exchanges,
like equity shares, and closed- end mutual funds, an investor can use a conventional
brokerage account to acquire and dispose of shares. Potential investors can place a variety
of orders like market orders, limit orders, and stop-loss orders, just the way they do for
equity shares. Shares of an ETF can be used for both margin trading and short-selling.
Mutual funds are required to disclose the composition of their portfolios only on a periodic
basis, which is typically every quarter. Consequently, investors are not aware of the current
composition of the underlying portfolio at any point in time. In contrast, the composition if
of the underlying portfolio of an ETF, is known on a daily basis.

Unlike open-ended mutual funds, shares of an ETF cannot be bought from or sold back to
the sponsor of the fund. In practice, the sponsor, will exchange large blocks of ETF shares in
kind for the securities of the underlying index. This large block of ETF shares is called a
creation unit. One creation unit is typically set equal to 50000 ETF shares. Broker-dealers
will usually purchase creation units from the fund and break them up into individual shares,
which will then be offered on the exchange to individual investors.

These broker-dealers can also redeem ETF shares by assembling creation units and
exchanging them with the fund for a basket of securities plus cash. The broker-dealers who
deal with the sponsors of ETFs, are known as Authorized Participants or APs. To acquire a
creation unit, an AP will acquire shares of the individual assets that constitute the portfolio
and exchange them with the fund sponsor. Having acquired the creation units, the APs will
sell them to retain investors. The reverse, or the redemption of a creation unit, is also
possible. An AP can handover creation units to the sponsor in exchange for basket of
securities.

The sponsor of an ETF will reveal the composition of the creation basket at the start of
every trading day. So, the APs know what exactly is required for the acquisition and
redemption of creation units. Thus, if shares of an ETF change hand on a stock exchange,
the sponsor of the fund has no role in the process. If the price of an ETF share were to
diverge significantly from its NAV, then arbitrageurs will step in. If the shares are
overpriced, then arbitrageurs will short sell ETF shares and buy creation units from the
sponsor to fulfil their delivery obligations. On the other hand, if the shares are underpriced,
they will buy ETF shares, assemble them into creation units, and sell them to the sponsor.

7.4.5 Insurance:

Insurance agencies are another set of important financial institutions that play a major role
by mobilizing savings and supplying long-term capital to the financial sector. Insurance
companies cater to various forms of insurance including life insurance, health insurance,
crop insurance and general insurance. The insurance agencies help mobilize resources by
developing a contractual saving portfolio for small investors. These agencies generate and
mobilize funds by providing the small investors a low risk saving instrument with insurance
and tax benefits.

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In the insurance sector in India, life insurance segment is much larger than the non-life
segment. The Life Insurance Corporation (LIC) of India is the biggest player in the life
insurance market segment in India. LIC accounts for approximate 66 percent of the life
insurance business in India. The insurance sector in India was completely regulated till
2000. During the year 2000, India partially deregulated the domestic insurance market and
made it open for private-sector and foreign companies. Initially, foreign companies were
allowed to hold a maximum of 26 percent share in their joint ventures with Indian
companies. In 2020, the Department for Promotion of Industry and Internal Trade (DPIIT)
has amended the foreign direct investment (FDI) policy to allow 100% FDI for insurance
intermediaries, which includes insurance brooking, insurance companies, third party
administrators, surveyors and loss assessors. Currently there are 24 licensed players
operating in the sector.

7.5 The Equity Market

The equity market in India has two segments: the primary market and the secondary
market. In the primary market, securities are offered to the public for subscription for the
purpose of raising capital or fund. Secondary market is an equity trading avenue where
already existing/pre- issued securities are traded amongst investors. Primary market and
secondary market do not work independently. There is a direct link between these two
markets.

A well-functioning stock market also generates demand for stocks by encouraging domestic
savings. The stock market provides investors with an array of assets with varying degree of
risk, return and liquidity. This increased choice of assets and the existence of a vibrant stock
market provide savers with a wider range of saving options and instruments and thereby,
induce more savings. There are a number of indicators to measure the size of a stock
market. They are as follows:

Market Capitalization: The size of the stock market is often measured by market
capitalization. Market capitalization of a certain company at time ‘t’ is calculated as the
share price of that company at time ‘t’, multiplied by the number of shares outstanding of
that public company. The sum of market capitalization of all listed companies of a stock
exchange at time ‘t’ gives the market capitalization of the stock exchange at time ‘t’.

Turnover Similarly turnover of a certain company at time ‘t’ is equal to the share price of
that company at time ‘t’ multiplied by the number of transactions of the shares of that
company in time ‘t’. The sum of turnover of all listed companies of a stock exchange at time
‘t’ gives the total turnover of the stock exchange at time ‘t’.

In India, the secondary segment of the stock market has performed well over the years.

National Stock Exchange has a total market capitalization of more than US$2.27 trillion,
making it the world's 11th-largest stock exchange as of April 2018. The BSE is the world's
10th largest stock exchange with an overall market capitalization of more than US$2.2
trillion on as of April 2018. However, the primary market in India has not Performed as well
as the secondary market. Figure 7.1 shows new capital issues by companies from the
primary market. The trends in the capital market in India found that total resources

93
mobilized through the issuance of equity declines continuously for 3 years from 2011-12 to
2014-15 and after that a huge rise is noted. Whereas debt market outflow was more during
2013-14 and 2016-17.

Figure 7.1. Resource Mobilization from the Primary Market through IPOs

7.6 Derivatives Market in India:

The two important segments of major Indian stock exchanges such as the National Stock
Exchange (NSE) and the Bombay Stock Exchange (BSE) are ‘spot’ markets and ‘derivatives’
markets. The spot market is a cash-for-delivery market where equities are traded for cash
and delivered immediately. Since June 2000, BSE and NSE started derivatives trading.
Currently, two types of derivatives are traded in NSE, namely options and futures. These
derivatives can be based on equity prices or on stock market indices. Over the years, the
turnover volume in the derivatives market has increased manifold in India. This is shown in
Table 7.1

Table 7.1. Turnover in the Equity Derivatives Market (Rs Crores)

Bombay Stock Exchange Limited (BSE) National Stock Exchange of India Limited (NSE)

Interest
Index Index Stock Stock Index Index Stock Stock
rate
Futures Options Futures Options Futures Options Futures Options
futures

2017-
3,217 8 35 0 48,10,455 13,49,21,877 1,55,97,521 96,55,010 3,21,207
18

2018-
40 2,193 17 0 55,68,915 20,33,02,404 1,61,47,010 1,25,82,374 2,45,408
19

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2019-
14,934 245,963 163 1209 67,01,072 31,14,47,325 1,49,19,551 1,23,23,407 3,60,811
20
Source: Handbook of Statistics on Indian Economy

7.7 The Debt Market:

Another extremely important market for financial system is the debt market. The debt
market can be broadly divided into government securities market and the corporate debt
market. Size of the corporate debt market is small in India. In 2020, it was estimated to be
only around 16 percent of the Indian debt market.

Governments issue securities with maturities ranging from less than a year to a very long-
term stretching up to 50 years. Typically, debt instruments with short-term maturities up to
one year (called Treasury Bills) form a part of the money market and facilitate the
Government's cash management operations, while government securities with maturities of
more than a year (called Bonds) facilitate its medium to long-term financing
requirements27. While treasury bills are the instrument bought and sold in the money
market, bonds are the instrument of the Government Securities Market. Government
securities market and the money market play extremely important roles in a country’s
economy. The primary segment of this market enables the managers of public debt to raise
resources from the market in a cost-effective manner. Government securities market also
allows the government to fund its fiscal deficit by borrowing money from the market
through the sale of government securities.

Let us now discuss the corporate bond market. A liquid and well-functioning corporate bond
market can play a critical role in supporting economic development as it supplements the
banking system to meet the requirements of the corporate sector for long-term capital
investment and asset creation. RBI and SEBI have taken a number of measures to promote
the corporate debt market. Notably, the FIIs have been allowed to invest in this market.
Currently, the limits are 6 per cent of outstanding stock for government securities, 2 per
cent for state development loans (SDLs) and 15 per cent. In corporate debt, of the Rs 4.3
lakh crore limit in March 2020, the utilization has been Rs. 1.56 lakh crore i.e., 36 per cent
of total limits. The corporate bond market in India is still not very well developed.

Within the corporate debt market, the private placement market is gradually becoming
important. In the private placement market, resources are raised through arrangers
(merchant banking intermediaries) who place securities with a small number of financial
institutions, banks, mutual funds and high net-worth individuals. Though the private 27
Government securities, also called the gilt-edged securities or G-secs, are free from default
risk and they provide reasonable returns placement market can involve issue of securities,
debt or equity, in practice it is essentially a market for corporate debt.

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 Chapter 8
REGULATORY INSTITUTIONS IN INDIA

8.1 Role of regulatory institutions in a market-based

economy
In a market-based economy, there is a need for a proper legal framework within which the
market can operate. The numerous building blocks of a market economy need to perform
their duties within the broad contours of this legal framework. Any sort of deviation from
this framework would lead to market failure; that is, markets fail to perform their primary
function. In today’s globalized world, deviation from the legal framework by a single
financial institution could lead to systemic risk and thereby jeopardize the entire economic
structure. Hence, proper monitoring and supervision is crucial to keep up the momentum in
the economy’s growth and stability. A host of regulatory institutions such as RBI, SEBI,
IRDA, PFRDA, FMC etc play a crucial role in ensuring the smooth functioning of the financial
system in India. The aim of this chapter is to discuss the role of these institutions in the
Indian economy.

8.2 The Reserve Bank of India (RBI)

The Reserve Bank of India (RBI) is the central bank of India. A central bank is the apex
body of a country’s financial system. The role of a central bank is crucial in maintaining the
orderly development of the market-based economy. The Reserve Bank of India was
established on April 1, 1935 under the Reserve Bank of India Act, which was passed in the
year 1934.

Under the Banking Regulation Act, 1949, the RBI has been vested with extensive powers of
supervision and control over banks. The RBI prescribes regulations for sound functioning of
banks and financial institutions, including non-banking finance companies. The RBI’s
regulatory functions relating to banks cover their establishment (that is, licensing), branch
expansion, liquidity of their assts, management and methods of working, amalgamation,
reconstruction and liquidation. The objective of such supervision and control is to ensure the
development of a sound and stable banking system in the country. The control by the RBI is
exercised through periodic inspections of banks and follow-up action and by calling for
returns and other information from them periodically.

In addition to the supervision and control of commercial banks, the RBI performs a wide
range of functions; particularly it

• Acts as currency authority; that is, it regulates the issue of currency in the country

96
• Controls money supply and credit (explained in Chapter 5)
• Manages foreign exchange reserves
• Serves as banker to the Government (It transacts all banking business of the
Government which involves the receipt and payment of money on behalf of the
government and carrying out its remittance and other banking operations.)
• Serves as Bankers Bank (i.e. RBI holds a part of the cash reserves of banks, lends them
funds for short periods and provides them with centralized clearing and cheap and quick
remittance facilities)

8.3 The Securities and Exchange Board of India (SEBI)

SEBI is the regulator for the securities market in India. SEBI Act 1992, was enacted to
empower SEBI with statutory powers for:

• protecting the interests of investors in securities,

• promoting the development of the securities market, and
• regulating the securities market.

Its regulatory jurisdiction extends over corporates in the issuance of capital and transfer of
securities, in addition to all intermediaries and persons associated with securities market.
SEBI can conduct enquiries, audits and inspection of all concerned and adjudicate offences
under the Act. It has powers to register and regulate all market intermediaries and also to
penalize them in case of violations of the provisions of the Act, Rules and Regulations made
there under. SEBI has full autonomy and authority to regulate and develop an orderly
securities market.

8.4 Insurance Regulatory and Development Authority

(IRDA)
IRDA was constituted as an autonomous body to regulate and develop the business of
insurance and re-insurance in the country under the Insurance Regulatory & Development
Authority Act, 1999. The key objective of IRDA is to promote market efficiency and ensure
consumer protection in the insurance sector. Development of IRDA was also important as
the insurance sector was opening up in India and a number of private and foreign players
were entering the insurance market.

Section 14 of IRDA Act, 1999 lays down the duties, powers and functions of IRDA. Some of
these are stated below:

• To regulate, promote and ensure orderly growth of the insurance business and re-
insurance business.
• Protection of the interests of the policy holders in matters concerning assigning of policy,
nomination by policy holders, insurable interest, settlement of insurance claim,
surrender value of policy and other terms and conditions of contracts of insurance;
• Promoting efficiency in the conduct of insurance business;

97
• Promoting and regulating professional organizations connected with the insurance and
re-insurance business;
• Regulating investment of funds by insurance companies;
• Adjudication of disputes between insurers and intermediaries or insurance
intermediaries.

8.5 Pension Fund Regulatory and Development Authority

(PFRDA)
In India, formal pension schemes only cover 12 percent of the working population. Only
government employees and workers in the organized private sector were covered by these
schemes. It was felt necessary to increase the coverage of the government pension scheme.
But the existing form of pension support for government employees was also putting fiscal
pressure on the government. These two considerations led to pension reforms in India for
both Central Government and for unorganized sectors.

On January 1, 2004, the government launched a New Pension System (NPS). The move
shifted all new central government employees (except for armed forces) to a defined
contribution plan from the current non-contributory defined benefit scheme, shifting the risk
of retirement financing from the government to individuals. Participants in the new scheme
will have access to a range of investment products from selected private sector companies.

The NPS would be open on a voluntary basis to non-government workers, including those in
the unorganized private sector. An important element of the reform was to set up a proper
regulatory framework. The Pension Fund Regulatory & Development Authority Act was
passed on 19th September, 2013 and the same was notified on 1st February, 2014. PFRDA
is regulating NPS, subscribed by employees of Govt. of India, State Governments and by
employees of private institutions/organizations & unorganized sectors.

The role of Pension Fund Regulatory and Development Authority (PFRDA) is to consolidate
the initiatives taken so far regarding the full New Pension System and expanding the reach
of the distribution network of NPS. The NPS architecture allows a subscriber to monitor
his/her investments and returns under NPS, the choice of Pension Fund Manager (PFM) and
the investment option would also rest with the subscriber. The design allows the subscriber
to switch his/her investment options as well as pension funds. PFRDA has set up a Trust
under the Indian Trusts Act, 1882 to oversee the functions of the PFMs.

PFRDA also intends to intensify its effort towards financial education and awareness as a
part of its strategy to protect the interest of the subscribers. PFRDA’s efforts are an
important milestone in the development of a sustainable and efficient voluntarily defined
contribution-based pension system in India.

8.6 Forward Markets Commission (FMC)

The Forward Markets Commission (FMC) was set up in 1953 under the Forward Contracts
(Regulation) Act, 1952. FMC is the commodities market regulator in India. It is a statutory

98
body headquartered at Mumbai. However, FMC is not an independent body and it is
overseen by the Ministry of Consumer Affairs, Food and Public Distribution, Govt. of India.

Some of the main regulatory measures imposed by the FMC include daily mark to market
system of margins, creation of trade guarantee fund, back-office computerization for the
existing single commodity exchanges, online trading for the new exchanges,
demutualization for the new exchanges, one-third representation of independent directors
on the boards of existing exchanges etc. These regulations have led to the creation of a
slew of modern commodity exchange boards in India like the National Commodity &
Derivatives Exchange Limited (NCDEX) and Multi Commodity Exchange of India Limited
(MCX). FMC also disseminates trading data for each of the 2 national & 21 regional
exchanges of futures trading in commodities in the country.

The functions of FMC are to:

a) To advise the Central Government in respect of the recognition of or the withdrawal

of recognition from any association or in respect of any other matter arising out of
the administration of this Act;
b) To keep forward markets under observation and to take such action in relation to
them as it may consider necessary, in exercise of the powers assigned to it by or
under this Act;
c) To collect and whenever the Commission thinks it necessary, to publish information
regarding the trading conditions in respect of goods to which any of the provisions of
this Act is made applicable, including information regarding supply, demand and
prices, and to submit to the Central Government periodical reports on the operation
of this Act and on the working of forward markets relating to such goods;
d) To make recommendations generally with a view to improving the organization and
working of forward markets;
e) To undertake the inspection of the accounts and other documents of [any recognized
association or registered association or any member of such association], whenever
it considers it necessary; and
f) To perform such other duties and exercise such other powers as may be assigned to
the Commission by or under this Act, or as may be prescribed.

8.7 Stock Exchanges in India

Stock exchange performs an important part in the economic life of a country, acting as a
free market for securities where prices are determined by the forces of supply and demand.
Apart from the above basic function it also assists in mobilizing funds for the Government
and the Industry.

In India, the stock exchanges have been entrusted with the primary responsibility of
undertaking market surveillance. Information relating to price and volume movements in
the market, broker positions, risk management, settlement process and compliance
pertaining to listing agreement are monitored by the exchanges on a real time basis as part

99
of their self-regulatory function. In India, there are numerous stock exchanges among
which the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are the
leading ones. The stock exchanges offer a wide range of products including equity shares,
Exchange Traded Funds (ETF), mutual funds, debt instruments, Index futures and Options,
stock futures and options and Currency futures etc.

100
 Chapter 8
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Mishkin, Frederic S. Macroeconomics: Policy and Practice (Pearson Series in Economics).

Prentice Hall, 2011

Iyengar, Murali. Money Matters: Macroeconomics and Financial Markets. India, SAGE
Publications, 2011.

Arestis, Philip, and Malcolm Sawyer. Economic and Monetary Union Macroeconomic Policies:
Current Practices and Alternatives. Springer, 2013.

Karakitsos. Macroeconomics and Financial Markets. United Kingdom, Wiley, 2005.

Wass, D. (1978) ‘The changing problems of economic management’, Economic Trends, 293,
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