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NCERT NOTES
ECONOMICS
12th Standard

Introductory
Macroeconomics

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Content Sheet

1. Introduction 3
2. National Income Accounting 6
3. Money and Banking 12
4. Determination of Income and Employment 18
5. Government Budget and the Economy 21
6. Open Economy Macroeconomics 31
Content Sheet

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1 Introduction

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

Distinction between Microeconomics and Macroeconomics:

MICROECONOMICS MACROECONOMICS

It studies the behaviour of individual It tries to address situations facing the

or small economic agents. economy as a whole.

It studies the aggregate effects of the

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

It focuses on consumers choice, test It focuses on consumption levels in an

and preference and income. economy and national income.

Macroeconomic policies are pursued

The decision makers are any
by the State itself or statutory bodies
individual, firms, households,
like the Reserve Bank of India (RBI),
business units, etc.
Securities and Exchange Board of India
(SEBI) and similar institutions.

The ultimate goal is profit The ultimate goal is macroeconomic

maximisation. stabilization.

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

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Importance of Macroeconomic Studies: countries of Europe and North America

Adam Smith, the founding father of fall by huge amounts. It affected other
modern economics, had suggested that countries of the world as well.
if the buyers and sellers in the market y Demand for goods in the market was
take decisions based on their own self- low, many factories were lying idle,
interest, there is no need to think of the workers were thrown out of jobs and
wealth and welfare of the country as a unemployment rate touched a new
whole separately. But it was found that heights.
in some cases: y These events led to persistent
y The markets did not or could not exist. development of macroeconomic
y The markets existed but failed to frameworks explained by Keynes.
produce equilibrium of demand and y His approach was to examine the
supply. working of the economy in its entirety
y In a large number of situations, society and examine the interdependence of
(or the State, or the people as a the different sectors.
whole) had decided to pursue certain
important social goals unselfishly (in
areas like employment, administration, Unemployment rate: It is defined
defence, education and health) for as the number of people who are
which some of the aggregate effects of not working and are looking for
the microeconomic decisions made by jobs divided by the total number of
the individual economic agents needed people who are working or looking for
to be modified. jobs.
Therefore, it is crucial to study the
effects of taxation and other budgetary
policies, money supply, interest rates, Interesting Points:
wages, employment and output in the y Today, the economic system of most of
market. the developed countries is capitalistic
in nature, where the production activity
Emergence of Macroeconomics: is mainly carried out by capitalist
y Macroeconomics emerged as a separate enterprises.
subject in the 1930s due to John y A typical capitalist enterprise has one
Maynard Keynes, a British economist. or several entrepreneurs, who exercise
y The classical school of thought, before control over major decisions and bear
Keynes, believed that all the labourers a large part of the risk associated with
who are ready to work will find the enterprise.
employment and all the factories will y Factors of Production: They are the
be working at their full capacity. inputs require for the production of
y However, the Great Depression of 1929 goods and services. The factors of
Introduction

and the subsequent years saw the production are capital, land, labour and
output and employment levels in the entrepreneur.

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Chapter 1
y Revenue: The money that is earned y Investment expenditure: It is the
by enterprises by selling goods and expenditure made out of profits in
services is called revenue. buying new machinery or to build new
y Profits: It is the earnings of the factories, so that production can be
entrepreneurs. It is the part of the expanded. These expenses which raise
revenue that remained after the productive capacity.
payments of rent (on land), interest (on
capital) and wages (on labour).

Introduction

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2 National Income Accounting

Chapter 2

National income accounting is referred

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

Circular Flow of Income:

It states that income in a simple
economy flows in a circular loop, as
Fig 2.1: Circular flow of income
follows:
y There is no government or the external
sector (Foreign Firms) in this simple
economic model. Added Method, Expenditure Method
y The households receive their income and Income Method.
from the firms, for the services that
they perform for the firms. The Product Method:
y Households dispose of their entire y It is also known as value-added method.
earnings only in one way by spending y This method is used to calculate the
it entirely on goods and services aggregate value of goods and services
produced by the domestic firms (that is, produced by all the firms in an economy
households do not save anything). during a financial year.
y In other words, factors of production y To calculate aggregate value of
use their remunerations to buy the production, the value of intermediate
goods and services which they assisted goods is subtracted from the value of
in producing. production of the firm.
y Thus, the entire income of the economy, Value Added by a firm = Value of
comes back to the producers in the production of the firm – Value of
form of sales revenue. intermediate goods
y The firms again use this revenue to pay y Value of aggregate amount of goods
for factor services and thus the loop and services produced by the economy
continues again. can be measured by summing the
gross value added of all the firms in
Based on this concept, the aggregate an economy during a year and the
National Income Accounting

value of goods and services can be value so obtained is the Gross Value
calculated through various ways. Added (GVA)
y If Depreciation is reduced from GVA
Methods to Calculate Aggregate Value to account for the normal wear and
of Production: tear of the Capital Factors of
There are three methods to calculate Production, it is said as Net Value Added
the said value, that is: Product or Value- (NVA).

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Chapter 2
received by all the factors of production
Depreciation: It is the deduction of taken together (final expenditure is
value, which is made from the value the spending on final goods, it does
of gross investment, as during use not include spending on intermediate
throughout the year regular wear and goods).
tear happens in capital equipment like y Revenues earned by the firms put
machinery. So this deduction accom- together must be distributed among
modates for this wear and tear. After the factors of production (land,
adjusting the GVA for relevant Product labour, capital and entrepreneurship)
taxes and Subsidies, GDP is obtained. as salaries, wages, profits, interest
earnings and rents. Let there be M
number of households in the economy.
Expenditure Method: y Therefore, GDP under this method is
y It is an alternative method to calculate obtained by adding up salaries, wages,
the GDP. profits, interest earnings and rents.
y Under this method, the aggregate value
of all goods and services produced in a Factor Cost, Basic Prices and Market
year, are calculated by looking on the Prices:
expenditure made by different sectors. y Net Production Taxes: Production
y In this method, following expenditures taxes and subsidies that are paid or
are added: received in relation to production
⚪ The final consumption expenditure and are independent of the volume
made by the firms on the goods and of production such as land revenues,
services produced by other firms. stamp, and registration fee.
⚪ The households which undertake Net Production Taxes = Production
consumption expenditure on various Taxes – Production Subsidies.
goods and services. y Net Product Taxes: Product taxes and
⚪ The final investment expenditure subsidies, are paid or received per unit
incurred by other firms on the capital or product, e.g., excise tax, service tax,
goods produced by a firm. export and import duties etc.
⚪ The expenditure (both consumption Net Product Taxes = Product Taxes
and investment) incurred by the – Product Subsidies.
government on the final goods and y Factor cost: It includes only the payment
services produced by firm. to factors of production; it does not
National Income Accounting

⚪ The export revenues that the firms include any tax or subsidy.
earn by selling their goods and y Basic prices: In addition to the factor
services abroad. cost, they include the net production
taxes but not net product taxes.
Income Method: y Market prices: Net Product taxes are
y The sum of final expenditures in the added to the basic prices. (Market
economy must be equal to the incomes prices include both the Indirect Taxes.)

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

GVA at basic price = GVA at factor costs + Net production taxes

GVA at market price = GVA at basic prices + Net product taxes

Some other Macro-Economic Identities of production of the rest of the world

Gross Domestic Product: employed in the domestic economy.
y It measures the aggregate production y Factor income earned by the domestic
of final goods and services taking place factors of production employed in
within the domestic economy during a the rest of the world – Factor income
year. earned by the factors of production of
Any citizen of India working abroad the rest of the world employed in the
and earning wages will be included domestic economy, is also called the
in the GDP of that particular country Net Factor Income from Abroad (NFIA).
but not in the GDP of India.
However, citizens of India even work Net National Product (NNP):
abroad and contribute to the Indian y It is the net value of national output
Economy from their earnings outside after subtracting depreciation.
the Domestic Territory of India. y Depreciation is the certain amount of
capital which is consumed due to wear
Gross National Product (GNP): and tear. It does not form the part of
y It measures the monetary value of all the anyone’s income and hence should
finished goods and services produced be deducted to get a more accurate
by the country’s factors of production measure.
irrespective of their location.
Net National Product (NNP) = Gross
National Income Accounting

GNP = GDP + Net factor National Product (GNP) – Depreciation

income from abroad
Personal Income:
y GNP = GDP + Factor income earned It is that part of the National Income,
by the domestic factors of production which is received by the households.
employed in the rest of the world – Following amounts are to be adjusted
Factor income earned by the factors for in the NI to obtain personal income:

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Chapter 2
y Undistributed Profits (UP): The part National Disposable Income:
of profit earned by the firms and y It is to give an estimate about the total
government enterprises, which is not amount of goods and services, that the
distributed to the factors of production. domestic economy has at its disposal.
y Corporate Tax: Which is imposed on the National Disposable Income = Net
earnings made by the firms and does National Product at market prices +
not accrue to the households. Other current transfers from the rest of
y Net interest payments made by the world.
households: The interest paid by Other current transfers from rest of the
the households to the firms or the world, include amounts received on
government for any past loan/borrowing account of gifts, aids, etc.
of any kind taken by them, adjusted
by any interest payment that the Private Income:
households may receive from the firms Private Income = Factor income from
or the government. net domestic product accruing to the
y Transfer payments to the households private sector + National debt interest +
from the government and firms: Net factor income from abroad + Current
Transfer payments that the households transfers from government + Other net
receive from government and firms (for transfers from the rest of the world.
example pensions, scholarship, prizes
etc.) Nominal and Real GDP
Personal Income (PI) ≡ NI – Undistributed Real GDP:
profits – Net interest payments made by y It is calculated in a way such that the
households – Corporate tax + Transfer goods and services are evaluated at
payments to the households from the some constant set of prices.
government and firms. y As these prices remain fixed, the
changes in Real GDP over different years
Personal Disposable Income: are thus only when the real volume of
y It refers to personal income minus taxes production undergoes change.
at a personal level. y It provides a more precise picture of a
y It measures the amount of net income nation’s actual rate of economic growth.
that remains after households pay all When calculating real GDP, a base year is
their tax levies. selected to control for inflation; the real
The Personal Tax Payments (income tax GDP figures capture the quantities of
National Income Accounting

y
etc.) and Non-tax Payments (such as goods produced in different years using
fines etc.) are deducted from PI, and the prices from the same base year.
then we obtain what is known as the
Personal Disposable Income. Nominal GDP:
Personal Disposable Income = PI – y It is simply, the GDP which is calculated
Personal tax payments – Non-tax at the current prevailing prices in the
payments market.

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y It includes all of the changes in market y Uniformity in Distribution of GDP: It is

prices that have occurred during the to be understood, that if the GDP rise
current year due to inflation or deflation. is only concentrated in the hands of a
y The market price of GDP few individuals/ firms, it may not mean
increased prosperity for all the residents
GDP Deflator: of a nation.
y It is the ratio of nominal GDP to real y Non-monetary exchanges: Many
GDP. productive activities, like the domestic
y This ratio gives us an idea that how services by the women at home, barter
prices in an economy have moved exchanges happening in the informal
during the subsequent years (Nominal sectors etc. are not translated into
GDP), in relation to the prices of a base monetary terms, and hence often not
year, which are used to determine the counted in GDP estimations of a country.
Real GDP. This may lead to underestimation of
GDP, not giving a clear idea about the
Consumer Price Index (CPI): productive activities and the well being
y It is another way to measure the change of a country.
of prices in an economy. y Externalities: Externalities refer to
y Generally expressed in percentage the benefits (or harms) a firm or an
terms, this is the index of prices of a individual causes to another for which
given basket of commodities which are they are not paid (or penalised).
bought by the representative consumer. ⚪ For example: During the course
y The price for the said basket of of manufacturing, an industry
commodities is calculated for a pre- may pollute a local river or lake,
determined base year and compared impacting the fish in the waterbody
to the price for the same basket of and in turn hampering the catch
commodities in the current year. that the fishermen may be able to
y The increase/decrease of prices in obtain. GDP being an estimation
the current year over the base year is of people’s welfare may be
represented in percentage terms. overestimated by not accounting
y Like CPI, the index for wholesale prices for such negative externalities
is called Wholesale Price Index (WPI). like pollution, environmental
degradation etc.
GDP and People’s Welfare: However, there may also be positive
National Income Accounting

Generally, higher levels of GDP are externalities.

understood as better prosperity and
well-being for the people, residing in Interesting Points:
that economy. y Final Goods: Products which will not go
However, there are certain other factors through any further stages of production
to consider apart from just GDP growth: and are meant for final consumption.

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Chapter 2
y Intermediate Goods: Goods used as in a short term instead they have a long
inputs in the manufacturing of other life and undergo normal wear and tear.
goods. (example: Steel sheets used in (example: Television, Radio etc.)
making automobiles). To estimate the y Flow Variables: Concepts that are
value of output, the value of Final Goods defined over a period of time. (example:
in monetary terms is considered, as the salary, profit etc. as they are defined for
value of Final Goods already include the a particular period of time.)
value of all the inputs that have been y Stock Variables: Concepts that are
consumed/used in their production. defined at a particular point of time.
y Consumption Goods: Goods that are (example: Buildings or Machines in a
consumed as and when they are factory etc.)
purchased by the ultimate consumer. y Gross Investment: That part of the
Examples include: Food, clothing, final output that comprises of capital
services like recreation etc. goods.
y Capital Goods: Goods of durable y Net Investment: New addition to capital
character, used to facilitate the stock in an economy. [Net Investment =
production process and to transform Gross investment – Depreciation].
other goods but not get transformed y Inventory (a Stock Variable): The
themselves. Examples include: stock of unsold finished goods, or
Machinery, Implements etc. semi-finished goods, or raw materials
y Consumer Durables: Goods meant for which a firm carries from one year to
consumption, but do not get used up the next.

National Income Accounting

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3 Money and Banking

Chapter 3

Money is the commonly accepted y Store of Value: Money is not perishable,

medium of exchange. In a modern and its storage costs are also
economy, money forms the cornerstone considerably lower. It is also acceptable
in enabling varied economic exchanges to anyone at any point of time. Thus,
between varied parties. money can act as a store of value for
individuals.
In an economy which consists of only
one individual there cannot be any Demand for Money and Supply of
exchange of commodities and hence Money
there is no role for money. However, if Demand for Money:
there is more than one economic agent It tells us as to what makes people,
who engage themselves in transactions desire a certain amount of money. It is
through the market, money becomes determined by:
an important instrument for facilitating y The value of transactions: Money is
these exchanges. required to conduct transactions; the
value of transactions determines the
Functions of Money: money people want to keep. The larger
y Medium of Exchange: By overcoming is the quantum of transactions to be
the limitation of double coincidence of made, the larger is the quantity of
wants money acts as a medium in terms money demanded.
of which different commodities can be y Income Levels: Quantum of transactions
measured and hence exchanged. depends on the income levels. A rise in
y Unit of Account: The value of all kinds income will lead to rise in demand for
of different goods and services can money.
be expressed in terms of money. y Interest rates: At higher interest rate,
For example: the value of a certain demand for money comes down as
wristwatch is Rs 500, which means people park their money (savings) in
that the wristwatch can be exchanged interest earning bank deposits and vice-
for 500 units of money, where a unit of versa.
money is rupee in this case.

Note:
y For well-functioning, the value of money must be sufficiently stable. A rising price
level may erode the purchasing power of money, which means the same unit of
money can purchase less of a commodity.
y It may be noted that any asset other than money can also act as a store of
Money and Banking

value, e.g. gold, landed property, houses or even bonds (to be introduced shortly).
However, they may not be easily convertible to other commodities and do not have
universal acceptability.

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Chapter 3
Supply of Money: ⚪ This difference between these two
In a modern economy, there are many types of interest rates, called the
forms of money including cash, bank ‘spread’. It is the profit appropriated
deposits etc. The supply of these are by the bank.
created by two types of institutions: ⚪ People prefer to keep money in
Central Bank of the economy and the banks because banks offer to pay
Commercial Banking System. some interest on any deposits
y Central Bank: made. Also, it may be safer to keep
⚪ It is a very important institution in excess funds in a bank, rather than
a modern economy. Almost every at home.
country has one central bank. ⚪ Cheques and debit cards make
⚪ India got its central bank in 1935. Its transactions more convenient and
name is the ‘Reserve Bank of India’. safer, even when they do not earn
⚪ It issues the currency of the country. any interest.
⚪ It controls money supply of the ⚪ However, a bank must balance its
country through various methods, lending activities to ensure that
like bank rate, open market sufficient funds are available to
operations and variations in reserve repay any depositor on demand, to
ratios. maintain depositor confidence.
⚪ It acts as a banker to the government.
⚪ It is the custodian of the foreign Money Creation by the Banking System:
exchange reserves of the economy. y Money creation is a process by which
⚪ It also acts as a bank to the banking the money supply of a country is
system. increased. Banks play a crucial role in
money creation.
y Money is created by banks through
Note: Currency issued by the central lending activities. Banks can lend
bank can be held by the public or by because they do not expect all the
the commercial banks, and is called depositors to withdraw what they have
the ‘high-powered money’ or ‘reserve deposited at the same time.
money’ or ‘monetary base’ as it acts y When the banks lend to any person, a
as a basis for credit creation. new deposit is opened in that person’s
name. Thus, the total money supply
increases, as these new deposits are
y Commercial Banks: added to the already existing deposits
⚪ They accept deposits from the with the bank.
public and lend out part of these
Money and Banking

funds to those who want to borrow. Money Multiplier:

⚪ The interest rate paid by the banks y It is a concept, through which money
to depositors is lower than the rate creation by the banking system can be
charged from the borrowers. understood.

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y Assume that a bank gets an initial form in the short term. This ratio is
deposit of Rs.100. The CRR for instance called Statutory Liquidity Ratio or SLR.
is say 10%. Meaning that the bank can
lend 90% of the deposit, which is Rs 90. Policy Tools to Create Money Supply:
y For these Rs.90 that have been lent, RBI plays a very important role as the
a new account in the name of the only issuer of currency in India, and also
borrower will be opened in the bank. provides funds to the commercial banks.
y After opening a new bank account, the Being ready to lend to the banks, at all
total desists with the bank is Rs (100 + times is another important function of
90) = Rs. 190. RBI as the Lender of Last Resort.
y Now, if again 90 % of this amount would RBI uses Quantitative as well as
be lent. This cycle will continue till the Qualitative methods to control money
required reserve will itself become the supply in the market.
original Rs.100.
y This process is called the money Quantitative Methods:
multiplier and it increases the money y This method uses tools (also known
supply till the extent of 1/ Cash Reserve as monetary policy instruments) such
Ratio. as CRR, SLR, Bank rate, Open Market
Operations (OMOs), to control the
Money Multiplier = 1/ Cash Reserve Ratio supply of money in the market. To
control money supply RBI changes the
y Thus, with the Cash Reserve Ratio of rates of such instruments based on the
10%, initial deposits of Rs.100 create requirements.
deposits of 1/10% * 100 = Rs.1000. y Open Market Operations: It refers to
buying and selling of government bonds
Limits to Credit Creation: in the open market. This function is
y The RBI determines a limit on the entrusted to the RBI.
amount that banks can lend, to ensure ⚪ When RBI buys a Government bond
that no bank is Over Lending. in the open market, it pays for it
y It also decides a certain percentage of by giving a cheque. This cheque
deposits which every bank must keep increases the total amount of
as reserves. This is a legal requirement reserves in the economy and thus
and is binding on the banks. This is increases the money supply.
called the ‘Required Reserve Ratio’ or ⚪ Selling of a bond by RBI to private
the ‘Reserve Ratio’ or ‘Cash Reserve individuals or institutions leads to
Ratio’ (CRR) reduction in quantity of reserves
⚪ CRR is the percentage of deposits and hence the money supply.
Money and Banking

which a bank must keep as cash ⚪ There are two types of open market
reserves with the bank. operations: outright and repo.
y Apart from the CRR, banks are also Outright open market operations
required to keep some reserves in liquid are permanent in nature: when the

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Chapter 3
central bank buys these securities Qualitative Methods:
(thus injecting money into the y It includes persuasion by the Central
system), it is without any promise to bank in order to make commercial
sell them later. banks discourage or encourage lending,
⚪ Similarly, when the central bank sells which is done through moral suasion,
these securities (thus withdrawing margin requirement, etc.
money from the system), it is without y Moral Suasion: It is a moral act of
any promise to buy them later. As a persuasion appeal aimed to influence
result, the injection/absorption of or change behaviour using verbal or
the money is of permanent nature. rhetorical techniques.
y Repurchase agreement (Repo): When y Margin Requirement: This is the
the RBI buys the security, this agreement difference between the value of the
of purchase also has specification about security being provided as collateral
date and price of resale of this security and the loan being granted.
(The lending Interest Rate is called repo
rate). Demand and Supply of Money: A
y Reverse Repo: is an agreement where Detailed Analysis:
instead of outright sale of securities y Money is the most liquid of all assets
the central bank may sell the securities and can be exchanged for other
through an agreement which has a commodities very easily.
specification about the date and price y On the other hand, it has an opportunity
at which it will be repurchased. The rate cost of the interest foregone, that could
at which the money is withdrawn in this have been earned by putting that money
manner is called the reverse repo rate. into for instance a Fixed Deposit, instead
⚪ The Reserve Bank of India conducts of holding it in cash.
repo and reverse repo operations at y While deciding on the amount of
various maturities: overnight, 7-day, money to be held at a certain point
14- day, etc. This type of operations of time, the consideration of the
has now become the main tool of trade-off between the advantage of
monetary policy of the Reserve Bank liquidity and the disadvantage of
of India. the foregone interest, has to be
y Bank rate: It is the rate at which RBI considered. Demand for money
gives loans to the commercial banks. By balance is thus often referred to as
changing it, the money supply can be liquidity preference.
influenced. Due to an increase in the y Money is held for two broad motives:
bank rate, loans taken by commercial transaction motive and speculative
banks become more expensive; this motive.
Money and Banking

reduces the reserves held by the

commercial bank and hence decreases Transaction Motive:
money supply and vice-versa in case of y The principal motive for holding money
decrease in the bank rate. is to carry out transactions.

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y The expenditure pattern generally does holding into bonds, to make profits in
not meet our receipts, that is the time the future.
at which money is received and the time y However, if they speculate that the
at which expenditure transactions are prices of bonds will go down in the
conducted from that amount of money, future, they will convert their current
are different. bond holdings into money, to prevent
y For instance, salary of Rs.100 is received future losses.
on the first day of the month, but
expenditures from this amount are Supply of Money:
evenly spread throughout the month. y The things that constitute money are as
y While transactions are conducted, follows:
money changes hand that is, it moves y Currency notes and coins issued by the
from one entity to other. monetary authority of the country.
y The number of times a unit of money ⚪ In India currency notes are issued by
changes hands during the unit period the Reserve Bank of India (RBI).
is called the velocity of circulation of ⚪ Coins are issued by the Government
money of India.
y The total value of annual transactions in y The balance in savings, or current
an economy includes transactions in all account deposits, held by the public in
intermediate goods and services and is commercial banks is also considered
much greater than the nominal GDP. money since cheques drawn on these
y However, normally, there exists a stable, accounts are used to settle transactions.
positive relationship between value of ⚪ Such deposits are called Demand
transactions and the nominal GDP. Deposits, as they are available on
y An increase in nominal GDP implies demand of the account holder.
an increase in the total value of y Deposits having a fixed period to
transactions and hence a greater maturity for example fixed deposits.
transaction demand for money. ⚪ Such deposits are referred to as
y Transaction demand for money is time deposits.
positively related to the real income
of an economy and also to its average Legal Definitions of Money Supply:
price level. y The value of the currency notes and
coins is derived from the guarantee
Speculative Motive: provided by the issuing authority (the
y Speculation means the assumptions RBI).
about the future value of a commodity/ y The value of the paper itself in a Rs.100
asset etc. note is negligible. RBI will be responsible
Money and Banking

y In case people in an economy, have for giving the person purchasing

positive speculation about the future power equal to the value printed on
prices of an asset like say bonds etc. the note, hence providing it value and
they would convert their current money acceptability.

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Chapter 3
y Currency notes and coins are therefore y M1 and M2 are known as Narrow Money.
called fiat money. They do not have M3 and M4 are known as Broad Money
intrinsic value like a gold or silver coin. y These measures from M1 to M4 are in
y Currency notes and coins are also the decreasing order of liquidity (M1
called legal tenders as they cannot be being the most liquid and M4 being the
refused by any citizen of the country for least liquid). M3 is the most commonly
settlement of any kind of transaction. used measure of Money Supply. Known
y Cheques drawn on savings or current as aggregate monetary resources.
accounts, however, can be refused
by anyone as a mode of payment. Demonetisation:
Hence, demand deposits are not legal y It is an act of cancelling the legal tender
tenders. status of a currency unit in circulation.
y The total stock of money in circulation y The Government of India, in the year
among the public at a particular point 2016, demonetised currency notes of
of time is called money supply (Stock Rs 500 and Rs 1000, with an aim to
Variable). tackle the problem of corruption, black
y RBI publishes figures for four alternative money, terrorism, and circulation of
measures of money supply, viz. M1, M2, fake currency in the economy.
M3 and M4, defined as follows: y Some of the positive impacts of
⚪ M1 = CURRENCY (NOTES PLUS demonetisation:
COINS) HELD BY THE PUBLIC + NET ⚪ Improved tax compliance.
DEMAND DEPOSITS HELD BY THE ⚪ Savings of more individuals were
COMMERCIAL BANKS. channelized into the formal financial
 Note: Only deposits of the system.
public held by the banks are to ⚪ Banks have more resources at their
be included in money supply. disposal which can be used to
The interbank deposits, which a provide more loans at lower interest
commercial bank holds in other rates.
commercial banks, are not to ⚪ Demonstration of State’s decision to
be regarded as part of money put a curb on black money, showing
supply. that tax evasion will no longer be
⚪ M2 = M1 + SAVINGS DEPOSITS WITH tolerated.
POST OFFICE SAVINGS BANKS ⚪ Tax evasion will result in financial
⚪ M3 = M1 + NET TIME DEPOSITS OF penalty and social condemnation.
COMMERCIAL BANKS ⚪ Tax compliance will improve and
⚪ M4 = M3 + TOTAL DEPOSITS corruption will decrease.
WITH POST OFFICE SAVINGS ⚪ Households and firms have begun
Money and Banking

ORGANISATIONS (EXCLUDING to shift from cash to electronic

NATIONAL SAVINGS CERTIFICATES) payment technologies.

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4 Determination of Income and

Employment
Chapter 4

Determination of income and ⚪ Consumer Demand is the sum of

employment is the core of the subject Autonomous Consumption and
matter of macroeconomics. Aggregate Induced Consumption.
demand and aggregate supply together ⚪ Marginal propensity to consume
determine the level of income and (MPC): It is the change in
employment in an economy. consumption per unit change in
income. MPC lies between 0 and 1,
Aggregate Demand and Its Components: this means that as income increases
Aggregate demand is the total demand wither the consumer does not
for all goods and services produced in an increase consumption at all (MPC =
economy. Aggregate demand is the sum 0) or use entire change in income on
of consumption (both autonomous and consumption (MPC = 1) or use part of
induced consumption) and investment. the change in income for changing
consumption (0< MPC<1).
Consumption: ⚪ Marginal propensity to save (MPS):
y It is the demand for goods and services It is the change in savings per unit
used by people in an economy for day- change in income.
to-day consumption. ⚪ Average propensity to consume
y Consumption is most importantly (APC): It is the consumption per unit
determined by the household income. of income.
In general, consumption expenditure ⚪ Average propensity to save (APS):
increases with an increase in income It is the savings per unit change in
and decreases with the decrease in income.
household income.
y A consumption function describes the Investment:
relation between consumption and y It is defined as addition to the
income. The simplest consumption func- stock of physical capital (machines,
tion assumes that consumption changes buildings, roads etc.) that adds to
Determination of Income and Employment

at a constant rate as income changes. the future productive capacity of

y Some important terms related to the economy and changes in the
Consumption Function: inventory (stock of finished goods) of a
⚪ Autonomous Consumption: A certain producer.
level of consumption takes place y Investment goods (such as machines)
even when income is zero. Since this are also part of the final goods unlike
level of consumption is independent intermediate goods like raw materials,
of income, it is called autonomous which are used up in the production
consumption. process.
⚪ Induced Consumption: It is the y The decision to invest is taken by the
portion of consumption that varies producers, largely based upon the
with the disposable income. prevailing market interest rates.

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Chapter 4
Determination of Income: services can be summarized by the
y Income is the money earned or received fiscal variables Tax (T) and Government
by individual or business, especially on Expenditure (G)
a regular basis, for a work or through ⚪ Government, through its expenditure
investments or through productions. on final goods and services, adds
y The national income can be determined to the aggregate demand like other
by summing up the all the incomes earned firms and households.
by individuals, firms, governments from ⚪ On the other hand, taxes imposed by
various economic activities. The term the government take a part of the
output can be interchangeably used as income away from the household,
income. which reduces the disposable
y Aggregate demand is an important income.
determinant of income. The aggregate y Therefore, the income can be
demand for final goods is the sum determined by summing up
total of consumption expenditure and consumption (autonomous), investment
investment expenditure on goods. (autonomous), government expenditure
y However, the major economic activities and induced consumption after taxes
of the government also affect the (Income – taxes).
aggregate demand for final goods and

Paradox of Thrift: If all the people of the economy increase the proportion of
income they save, the total value of savings in the economy will not increase - it
will either decline or remain unchanged. This result is known as the Paradox of
Thrift, which states that as people become thriftier (tend to spend less) they end
up saving less or same as before.

This happens as follows:

Determination of Income and Employment

y When people become thriftier, the consume less than before hence pulling down
the AD.
y Due to the reduction in AD, a situation of excess supply is created in the market.
y Due to piling up of stocks, and reduced production activity, the flow of factor
payments from firms to the households also reduce.
y This pull downs the incomes of the households, as the MPC had already reduced
due to people becoming thriftier the fall in incomes will again reduce the AD in
the market.
Due to the reduction in incomes, the impact of reduced consumption is not evenly
observed on the savings by the people, they either save the same or even lesser.

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Equilibrium: change in national income of Rs 8000,

y An equilibrium situation in the market the multiplier (8000/2000) is 4.
which arises, when the aggregate
demand is equal to the aggregate supply. Interesting Points:
y Aggregate demand that is the demand y Full Employment Level of Income: That
for all finished goods and services level of income where all the factors
produced in an economy, whereas the of production are fully employed in
aggregate supply that is the total supply the production process. (Factors of
of finished goods and services available production include Land, Labour,
in an economy. Physical Capital and Human Capital).
y Deficient Demand: A situation where
Investment Multiplier: the equilibrium level is less than the full
y It is the ratio of the change in national employment of output since demand
income to the initial change in planned is not enough to employ all factors of
investment expenditure. production. It leads to decline in prices
y It can also be defined as the ratio of in the long run.
the total increment in equilibrium y Excess Demand: A situation where the
value of final goods output to the initial equilibrium level of output is more
increment in autonomous expenditure than the full employment level, since
is called the investment multiplier of demand is more than the level of
the economy. output produced at full employment
y Thus, for instance, if a change in level. It leads to rise in prices in the
investment of Rs 2000 may cause a long run.
Determination of Income and Employment

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5 Government Budget and

the Economy

Chapter 5
The government prepares the budget Income redistribution:
every year for fulfilling certain national ⚪ The government sector affects
objectives such as allocation of scarce the personal disposable income of
resources, distribution of income, households by making transfers and
reducing regional disparity, etc. collecting taxes to ensure a fair and
In a Mixed Economy where both the equitable distribution of this income.
public as well as private sector exists, ⚪ The redistribution objective is sought
the government can influence the to be achieved through progressive
economy in many ways, one such way is income taxation, in which higher the
the government budget. income, higher is the tax rate.
⚪ With respect to indirect taxes,
Government Budget: necessities of life are exempted or
y It is the annual financial statement of taxed at low rates, comforts and
the government. semi-luxuries are moderately taxed,
y It shows the receipts and expenditure and luxuries, tobacco and petroleum
of the government for a particular products are taxed heavily.
financial year.
y Article 112 of the Indian Constitution Economic stabilisation:
makes a requirement in India to present ⚪ Economic stabilisation is crucial
before the Parliament a statement of to correct fluctuations in income
estimated receipts and expenditures and employment. Any intervention
of the government in respect of every by the government to expand or
financial year which runs from 1st April to reduce the aggregate demand
to 31st March. in the economy constitutes the
y The budget comprises mainly of two stabilisation function.
accounts: ⚪ The overall level of employment and
⚪ revenue account (revenue budget), prices in the economy depend upon
that relates to the current financial the level of aggregate demand which
year transactions; and in turn depends upon the spending
⚪ capital account (capital budget), that by private and government entities.

Government Budget and the Economy

relates to the assets and liabilities
of the government. Components of Budget:
The budget primarily consists of
Objectives of Government Budget: two components such as receipts
y Allocation of resources: Through budget and expenditures. The receipts are
the government allocates and mobilise further classified into revenue receipts
resources that benefit all. This also and capital receipts whereas the
provides public goods and services such expenditures are further classified
as national defence, roads, government into revenue expenditure and capital
administration etc. expenditure.

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Revenue Receipts: y Examples of these receipts include:

y These receipts that do not lead to a ⚪ Money received by way of Loans
claim on the government (that is, they (Liability of future re-payment is
neither create a liability nor decrease created here).
an asset for the government). They are ⚪ Money received by, sale of
divided into tax and non-tax revenues. government assets, like sale of
y Tax revenues, further are divided into: shares in Public Sector Undertakings
⚪ Direct Taxes: Like personal income (PSUs) which is referred to as PSU
tax and corporation tax etc. disinvestment, sale of assets etc.
⚪ Indirect Taxes: Like excise taxes (This reduces the asset pool held by
(duties levied on goods produced the government).
within the country), customs duties
(taxes imposed on goods imported Revenue Expenditure:
into and exported out of India) and y It is expenditure incurred for purposes
service tax. other than the creation of physical
⚪ Other direct taxes like wealth tax, gift or financial assets of the central
tax and estate duty (now abolished) government.
have never brought in large amount y This, expenditure relates to the expenses
of revenue and thus have been incurred for the normal functioning of the
referred to as ‘paper taxes’. government departments and various
y Non-tax revenue, of the central services, interest payments on debt
government mainly consists of: incurred by the government, and grants
⚪ Interest Receipts on account of given to state governments and other
loans by the central government. parties (even though some of the grants
⚪ Dividends and profits on investments may be meant for creation of assets).
made by the government, y Subsidies, also constitute a significant
⚪ Fees and other receipts for services part of the Revenue Expenditure, which
rendered by the government. are incurred on under-pricing of goods,
⚪ Cash grants-in-aid from foreign subsidised health, exports etc.
countries and international
Government Budget and the Economy

organisations are also included. T Capital Expenditure:

y The estimates of revenue receipts take y These are the expenditures of the
into account the effects of tax proposals government which result in creation of
made in the Finance Bill. physical or financial assets or reduction
in financial liabilities.
Capital Receipts: y This includes expenditure on the
y All those receipts of the government acquisition of land, building, machinery,
which create liability or reduce financial equipment, investment in shares, and
assets are termed as capital receipts. loans and advances by the central
y These receipts can be debt creating or government to state and union territory
non-debt creating. governments, PSUs and other parties.

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Chapter 5
Fig 5.1: Government Budget

Budget as a National Policy Statement: the economy with respect to the GDP
y Instead of merely being a statement of growth rate, fiscal balance of the central
receipts and expenditures, the budget government and external balance.
has also become a significant national
policy statement. Balanced, Surplus and Deficit Budget:
y Along with the budget, three policy y Balanced Budget: The government may
statements are mandated by the Fiscal spend an amount equal to the revenue
Responsibility and Budget Management it collects. In case the government
Act, 2003 (FRBMA). need to incur higher expenditure, a
y The Medium-term Fiscal Policy similar amount of revenue would have
Statement: It sets a three-year rolling to be raised, in order to keep the budget
target for specific fiscal indicators and balanced.
examines whether revenue expenditure y Surplus Budget: A situation, in which

Government Budget and the Economy

can be financed through revenue the amount of tax collection exceeds
receipts on a sustainable basis and how the required amount of expenditure.
productively capital receipts including y Deficit Budget: This the most common
market borrowings are being utilised. situation, in which the Government’s
y The Fiscal Policy Strategy Statement: expenditure amount exceeds the
It sets the priorities of the government amount of revenue raised.
in the fiscal area, examining current
policies and justifying any deviation in Measures of Government Deficit:
important fiscal measures. The amount of deficit (When the
y The Macroeconomic Framework spending is more than the revenue
Statement: It assesses the prospects of earned), can be captured in different

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ways, each having their own implications y Hence, often the government reduces
for the economy. productive capital expenditure or
welfare expenditure.
Revenue Deficit: y Overall, this leads to lower growth and
y This refers to the excess of the adverse welfare implications.
Government’s revenue expenditure over
its revenue receipts. Fiscal Deficit:
y It is the difference between the
Revenue deficit = Revenue expenditure government’s total expenditure and its
– Revenue receipts total receipts excluding borrowing.

Gross fiscal deficit = Total expenditure –

y The revenue deficit includes only (Revenue receipts + Non-debt creating
such transactions that affect the capital receipts)
current income and expenditure of the
government. y Non-debt creating capital receipts are
y Revenue deficit in 2018-19 was 2.3 per those receipts which are not borrowings
cent of GDP. and, hence do not give rise to debt (E.g.:
Proceeds from the sale of Public Sector
Implications of Revenue Deficit on the Undertakings).
Economy: y These Non-debts creating capital
y It implies that the government is receipts are obtained by subtracting,
dissaving and is using up the savings borrowing and other liabilities from
of the other sectors of the economy total capital receipts.
to finance a part of its consumption y The fiscal deficit will have to be financed
expenditure. through borrowing. Thus, indicating the
y This situation means that the total borrowing requirements of the
government will have to borrow to even government from all sources.
finance the day-to-day consumption y This borrowing can also be calculated
requirements in addition to borrowing as follows:
for investments.
Government Budget and the Economy

y High borrowing will eventually lead to high Gross fiscal deficit = Net borrowing at
debt and interest payment obligations, home (Money directly borrowed from
which will force the government to the public through debt instruments
eventually cut expenditure. + indirectly from commercial banks
y However, since a major part of revenue through Statutory Liquidity Ratio) +
expenditure is committed expenditure Borrowing from RBI + Borrowing from
(in a sense that the payment obligations abroad
have already been created even before Implications of Fiscal Deficit:
the actual payment is done for example y It is a key variable in judging the financial
salaries of government staff etc.), it health of the public sector and the
cannot be reduced. stability of the economy.

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Chapter 5
y It can be seen that revenue deficit is become another reason for further
a part of fiscal deficit (Fiscal Deficit = borrowings.
Revenue Deficit + Capital Expenditure -
non-debt creating capital receipts). Perspectives on the Handling of
y A large share of revenue deficit in fiscal Government Debt:
deficit indicated that a large part of y The debt of the government can be
borrowing is being used to meet its financed by raising money through
consumption expenditure needs rather taxation or printing new currency.
than investment. y However, borrowing by the government
today may create a burden on future
Primary Deficit: generations, as money borrowed today
y The goal of measuring primary deficit is may be paid by the government some
to focus on present fiscal imbalances. decades later, financed by new taxes
y Primary deficit is calculated to obtain on the young generation, reducing their
an estimate of borrowing on account disposable incomes.
of current expenditures exceeding y Also, government borrowing from the
revenues. It is simply the fiscal deficit people reduces the savings available to
minus the interest payments. the private sector.
y The total borrowing requirements, y There, are two broad views on the
of the government also include an handling of government debt:
amount incurred on account of interest ⚪ Second view holds that households
payments on old, accumulated debt are forward-looking and will base
(loans). their spending not only on their
Gross primary deficit = Gross fiscal current disposable income but also
deficit – Net interest liabilities on their expected future income
y Net interest liabilities consist of interest and hence will increase their savings
payments minus interest receipts by the today.
government on net domestic lending. y They will understand that borrowing
today means higher taxes in the future.
Government Debt: Further, the consumer will be concerned

Government Budget and the Economy

Budgetary deficits can be financed by about future generations.
either taxation, borrowing or printing y Such an increase in household savings
money. To finance such deficit the will offset the dissaving that the
governments have mostly relied on government would have to do on
borrowing, known as government account of budgetary deficit and the
debt. national savings will stay at a constant
level.
However, if the government continues to y This, second view is also called as the
borrow year after year, the outstanding Ricardian equivalence, named after
debt accumulates causing greater nineteenth century economists David
interest liability, which itself can Ricardo.

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Other Perspectives on Deficits and steady rise the negative externalities

Debt: can be off set.
Inflationary perspective:
y One of the main criticisms of deficits is Similarly, investment in better
that they are inflationary. infrastructural facilities today may
y As increase in government spending or prove to be very beneficial for the future
tax cut leads to an increase in AD. generations.
y But firms may not be able to meet Hence, debt should not be considered
the increased demand due to which burdensome at the face of it, however
the prices of existing output will rise judged in accordance with the overall
(Situation of Inflation). growth of the economy.
y However, if there are unutilised
resources able to match the increased Deficit Reduction:
AD. A high fiscal deficit is accompanied Government deficit can be reduced
by higher demand and greater output by an increase in taxes or reduction in
and, therefore, need not be inflationary. expenditure.

Crowding Out perspective: Deficit Reduction scenario in India:

y When government borrows, there is y The government has been trying to
a decrease in investment due to a increase tax revenue with greater
reduction in the amount of savings reliance on direct taxes as indirect
available to the private sector. taxes are regressive in nature and they
y This is because if the government impact all income groups equally.
decides to borrow from private citizens y Receipts are being raised through the
by issuing bonds to finance its deficits, sale of shares in PSUs.
these bonds will compete with corporate y However, the major thrust has been
bonds and other financial instruments towards reduction in government
for the available supply of funds. expenditure, through better planning of
y If some private savers decide to buy programmes and better administration.
bonds, the funds remaining to be
Government Budget and the Economy

invested in private hands will be smaller. Suggestive Measures:

y Thus, some private borrowers will get y Changing the scope of the government
‘crowded out’ of the financial markets by withdrawing from some of the areas
as the government claims an increasing where it operated before (non-core
share of the economy’s total savings. government activities).
However, the above perspectives hold y As, cutting back government programmes
true under the circumstances, where in vital areas like agriculture, education,
the government deficit and resultant health, poverty alleviation, etc., would
debt would not be able to augment adversely affect the economy.
the incomes in the economy. If y However, it must be noted that larger
due to deficit budgets, incomes see a deficits do not always signify a more

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Chapter 5
expansionary fiscal policy (aiming to y This will increase the production
increase income and output through capacity in the economy and also the
increased government spending and incomes.
reduced taxes). y As, under the concept of Circular Flow
y The same fiscal measures can give rise of Income if all income is spent on
to a large or small deficit, depending on consumption then the total demand in
the state of the economy. the economy (AD) = Income (Y). Hence
y For example, if an economy experiences increased AD = Increased Y.
a recession and GDP falls, tax revenues
fall because firms and households Changes in Taxes:
pay lower taxes when they earn less. y A cut in taxes increases disposable
Meaning that the deficit increases in a income at each level of income.
recession and falls in a boom, even with y Due to the increased disposable
no change in fiscal policy. income, the consumption expenditure
of the households will also increase, in
Fiscal Policy of the Government: proportion to the tax cut.
It is the policy by which the government y Changes in government expenditure
adjusts its expenditure (spending) and impact the economy directly by
tax rates to increase output and income increasing the AD, however, changes in
and seeks to stabilise the ups and taxes impact this mechanism through
downs in the economy. changes in the disposable incomes of
The change in Government Spending and the households.
Taxation policies impact the functioning
of the economy in the following ways: Proportional Income Tax:
Under proportional income tax
Changes is Government Expenditure: government collects a constant fraction,
y If taxes are kept constant, and the of income in the form of taxes. This
government consumption expenditure kind of taxation acts as an automatic
is increased, it increases the Aggregate stabiliser because:
Demand (AD) in the economy. y It makes disposable income, and thus

Government Budget and the Economy

y At the initial level of output, due to consumer spending, less sensitive to
increased government spending, the fluctuations in GDP.
AD would exceed the supply in the y When GDP rises, disposable income
economy (as government expenditure also rises but by less than the rise in
forms a part of the AD). GDP because a part of it is siphoned off
y Due to the increased AD, the equilibrium as taxes. This helps limit the upward
would be disturbed due to which the fluctuation in consumption spending.
firms would increase their production in y During a recession when GDP falls,
order to meet the new levels of demand. disposable income falls less sharply,
y This will set the market equilibrium to a and consumption does not drop as
point higher than before. much as it otherwise would have fallen

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had the tax liability been fixed. Thus, y The Reserve Bank of India must not
reducing the fall in aggregate demand subscribe to the primary issues of
and stabilises the economy. central government securities from the
year 2006-07.
Fiscal Responsibility and Budget y Measures to be taken to ensure greater
Management Act, 2003 (FRBMA): transparency in fiscal operations.
The enactment of the FRBMA, in August y The central government to lay before
2003, marked a turning point in fiscal both Houses of Parliament three
reforms, binding the government statements along with the Annual
through an institutional framework to Financial Statement:
pursue a prudent fiscal policy. ⚪ Medium-term Fiscal Policy
Aim: That, the central government must Statement
ensure intergenerational equity and ⚪ The Fiscal Policy Strategy Statement
long-term macro-economic stability ⚪ The Macroeconomic Framework
by achieving sufficient revenue surplus, y Quarterly review of the trends in
removing fiscal obstacles to monetary receipts and expenditure in relation
policy and effective debt management to the budget be placed before both
by limiting deficits and borrowing. Houses of Parliament.
The act applies to the central
Main Features of the Act: government. However, most states have
It mandates the Central Government to: already enacted fiscal responsibility
y Reduce fiscal deficit to not more than 3 legislations which have made the rule
percent of GDP. based fiscal reform programme of the
y Eliminate the revenue deficit by March government more broad based.
31, 2009 and thereafter build up However, this act is for fiscal prudence
adequate revenue surplus. there are fears that it may lead to
y Reduction in fiscal deficit by 0.3 per reduction in welfare expenditure.
cent of GDP each year and the revenue Since, the enactment of the FRBMA
deficit by 0.5 per cent (if not achieved Indian economy has moved to the
through the tax revenue, must be states of a middle income country and
Government Budget and the Economy

achieved by reducing expenditure). much has changed both domestically

y The actual deficits may exceed the and globally, while affirming faith in the
targets specified only on grounds of fiscal principles set out in the FRBM but
national security or natural calamity or to incorporate the changing scenario in
such other exceptional grounds as the the country for better future growth,
central government may specify. the FRBM Review Committee had been
y The central government shall not borrow constituted.
from the Reserve Bank of India except
by way of advances to meet temporary Goods and Service Tax:
excess of cash disbursements over cash It is a single comprehensive indirect
receipts. tax, operational from 1 July 2017. GST

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Chapter 5
is levied on the supply of goods and y Tobacco and tobacco products will
services, right from the manufacturer/ attract both GST and Central Excise
service provider to the consumer. Duty.
The 101st Constitution Amendment Act y Under GST, there are 6 (six) standard
was enacted to facilitate the GST. The rates applied i.e. 0%, 3%,5%, 12%,18%
amendment introduced Article 246A and 28% on supply of all goods and/or
in the Constitution cross empowering services across the country.
Parliament and Legislatures of States
to make laws with reference to Goods Differences between old tax regimes
and Service Tax imposed by the Union and GST:
and the States. Thereafter CGST Act, y Pre GST tax regime-imposed taxes not
UTGST Act and SGST Acts were enacted on the value added at each stage but
for GST. on the total value of the commodity or
service with minimal facility of utilisation
Main Features of the Act: of Input Tax Credit (ITC).
y It is a destination-based consumption y The total value included taxes paid
tax with facility of Input Tax Credit in on intermediate goods or services
the supply chain. amounting to cascading of tax.
y It is applicable throughout the country y Under GST, the tax is discharged at every
with one rate for one type of goods or stage of supply and the credit of tax paid
service. at the previous stage is available for set
y It has subsumed (replaced) a large off at the next stage of supply of goods
number of Central and State taxes and and/or services. It is thus effectively a tax
cesses: on value addition at each stage of supply.
⚪ These include Central taxes like
Central Excise Duty, Service Tax, Benefits of GST:
Central Sales Tax, Cesses like KKC y Parity in taxation across the country
and SBC. and extend principles of ‘value- added
⚪ State taxes like VAT/Sales Tax, Entry taxation’ to all goods and services.
Tax, Luxury Tax, Octroi, Entertainment y It has replaced various types of taxes

Government Budget and the Economy

Tax, Taxes on Advertisements, Taxes and cesses, levied by the Central and
on Lottery /Betting/ Gambling, State State/UT Governments.
Cesses on goods etc y GST has simplified the multiplicity of
y Five petroleum products have been kept taxes on goods and services.
out of GST for the time being but with y The laws, procedures and rates of taxes
passage of time, they will get subsumed across the country are standardised.
in GST. y It has facilitated the freedom of
y State Governments will continue to movement of goods and services
levy VAT on alcoholic liquor for human and created a common market in the
consumption. country.

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

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6 Open Economy Macroeconomics

Chapter 6
An open economy is one which interacts flow, increasing AD for goods produced
with other countries through various within the domestic economy.
channels such as trade in goods and
services and most often in financial Exchange Mechanism in Foreign Trade:
assets. Today, most modern economies y Generally, the economic agents involved
are open. There are three ways in which in foreign trade accept currencies that
these linkages are established: are relatively stable (value of currency
y Output Market: It enables trading in does not change frequently) and have
goods and services with other countries. international acceptance.
This enables a choice between foreign y Different currencies have different values.
and domestic goods for both consumers Thus, in order to facilitate foreign trade,
and domestic and foreign markets for the government announced that the
producers. national currency will be freely convertible
y Financial Market: Most often an at a fixed price into another asset.
economy can buy financial assets from y It requires the credibility of the issuing
other countries. This gives investors authority and a guarantee to transfer
the opportunity to choose between purchasing power in the hands of even
domestic and foreign assets. the international holders of the currency.
y Labour Market: Firms can choose where y This is generally ensured by allowing for
to locate production and workers to convertibility of the currency into some
choose where to work. There are various common form of asset.
immigration laws which restrict the y In modern times currencies are
movement of labour between countries. interpreted in terms of exchange rates
Due to open nature of the economy, that is the price of one currency in
Indians for instance, can consume terms of another currency.
products which are produced around There are two aspects of this
the world and some of the products commitment that has affected its
from India are exported to other credibility —
countries. y The ability to convert freely in unlimited
amounts and the price at which this
Influence of Foreign Trade on Aggregate conversion takes place. The international
Demand (AD): monetary system has been set up to
Open Economy Macroeconomics

Aggregate demand is the total demand handle these issues and ensure stability
for goods and services within a particular in international transactions.
market. Foreign trade can influence the y With the increase in the volume of
AD in the country in two ways: transactions, gold ceased to be the
y First, when Indians buy foreign goods, asset into which national currencies
this spending escapes as a leakage could be converted.
from the circular flow of income
decreasing AD. Balance of Payments (BoP):
y Second, our exports to foreigners It is a record of the transactions in
enter as an injection into the circular goods, services and assets between

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residents of a country with the rest of Current Account:

the world for a specified time period y It is the record of trade in goods and
typically a year. services and transfer payments.
y There are three main components in
There are two main accounts maintained the current account which are, trade
under BoP which are the current account in goods, trade in services and transfer
and the capital account. payments.

Fig 6.1: Components of Current Account

y Trade in goods includes exports and ⚪ A surplus current account means

imports of goods. that the nation is a lender to other
y Trade in services includes factor income countries.
and non-factor income transactions. ⚪ A deficit current account means
y Transfer payments are the receipts that the nation is a borrower from
Open Economy Macroeconomics

which the residents of a country get other countries.

for ‘free’, without having to provide any y Balance on current account has two
goods or services in return. They could components such as balance of trade
be given by the government or by private and ·balance on invisibles.
citizens living abroad. y Balance of trade (BoT): It is the difference
y Balance on Current Account: Current between the value of exports and value
Account is in balance when receipts of imports of goods of a country in a
on current account are equal to the given period of time.
payments on the current account.

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Chapter 6
⚪ Export of goods is entered as a and value of imports of invisibles of a
credit item in BoT, whereas import country in a given period of time.
of goods is entered as a debit item ⚪ Invisibles include services, transfers
in BoT. and flows of income that take place
⚪ Surplus BoT or Trade surplus will between different countries.
arise if country exports more goods ⚪ Services trade includes both factor
than what it imports. Whereas and non-factor income. Factor
deficit BoT or Trade deficit will arise income includes net international
if a country imports more goods earnings on factors of production
than what it exports. (like labour, land and capital).
y Balance of invisibles (BoI): It is also ⚪ Non-factor income is net sale of ser-
referred to as net invisibles. It is the vice products like shipping, banking,
difference between the value of exports tourism, software services, etc.

Current Account Balanced Current

Current Account Deficit
Surplus Account

Receipts > Payments Receipts = Payments Receipts < Payments

Capital Account: y Balance on Capital Account: Capital

y It records all international transactions account is in balance when capital
of assets. An asset is any one of the inflows (like receipt of loans from
forms in which wealth can be held, abroad, sale of assets or shares in foreign
for example: money, stocks, bonds, companies) are equal to capital outflows
Government debt, etc. (like repayment of loans, purchase of
y There are three main components of assets or shares in foreign countries).
capital account which are investment, ⚪ Surplus in capital account arises
external borrowings and external when capital inflows are greater
Open Economy Macroeconomics
assistance. than capital outflows.
y Purchase of assets is a debit item on the ⚪ Deficit in capital account arises
capital account. If an Indian buy a UK when capital inflows are lesser than
Car Company, it enters capital account capital outflows.
transactions as a debit item (as foreign
exchange is flowing out of India). Sale Surplus and Deficits in the Balance of
of assets like sale of share of an Indian Payments:
company to a Chinese customer is a y A country that has a deficit in its current
credit item on the capital account. account (spending more than it receives

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Fig 6.2: Components of Capital Account

from sales to the rest of the world) (or the recipients of any surplus). We
must finance it by selling assets or by note that official reserve transactions
borrowing from abroad. are more relevant under a regime of fixed
y Thus, any current account deficit exchange rates than when exchange
must be financed by a capital account rates are floating.
surplus, that is, a net capital inflow.
Current account + Capital account Autonomous Transactions:
=0 y It is also called “above the line” items
y In this case, in which a country is said to in BoP.
be in balance of payments equilibrium, y International economic transactions are
the current account deficit is financed called autonomous when transactions
entirely by international lending without are made due to some reason other
any reserve movements. than to bridge the gap in the balance
y Alternatively, the country could use its of payments, that is, when they are
Open Economy Macroeconomics

reserves of foreign exchange in order independent of the state of BoP.

to balance any deficit in its balance of y The balance of payments is said to be in
payments. surplus (deficit) if autonomous receipts
y The reserve bank sells foreign exchange are greater (less) than autonomous
when there is a deficit. This is called payments.
official reserve sale.
y The basic premise is that the monetary Accommodating Transactions
authorities are the ultimate financiers of y It is also called “below the line” items
any deficit in the balance of payments in BoP. It depends, whether there is a

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Chapter 6
deficit or surplus in the balance of purchasing goods, sending gifts abroad
payments. or purchasing financial assets of a
y They are determined by the gap in the certain foreign country.
balance of payments. y A rise in price of foreign exchange will
y They are also determined by the net increase the cost (in terms of rupees) of
consequences of the autonomous purchasing a foreign good. This reduces
transactions. demand for imports and hence demand
y Since the official reserve transactions for foreign exchange also decreases.
are made to bridge the gap in the BoP,
they are seen as the accommodating Supply of Foreign Exchange:
item in the BoP (all others being y Supply of foreign exchange arises due
autonomous). to the inflow of foreign currency flows
into the home country.
y The reasons are exports by a country
Note: lead to inflow of forex, foreigners send
y According to the new classification, gifts or make transfers; and the assets
the transactions are divided into of a home country are bought by the
three accounts: current account, foreigners.
financial account and capital y A rise in price of foreign exchange will
account. reduce the foreigner’s cost (in terms
y The most important change is that of USD) while purchasing products
almost all the transactions arising from India, other things remaining
on account of trade in financial constant.
assets such as bonds and equity y This increases India’s exports and
shares are now placed in the hence supply for foreign exchange may
financial account. increase.
y However, RBI continues to publish
the balance of payments accounts Determination of the Exchange Rate:
as per the old system. Various countries use different methods
to determine the exchange rates. These
methods are as follows:
The Foreign Exchange Market:
Open Economy Macroeconomics
It is the market in which national Flexible Exchange:
currencies are traded for one another. y It is also known as floating exchange
The rate at which price of one currency is rate.
determined in terms of another is called y Under this system, exchange rate is
foreign exchange rate or forex rate. determined by the market forces of
demand and supply.
Demand for Foreign Exchange: y In a completely flexible system, the
y The demand for foreign exchange Central banks do not intervene in the
arises due to various reasons such as foreign exchange market.

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y An increase in exchange rate implies Demerits and Merits of Flexible and

that the price of foreign currency Fixed Exchange Rate Systems:
(dollar) in terms of domestic currency
(rupees) has increased and vice-versa. Demerits of Fixed Exchange Rate
⚪ When the price of domestic currency System:
(rupee) in terms of foreign currency y In order for this system to work, there
(dollar) decreases, it is called must be credibility that the government
depreciation of domestic currency. will be able to maintain the exchange
⚪ Similarly, when the price of domestic rate at the level specified.
currency (rupees) in terms of foreign y In case of deficit in BoP, governments
currency (dollars) increases, it is will have to intervene to take care of the
called appreciation of the domestic gap by use of its official reserves.
currency. y In case people learn that the amount in
y In a flexible exchange regime, market these reserves is insufficient to do so
determines the currency exchange they would begin to doubt the ability
rate. The exchange rate is typically of the government to maintain the
determined at the equilibrium point on fixed rate.
the demand and supply curve. y This may give rise to speculation of
y More demand for foreign goods may devaluation. When this belief translates
increase the exchange rate because into aggressive buying of one currency
more of domestic currency has to be thereby forcing the government to
paid in order to obtain a unit of foreign devalue,
currency. y It is said to constitute a speculative
attack on a currency. Fixed exchange
Fixed Exchange Rates: rates are prone to these kinds of
y In this system, the Government fixes attacks.
the exchange rate at a particular level.
y The government can maintain any Managed Floating Exchange Rate
exchange rate in the economy. But it will System:
be accumulating more and more foreign y It is also known as dirty floating
exchange so long as this intervention exchange rate.
goes on. y It is a mixture of a flexible exchange
Open Economy Macroeconomics

y Devaluation: It makes the domestic rate system (the float part) and a fixed
currency cheaper for foreigners by fixing rate system (the managed part).
a higher exchange rate than the current y In this exchange rate regime, RBI
one. It is done to encourage the exports. intervene in the market to buy and
y Revaluation: When the government sell foreign currencies in an attempt to
decreases the exchange rate (thereby, moderate exchange rate movements
making domestic currency costlier) in a whenever they feel that such actions
fixed exchange rate system are appropriate.

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Chapter 6
y Official reserve transactions are, entirely backed by gold; typically,
therefore, not equal to zero. countries held one-fourth gold against
its paper currency.
Exchange Rate Management: The y Under gold exchange standard, countries
International Experience and Evolution although fixed their currency prices
y From around 1870 to the outbreak of based on gold, but held little or no gold
the First World War in 1914, the prevail- reserves instead, held the currency of
ing system to determine the exchange some large country which was on the
rate of various currencies was the gold gold standard.
standard. y Post World War - II, Bretton Woods
y Under it, all currencies were defined in Conference was held in 1944. It made the
terms of gold. following changes in the International
y Each country in the framework of this Exchange Rate Systems:
system, committed to guarantee the ⚪ International Monetary Fund (IMF)
free convertibility of its currency into and the World Bank were set up.
gold at a fixed price. ⚪ A system of fixed exchange rates
y This also made it possible for each was re-established.
currency to be convertible into all ⚪ This was different from the
others at a fixed price. international gold standard in the
y Exchange rates were determined by its choice of the asset in which national
worth in terms of gold. currencies would be convertible.
y To maintain the official parity each ⚪ A two-tier system of convertibility
country needed an adequate stock of was established at the centre of
gold reserves. which was the US dollar.
y All countries on the gold standard had ⚪ The US monetary authorities
stable exchange rates. guaranteed the convertibility of the
y However, certain problem arose under dollar into gold at the fixed price of
this system: $35 per ounce of gold.
⚪ World prices were at the mercy of y The second tier of the system was the
gold discovery. commitment of monetary authority of
⚪ Subsequently, with mine being each IMF member participating in the
unable to produce sufficient gold, system to convert their currency into
Open Economy Macroeconomics

the world prices started to fall. dollars at a fixed price (called the official
⚪ This gave rise to social unrest in exchange rate).
many countries. y A change in exchange rates was to be
y Some alternate ways emerged such as: permitted only in case of a ‘fundamental
⚪ For a period, silver supplemented disequilibrium’ in a nation’s BoP – which
gold introducing ‘bimetallism’. came to mean a chronic deficit in the
y Under fractional reserve banking the BoP of sizeable proportions.
paper currency of countries was not

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Reasons for introducing this system: known as ‘paper gold’, in the IMF as a
y Distribution of gold reserves across replacement to gold as an international
countries was uneven with the US reserve standard.
having almost 70 per cent of the official y However, SDRs were defined in terms of
world gold reserves. gold.
y A credible gold convertibility would y At present, it is calculated daily as the
have required massive re-distribution weighted sum of the values in dollars of
of gold reserves. four currencies (euro, dollar, Japanese
y It was believed that the existing gold yen, pound sterling).
stock would be insufficient to sustain y It derives its strength from IMF
the growing demand for international members being willing to use it as a
liquidity. reserve currency and use it as a means
y Post–World War II scenario, countries of payment between central banks to
devastated by the war needed enormous exchange for national currencies.
resources for reconstruction, raising y The original instalments of SDRs were
their imports which put pressure on distributed to member countries
their forex reserves to finance the BoP according to their quota in the Fund
deficit. These reserves mainly consisted (the quota was broadly related to the
of US Dollars at that time. country’s economic importance as
indicated by the value of its international
Problems with this system: trade).
y The holdings of US Dollars by other Slowly many countries began to adopt
countries, was in effect a liability for the the floating exchange rates, and IMF
US to convert dollars into gold whenever gave the freedom to countries to decide,
needed. if they wanted to go for a floating market
y Such an extent of the liability in determined exchange rate, or peg (tie
relation to its gold reserves could put the exchange rate) their currencies to a
convertibility in doubt. particular asset like the SDR.
y The central banks would thus have an
overwhelming incentive to convert the The Current Scenario:
existing dollar holdings into gold, and y Today, the global exchange rate system
that would, in turn, force the US to give is characterized by multiple kinds of
Open Economy Macroeconomics

up its commitment. regimes, involving free floating exchange

y This was called the Triffin Dilemma rates, pegging their exchange rates to
after Robert Triffin, the main critic of other developed countries, introducing
the Bretton Woods system. common currencies like Euro etc.
y Most exchange rates fluctuate slightly
Further Evolution: on a day to day basis, with even those
y In 1967, gold was displaced by creating nations tilting towards fixed exchange
the Special Drawing Rights (SDRs), also rate systems, only specifying a certain

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Chapter 6
range for their currency instead of y In the beginning of 1990s, the situation
actually fixing them. for India became problematic
y Gold is now not being used for exchange requiring reforms in line with IMF
rate purposes, instead the prices of gold recommendations (explained in class
are controlled by demand and supply. 11th Notes).
y Along with other reforms there was a
Exchange Rate Management in India: two-step devaluation of 18-19 per cent
y Post-independence, in line with Bretton of the rupee on July 1 and 3, 1991.
Woods system Rupee was pegged to y In March 1992, the Liberalised Exchange
the pound sterling. Rate Management System (LERMS)
y The rupee was devalued by 36.5 per involving dual exchange rates was
cent in June 1966. introduced.
y The rupee was delinked from the pound y Under this system, 40 per cent of
sterling in September 1975, due to the exchange earnings had to be surrendered
breakdown of Bretton Woods system at an official rate determined by the
and declining share of UK in India’s Reserve Bank and 60 per cent was to
trade. be converted at the market determined
y During the period between 1975 to 1992, rates.
the exchange rate of the rupee was y The dual rates were converged into one
officially determined by the Reserve from March 1, 1993.
Bank within a nominal band of plus or y Current account convertibility was
minus 5 percent of the weighted basket achieved in August 1994. Meaning that
of currencies of India’s major trading the Rupee could now by converted into
partners. any foreign currency at existing market
y Requiring day-to-day intervention of the rates for trade purposes for nay amount.
Reserve Bank, which resulted in wide y The exchange rate of the rupee thus
changes in the size of reserves. became market determined, with
y The exchange rate regime of this period the Reserve Bank ensuring orderly
can be described as an adjustable conditions in the foreign exchange
nominal peg with a band. market through its sales and purchases.

Open Economy Macroeconomics

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