Economics – Macro Economics (English Version) – Old Syllabus-munotes

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1Module 1
Unit -1
CONCEPTS AND DEFINITIONS
Unit Structure:
1.0 Objectives
1.1 Introduction
1.2 Importance ofMacroeconomics
1.3 Circular flow of income
1.4 Importance oftheCircular Flow
1.5 Questions
1.0OBJECTIVES
Introduction to macroeconomi cs
To acquaint the students with concept of macroeconomics
to study the scope and importance of macroeconomics
to understand how circular flow of income takes place in
closed & open economy
To study leakages & injections of circular flow of income
1.1INTRODUCTION
Macroeconomics is that part of economic theory which
studies the economy in its totality or as a whole. It studies not
individual economic units like a household, a firm or an industry but
the whole economic system. Macroeconomics is the study of
aggregates and averages of the entire economy. Such aggregates
are national income, total employment, aggregate savings and
investment, aggregate demand, aggregate supply general price
level, etc.
Here, we study how these aggregates and averages of th e
economy as a whole are determined and what causes fluctuations
in them. Having understood the determinants, the aim is how to
ensure the maximum level of income and employment in a country.
In short, macroeconomics is the study of national aggregates or
economy -wide aggregates. In a way it is like study of economic
forest as distinguished from trees that comprise the forest. Main
tools of its analysis are aggregate demand and aggregate supply.munotes.in

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2Since the subject matter of macroeconomics revolves
around de termination of the level of income and employment,
therefore, it is also known as ‘Theory of Income and Employment’.
These days when the study of lakhs of individual units has become
almost impossible and when government’s participation through
monetary an d fiscal measures in the economy has increased very
much, use of macro analysis has become indispensable. Correct
economic policies formulated at macro level have made it possible
to control business cycles (inflation and deflation) and as a result
violent booms and depressions have become things of the past.
In a suitably modified form, macroeconomics is the basis of
all plans of economic development of underdeveloped economies.
Economists are now confidently exploring the possibilities and ways
of mainta ining economic growth and full employment. More than
anything else, macroeconomic thought has enabled us to properly
organise, collect and analyse the data about national income and
coordinate international economic policies.
Thescope ofmacroeconomics includes thefollowing parts:
1.Theory of national Income
2.Theory of employment
3.Theory of money
4.Theory of general price level
5.Theory of economic growth
Clearly, the study of the problem of unemployment in India or
general price level or problem of balance of payment is
macroeconomic study because these relate to the economy as a
whole.
1.2IMPORTANCE OFMACROECONOMICS
1. It helps to understand the functioning of a complicated modern
economic system. It describes how the economy as a whole
functions and how t he level of national income and employment is
determined on the basis of aggregate demand and aggregate
supply.
2. It helps to achieve the goal of economic growth, higher level of
GDP and higher level of employment. It analyses the forces which
determine economic growth of a country and explains how to reach
the highest state of economic growth and sustain it.
3. It helps to bring stability in price level and analyses fluctuations in
business activities. It suggests policy measures to control Inflation
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34. It explains factors which determine balance of payment. At the
same time, it identifies causes of deficit in balance of payment and
suggests remedial measures.
5. It helps to solve economic problems like poverty, unemployment,
business cyc les, etc., whose solution is possible at macro level
only, i.e., at the level of whole economy.
6. With detailed knowledge of functioning of an economy at macro
level, it has been possible to formulate correct economic policies
and also coordinate interna tional economic policies.
7. Last but not the least, is that macroeconomic theory has saved
us from the dangers of application of microeconomic theory to the
problems of the economy as a whole.
1.3 CIRCULAR FLOW OF INCOME
The circular flow of income is aw a yo fr e p r e s e n t i n gt h ef l o w s
of money between the two main groups in society -producers
(firms) and consumers (households). These flows are part of the
fundamental process of satisfying human wants. As we have
already seen, a free market economy consis ts of two components,
orsectors, as they are called. These are firms andhouseholds .
People in households work for firms (selling their factor services)
and receive wages in exchange. On the scale of the whole
economy, this is known as national income -the total amount of
income earned over a given time period. This money is spent on
food, clothing, transport, entertainment etc, and so it returns to the
firms. This is the circular flow.
Fig.:1.1 Circular flow of Income
We can see this circular flow in Figure 9.1. Households sell
their factor services to firms (in the factor markets) and in exchange
receive wages (the left hand side of the flow). In the meantime,
households spend this income on goods and services (in the goodsmunotes.in

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4market) and in exchange rec eive the goods and service themselves
(the right hand side of the flow). Economists call the wages plus the
other forms of income, national income and give it the code ' Y'.
Domestic consumption is given the code ' C'.Not all income is
spent, however. Some is saved. Savings are coded as ' S'. Other
money is used to buy goods or services produced overseas. The
money to buy these goods and services flows out of the country. It
is given the code ' M' for imports. Savings (S) andImports ( M)are
called leakages from the circular flow. The effect of these leakages
can be seen in Figure 1.2.
Fig.: 1.2 Circular flow with Savings & Imports
Leakage: A leakage is any income not passed on in the circular
flow.
On the other hand, some firms make and sell exports
overs eas, and others borrow money and invest it in their firms in
the form of capital goods. These are coded ' X'forexports and ' I'
forinvestment and are called injections as the money returns into
the circular flows. Injection: An injection is any expenditur en o t
originating in the household sector, including investment,
government spending and exports.
Figure 1.3 Circular flow -two sector, open economymunotes.in

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5This is a 2 -sector, open economy. The flow will be balanced
and therefore in equilibrium when the inje ctions are equal to the
leakages. If the leakages are greater than the injections then
national income will fall, while if injections are greater than leakages
national income will rise. This starts to show us some possible
policies to promote growth -policies that help boost exports or
investment will lead to more injections into the circular flow and
therefore boost national income.
We called the economy illustrated in Figure 1.3a no p e n
economy because it is open to trade with the outside world. If it did
not trade outside of itself, we would call it a 2 -sector, closed
economy. In almost all economies, the government plays an active
part. It taxes us, T, and uses this money to finance its spending.
Even though this partly goes to pay themselves and thei r
bureaucracy, as well as funding schools and hospitals, it finds its
way back into the flow. This spending is coded as ' G'f o r
government expenditure. Add this to the earlier model and we get
the model of a 3 -sector, open economy, the most common type of
economy in the real world. We can see the circular flow for this
economy in Figure 9.4b e l o w .
Figure 1.4 Circular flow in 3 sector open economy
We could also represent the government separately in this
circular flow -here's an alternative representatio no fF i g u r e 9.4. It
shows exactly the same flows, but represents them a little
differently.
Figure 1.5 Circular flow -3 sector, open economymunotes.in

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6Theleakages from the circular flow are:
Savings (S)
Taxation (T)
Purchase of imported goods and services (M) (g oods and
services in but money out –Indian firms pay overseas ones)
Theinjections are
Investment (I) -expenditure on capital goods
Sale of exports (X) (goods and services out, but money now
flows in)
Government Expenditure (G)
An economy is in equilibr ium when injections match the
leakages.
The standard codes used in this model, and in economics in
general are:
Y=N a t i o n a lI n c o m e
C = Domestic Consumption
S=S a v i n g s
M=I m p o r t s
T=T a x a t i o n
I = Investment
X=E x p o r t s
G=G o v e r n m e n tS p e n d i n g
The circu lar flow model of an economy is very useful within
the study of economics. We will be looking at the actions and
behaviour of firms and households, and how governments interact
with them. We will look at how changes in the leakages and
injections affect th e stability of an economy.
1.4IMPORTANCE OFTHE CIRCULAR FLOW
The concept of the circular flow gives a clear -cut picture of
the economy. We can know whether the economy is working
efficiently or whether there is any disturbance in its smooth
functioning . As such, the circular flow is of immense significance for
studying the functioning of the economy and for helping the
government in formulating policy measures.
1.Study ofProblems ofDisequilibrium:
It is with the help of circular flow that the proble ms of
disequilibrium and the restoration of equilibrium can be studied.
2.Effects ofLeakages andInflows:
The role of leakages enables us to study their effects on the
national economy. For example, imports are a leakage out of themunotes.in

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7circular flow of inco me because they are payments made to a
foreign country. To stop this leakage, government should adopt
appropriate measures so as to increase exports and decrease
imports.
3.Link between Producers andConsumers:
The circular flow establishes a link betwee n producers and
consumers. It is through income that producers buy the services of
the factors of production with which the latter, in turn, purchase
goods from the producers.
4.Creates aNetwork ofMarkets:
As a corollary to the above point, the linking of producers
and consumers through the circular flow of income and expenditure
has created a network of markets for different goods and services
where problems relating to their sale and purchase are
automatically solved.
5.Inflationary andDeflationary Tendencies:
Leakages or injections in the circular flow disturb the smooth
functioning of the economy. For example, saving is a leakage out of
the expenditure stream. If saving increases, this depresses the
circular flow of income. This tends to reduce em ployment, income
and prices, thereby leading to a deflationary process in the
economy. On the other hand, consumption tends to increase
employment, income, output and prices that lead to inflationary
tendencies.
6.Basis oftheMultiplier:
Again, if leaka ges exceed injections in the circular flow, the
total income becomes less than the total output. This leads to a
cumulative decline in employment, income, output, and prices over
time. On the other hand, if injections into the circular flow exceed
leakages , the income is increased in the economy. This leads to a
cumulative rise in employment, income, output, and prices over a
period of time. In fact, the basis of the Keynesian multiplier is the
cumulative movements in the circular flow of income.
7.Import ance ofMonetary Policy:
The study of circular flow also highlights the importance of
monetary policy to bring about the equality of saving and
investment in the economy. Figure 2 shows that the equality
between saving and investment comes about through th e credit or
capital market.
The credit market itself is controlled by the government
through monetary policy. When saving exceeds investment or
investment exceeds saving, money and credit policies help tomunotes.in

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8stimulate or retard investment spending. This is h ow a fall or rise in
prices is also controlled.
8.Importance ofFiscal Policy:
The circular flow of income and expenditure points toward
the importance of fiscal policy. For national income to be in
equilibrium desired saving plus taxes (S+T) must equal desired
investment plus government spending (I + G). S+ T represents
leakages from the spending stream which must be offset by
injections of I + G into the income stream. If S + T exceed I + G,
government should adopt such fiscal measures as reduction in
taxes and spending more itself. On the contrary.
If I + G exceed S+T, the government should adjust its
revenue and expenditure by encouraging saving and tax revenue.
Thus the circular flow of income and expenditure tells us about the
importance of compensa tory fiscal policy.
9.Importance ofTrade Policies:
Similarly, imports are leakages in the circular flow of money
because they are payments made to a foreign country. To stop it,
the government adopts such measures as to increase exports and
decrease imp orts. Thus the circular flow points toward the
importance of adopting export promotion and import control
policies.
10.Basis ofFlow ofFunds Accounts:
The circular flow helps in calculating national income on the
basis of the flow of funds accounts. The flow of funds accounts are
concerned with all transactions in the economy that are
accomplished by money transfers.
1.5 QUESTIONS
1.Explain the meaning, scope and importance of
Macroeconomics.
2.Discuss the concept of circular flow of national income.
3.What is the importance of circular flow of income?
4.Discuss circular flow of income in a closed economy.
5.Explain the circular flow of income in an open economy.
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9Unit -2
GROSS DOMESTIC PRODUCT (GDP )&
TRENDS IN GDP’S GROWTH RATE
Unit Structure:
2.0 Objectives
2.1 Introduction
2.2 Definition of GNP
2.3 Key Differences between GDP and GNP
2.4 Net National Product
2.5 GDP Deflator
2.6 Importance ofGFPDeflator
2.7 Exchange Rate asP r i c e
2.8 'Purchasing Power Parity'
2.9 Problems of Measuring G DP inPPP
2.10 GDP Growth
2.11 Why GDPGrowth Rate isimportant
2.12 India’s Experience inGDPGrowth
2.13 Sector -Wise Contribution ofGDPofI n d i a
2.14 Questio ns
2.0 OBJECTIVES
To familiar with concept of GDP, GNP, NNP, NDP etc.
To acquaint the students with concept of GDP deflator
To study the GDP at Purchasing Power Parity & exchange rate
as price
to understand India’s experience in GDP growth in recent
years
To study the trends & sectoral composition of GDP in India
2.1INTRODUCTION
Gross Domestic Product or GDP, is the value of everything
that is produced within the country’s domestic territory in a
particular financial year. During the calculation of GD P, the primarymunotes.in

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10focus is to capture the goods produced or services rendered within
the nation’s border, whether the output is produced by the residents
or non -residents of the country. The output produced outside the
geographical boundaries of the country i s not included in GDP.
GDP is an indicator of the size of the economy. It reflects the
aggregate of consumption, investments, spending by the
government and net export (export –import). In general, the GDP is
calculated for one year. However, it can also be calculated for any
term to forecast economic trends.
Calculation of GDP:
GDP = Consumption + Investment + Government Spending + Net
Export
GDP = C + I + G+ (X -M)
2.2DEFINITION OF GNP
Gross National Product or GNP is the total market value of
everyt hing (i.e. goods and services) produced by the residents of
the country during a particular accounting year.
GNP includes the income earned by the country’s nationals
within and outside the country, but it excludes the income earned
by the foreign citizen s and companies within the country. You can
understand the statement, through an example: There are many
enterprises which are operating outside the country. Many citizens
of a country work in another country. The income earned by all
these persons is know n as factor income earned from abroad.
Likewise, non -residents render factor services within the domestic
territory of the country for which they earn income. When you
deduct the factor income paid to non -residents for rendering
services from factor income received from abroad, the result will be
the Net Factor Income received from Abroad (NFIA).
GNP = GDP +NFIA or GNP = C + I + G+ (X -M) + (R -P)
R= Income received by domestic factors for their contribution to
production abroad;
P= Payments made to the foreign factors for their contribution to
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112.3KEY DIFFERENCES BETWEEN GDP AND GNP
Basis for
ComparisonGDP GNP
Meaning The worth of goods and
services produced within the
geographical limits of the
country i s known as Gross
Domestic Product (GDP).The worth of goods
and services
produced by the
country's citizens
irrespective of the
geographical
location is known as
Gross National
Product (GNP).
What is it? Production of products within
the country's boundar y.Production of
products by the
enterprises owned
by the residents of
the country
Basis Location Citizenship
Calculation GDP = Consumption +
Investment + Government
Spending + Net ExportGNP = C + I + G+
(X-M) + ( R -P)
On which scale
productivity is
measured?On a local scale On international
scale
Focus on Domestic production Production by
nationals
Outlines The strength of the country's
domestic economy.How the residents
are contributing
towards the
country's economy.
2.4 NET NATIONAL PRODUCT
Net national product (NNP) is the monetary value of finished
goods and services produced by a country's citizens, overseas and
domestically, in a given period (i.e., the gross national
product (GNP) minus the amount of GNP required to purchase new
goods to m aintain existing stock (i.e., depreciation).munotes.in

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12Calculating NNP:
The formula for NNP is:
NNP = Market Value of Finished Goods + Market Value of Finished
Services -Depreciation
or, NNP can be calculated as
NNP = Gross National Product -Depreciation
Simil arly, net domestic product (NDP) corresponds to gross
domestic product (GDP) minus depreciation.
NDP = GDP –Depreciation
2.5GDP DEFLATOR
Ineconomics ,t h e GDP deflator (implicit p rice deflator )i s
a measure of the level of prices of all new, domestically produced,
final goods and services in an economy. GDP stands for gross
domestic prod uct,t h et o t a lm o n e t a r yv a l u eo fa l lf i n a lg o o d sa n d
services produced within the territory of a country over a particular
period of time (quarterly or annually).
Like the consumer price index (CPI), the GDP deflator is a
measure of price inflation/deflation with respect to a specific base
year; the GDP deflator of the base year itself is equal to 100. Unlike
the CPI, the GDP deflator is not based on a fixed basket of goods
and services; the "basket" for the GDP deflator is allowed to
change from year to year with people's consumption and
investment patterns.
TheGross Domestic Product ( GDP) deflator is a measure of
general price inflation. It is calculated by dividing nominal GDP by
realGDP and then multiplying by 100. Nominal GDP is the market
value of goods and services produced in an economy, unadjusted
for inflation (It is the GDP m easured at current prices). Real GDP is
nominal GDP, adjusted for inflation to reflect changes in real output
(It is the GDP measured at constant prices).
GDP Deflator = Nominal GDP x1 0 0
Real GDP
2.6 IMPORTANCE OF GDP DEFLATOR
There are other measures of inflation too like Consumer
Price Index (CPI) and Wholesale Price Index (or WPI); however
GDP deflator is a much broader and comprehensive measure.
Since Gross Domestic Product is a na g g r e g a t em e a s u r eo f
production, being the sum of all final uses of goods and services
(less imports), GDP deflator reflects the prices of all domestically
produced goods and services in the economy whereas, othermunotes.in

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13measures like CPI and WPI are based on a limited basket of goods
and services, thereby not representing the entire economy (the
basket of goods is changed to accommodate changes in
consumption patterns, but after a considerable period of time).
Another important distinction is that the basket of WPI (at present)
has no representation of services sector. The GDP deflator also
includes the prices of investment goods, government services and
exports, and excludes the price of imports. Changes in
consumption patterns or the introduction of new goods and services
or structural transformation are automatically reflected in the
deflator which is not the case with other inflation measures.
However WPI and CPI are available on monthly basis
whereas deflator comes with a lag (yearly or quarterly, after
quarterly GDP data is released). Hence, monthly change in inflation
cannot be tracked using GDP deflator, limiting its usefulness.
2.6.1Statistics
Ministry of Statistics and Programme Implementation
(MOSPI) comes out with GDP deflator in National Accounts
Statistics as price indices. The base of the GDP deflator is revised
when base of GDP series is changed.
India GDP Deflator 2005 -2018
GDP Deflator in India increased to 128.80 Index Points in
2018 from 125.10 Index Points in 2017. GDP Deflator in Ind ia
averaged 118.39 Index Points from 2005 until 2018, reaching an
all-time high of 146.50 Index Points in 2011 and a record low of 100
Index Points in 2005.
2.7EXCHANGE RATE AS PRICE
Infinance, an exchange rate is the rate at which one
currency will be exchanged for another. It is also regarded as the
value of one country’s currency in relation to another currency. Anmunotes.in

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14exchange rate is the price of a nation’s currency in terms of another
currency. Thus, an exchange rate has two components, the
domestic c urrency and a foreign currency, and can be quoted either
directly or indirectly. In a direct quotation, the price of a unit of
foreign currency is expressed in terms of the domestic currency. In
an indirect quotation, the price of a unit of domestic curren cy is
expressed in terms of the foreign currency. Exchange rates are
quoted in values against the US dollar. However, exchange rates
can also be quoted against another nations currency, which are
known as a cross currency, or cross rate .
Exchange rates ca nb ef l o a t i n go rf i x e d .A floating exchange
rateis where a currency rate is determined by market forces. This
is the norm for most major nations. However, some nations prefer
to fix or peg their domestic currencies to a widely accepted
currency like the U S dollar. Reasons for fixing an exchange rate
can be to reduce volatility or better manage trade relations.
2.8PURCHASING POWER PARITY
The theory aims to determine the adjustments needed to be
made in the exchange rates of two currencies to make them at par
with the purchasing power of each other. In other words, the
expenditure on a similar commodity must be same in both
currencies when accounted for exchange rate. The purchasing
power of each currency is determined in the process.
Description: Purch asing power parity is used worldwide to
compare the income levels in different countries. PPP thus makes it
easy to understand and interpret the data of each country.
Example: Let's say that a pair of shoes costs Rs 2500 in India.
Then it should cost $50 in America when the exchange rate is 50
between the dollar and the rupee.
There are two ways to measure GDP (total income of a
country) of different countries and compare them. One way, called
GDP at exchange rate, is when the currencies of all countries are
converted into USD (United States Dollar). The second way is GDP
(PPP) or GDP at Purchasing Power Parity (PPP) The concept of
purchasing power parity allows one to estimate what the exchange
rate between two currencies would have to be in order for the
exchange to be at par with the purchasing power of the two
countries' currencies. Using that PPP rate for hypothetical currency
conversions, a given amount of one currency thus has the same
purchasing power whether used directly to purchase a market
basket of goods or used to convert at the PPP rate to the other
currency and then purchase the market basket using that currency.
Observed deviations of the exchange rate from purchasing powermunotes.in

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15parity are measured by deviations of the real exchange rate from its
PPP value of 1.
How to Calculate Purchasing Power Parity
The relative version of PPP is calculated with the following formula:
Where:S represents exchange rate of currency 1 to currency 2
P1represents the cost of good x in currency 1
P2represents the cost of good x in currency 2
Uses
Purchasing Power Parity (PPP) is measured by finding the
values (in USD) of a basket of consumer goods that are present in
each country (such as pineapple juice, pencils, e tc.). If that basket
costs $100 in the US and $200 in India, then the purchasing power
parity exchange rate is 1:2.
2.9 PROBLEMS OF MEASURING GDP IN PPP
1.Purchasing Power Parity. When comparing living standards
between different countries, it is important to take into account
different purchasing power parity’s (PPP) –GDP per capita in $
terms does not necessarily reflect the local purchasing power of
a country.
2.Economic activity not measured. Some countries may have
large ‘black market’ or economic acti vity that isn’t measured by
official statistics.
3.Externalities of growth. Higher GDP suggests higher living
standards, but higher economic growth may be at the cost of
increased pollution and congestion. This leads to a decline in
living standards (poor he alth from pollution, time wasted from
congestion).
4.Hours worked Two countries may have similar GDP, but if one
country has an average hourly week of 60 hours worked, this
suggests lower living standards than a country which has an
average of only 40 hours per week.
5.Poverty. Living standards need to take into account how income
and expenditure are distributed through society. A country may
have high GDP per capita but still have significant poverty.
Other measures of living standards, such as Human
Development Index (HDI), try to include these factors.
6.Intangibles. Living standards are not just about consumption of
goods and services. Arguably a key factor in living standards is
issues such as a degree of individual liberty/democracy andmunotes.in

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16freedom. This becomes difficult to quantify from an economic
perspective.
7.Literacy. Access to education is considered an important
aspect of living standards. Without education, people will
struggle to obtain their potential and their human capital will be
lower. Education can also improve living standards in non -
monetary ways –enjoying a greater degree of culture
8.What do we mean by living standards? Some may think of living
standards through financial measures (e.g. income etc.). Others
may place less emphasis on this and focus on issues such as
the environment, ‘general well -being’ and levels of happiness.
2.10 GDP GROWTH
The GDP growth rate measures how fast the economy is
growing. It doe s this by comparing one quarter of the
country's gross domestic product to the previous quarter. GDP
measures the economic output of a nation.
Economic gro wth is the increase in the inflation -
adjusted market value of the goods and services produced by
aneconomy over time. It is conventionally measured as the percent
rate of increas ei nr e a l gross domestic product, or real GDP.
The "rate of economic growth" refers to the geometric annual
rate of growth in GDP between the first and the last year over a
period of time. Implicitly, this growth rate is the trend in the average
level of GDP over the period, which implicitly ignores the
fluctuations in the GDP around this trend.
The GDP growth rate is driven by the four components of
GDP .T hem a i nd r i v e ro fG D Pg r o w t hi s personal consumption .
This includes the critical sector of retail sales . The second
component is business investment, including construction
andinventory levels. Government spending is the third driver of
growth. I ts largest categories are Social Security benefits, defence
spending and Medicare benefits. The government often increases
spending to jumpstart the economy during a recession .F o u r t hi s
net trade: Exports add to GDP while imports subtract from it.
2.11 WHY THE GDP GROWTH RATE IS IMPORTANT
The GDP growth rate is the most important indicator of
economic health. It changes during the four phases of the business
cycle: peak, contraction, trough, and expansion. When the
economy is expanding, the GDP growth rate is positive. If it's
growing, so will businesses, jobs and personal income. But if itmunotes.in

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17expands beyond 3 -4 percent, then it could hit the peak. At that
point, the bubble bursts and economic growth stalls.
If it's contracting, then businesses will hold off investing in
new purchases. They’ll delay hiring new employees until they are
confiden t the economy will improve. Those delays further depress
the economy. Without jobs, consumers have less money to spend.
If the GDP growth rate turns negative, then the country's
economy is in a recession. With negative growth, GDP is less than
the quarter or year before. It will continue to be negative until it hits
a trough. That’s the month things start to turn around. After the
trough, GDP turns positive again.
Contraction happened most recently in late 2008 and early
2009. U.S. GDP growth was negative for four quarters in a row.
The last time this happened was during the Great Depression .T h e
growth rate turn ed positive in Q2 2008. It then turned negative
again, prompting concerns about a double -dip recession. In the
2001 recession, the growth rate had been negative for only two
quarters.
2.12 INDIA’S EXPERIENCE IN GDP GROWTH
National Income Trends:
Featu res of Growth in the Planning Era:
From the above description, one can point out several
features of growth during the planning period.munotes.in

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18First, the growth rates of national income and per capita
income over the last 58 years have been encouraging, particul arly
in the light of the growth rates achieved during the British period.
But, at the same time it is to be noted that the actual performance
has been below the targets set.
Barring the First, Seventh, Eighth, Ninth and Tenth Plan,
actual growth rate rema ined below the target growth rate. In the
First Plan, actual growth rate (3.6 p.c.) exceeded the targeted (2.5
p.c.) rate. In all the plans, targeted growth rate was kept at 5 p.c. or
5.5 p.c. The actual growth rate achieved in various plans has been
shown in the Table 10.1 . As is expected, the economy must grow at
ah i g h e rr a t ea sp l a np e r i o dr o l l so n .T h ea n n u a lg r o w t hr a t ef o rt h e
period 1981 -91 works out to be 5.75 p.c. and for the period 1993 -07
it is 7.5 p.c.
Obviously, if these growth rates are expl ained in real terms
(i.e., at constant prices) the annual growth would be much below
the targeted rates of 6.0 and 6.5 p.c. Secondly, per capita income is
also very small by current standards though it is rising.
Unimpressive growth rate of national income over the plan period
has resulted in a marginal increase in per capita income. It is
observed that, out of 58 years of economic planning, the rate of
increase in NNP was lower than the population growth rate for
more than 22 years. As a result, per capita income registered a
decline in all these years.
Even there are some years when the country has suffered
economic retrogression. Consequently, levels of living of the poor
have gone down to a low level. This can be evidenced from the fact
that in 2004 -0527.5 p.c. of total population lived below the poverty
line compared to 36 p.c. in 1993 -94.This poverty estimate has been
made on consumption distribution using a 30 -day recall —called
Uniform Recall Period (URP). However, poverty estimates based
on Mixed R ecall Period (MRP) has declined from 26.1 p.c. in 1999 -
2000 to 21.8 p.c. in 2004 -05.
Thirdly, India’s national income, even after 58 years of
planning, is largely dependent on agriculture. Good harvests result
in higher growth rates in income and bad har vests cause a fall or
even negative growth rate. So India’s growth rate of national
income is very much linked with the agricultural growth rate. In
recent years, tertiary sector has been contributing largely. Fourthly,
compared to the growth rates of diff erent countries between 1950 -
1980, India’s performance is rather disappointing. At the moment,
world’s highest per capita income country is Norway whose per
capita income was equivalent of $ 66,530 in 2006. India’s per
capita income was of the order of $ 8 20. Burundi ranked lowestmunotes.in

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19among the 133 members of the World Bank with a 2006 annual per
capita income of just $ 100.
Hence the necessity of raising the growth rate arises to close
the increasing gap between developed countries and India and
even between India and other underdeveloped nations of the world
whose growth rates are higher than India. Again, as far as per
capita income trends are concerned, one notices favourable
change also. There was a break in the Sixth Plan when per capita
income rose by 3. 1 p.c. p.a. In the Seventh Plan, it rose further to
3.3 p.c. p.a., in the Eighth Plan, to 4.5 p.c. p.a., and to a high of 6.1
p.c. p.a. in the Tenth Plan.
This is not a mean achievement against the background of
population growth rate of approximately 2 p.c. Between 1990 -01,
per capita income grew at the rate of 3.14 p.c. p.a. This amounts to
saying that in the 1990s and early 2000s number of people living
below the poverty line is on the decline. Even then roughly after 58
years of planning nearly 260 mi llion population live below the
poverty line by any measure. Sectoral composition of national
income between 1950 and 1980 -81 clearly showed predominance
of the primary sector in terms of its contribution towards GDP. Its
share was 38.1 p.c. as contrasted to 36 p.c. of the tertiary sector in
1981.
In 2007 -08, the relative share of primary sector declined to
19.4 p.c. of GDP, while the share of the tertiary sector rose to 55.7
p.c. This suggests a progressive development of the Indian
economy. Finally, Indi a’s performance is not altogether
discouraging if she is compared with other nations though India’s
per capita income is one of the lowest in .the world. India’s average
annual GNP per capita between 1985 and 2006 grew at the rate of
7.4 p.c. as contrasted to the U.S.A’s and U.K’s 1.3 p.c.
However, China performed much better than India. Its GDP
per capita during the same period grew at the rate of 9.8 p.c. In
recent years, growth rates in all the economies have slumped down
due to global recession. Now, w e may sum up the main points. We
have registered a higher growth rate in national income and per
capita income —an improvement over the Hindu rate of growth of
3.5 p.c. during the previous three decades. The query is whether
such high growth can be sustain ed or not. Sustainability of higher
growth rate for a long period is of utmost importance.
However, after the initiation of economic reforms process in
1991, the country is poised for higher economic growth. Between
1992 -93 and 2001 -02, GDP grew at an ave rage annual rate of 6.1
p.c. Although, the GDP growth rate declined to 5.3 p.c. in 2002 -03,
it increased to around 8.5 p.c. in 2003 -04 and 9.2 p.c. in 2006 -munotes.in

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2007.Thus, an air of optimism prevails. It is hoped that sustainable
growth on a long -term basis has b een achieved against some
unexpected shocks like the East Asian crisis, global recession,
unprecedented rise in international oil prices, Indo -Pak border
tension, severe natural calamities, the Iraq war, etc.
Above all, there is some sort of macroeconomic stability (like
low rate of inflation, reasonable stable exchange rate, high foreign
exchange reserves, and adequate stocks of food grains even in the
midst of drought). It may not be out of place to point out here that
the primary objective of the New Ec onomic Policy was to put the
Indian Economy on a sustainable high growth path.
Real GDP growth or Gross Domestic Product (GDP) growth
of India at constant (2011 -12) prices in the year 2016 -17 is
estimated at 7.11 percent as compared to the growth rate of 7.93
percent in 2015 -16. Quarterly GDP growth rates are :Q1 (7.2%), Q2
(7.4%), Q3 (7.0%).
Gross Value Added (GVA) growth rates of Agriculture &
allied, Industry, and Services sector are 4.37%, 5.77%, and 7.87%,
respectively. Manufacturing growth is at 7.7 %. India has registered
highest growth of 11.2% in 'Public Administration, defence and
other services' sector and lowest 1.3% in 'Mining & quarrying'
sector. At current prices, GDP growth rates for year 2016 -17 is
11.52%. Growth for Q1, Q2, Q3 are 10.8%, 1 1.8%, 10.6%,
respectively. GVA growth rates of Agriculture & allied, Industry, and
Services sector are 9.64%, 8.32%, and 11.87%, respectively. At
constant prices GVA (Gross Value Added), GNI (Gross National
Income), NNI (Net National Income) growth of Indi a is estimated at
6.67%, 7.17% and 7.24%, respectively. At cu rrent prices these
figures is 10.43%, 11.60% and 11.61%.
Data from 1950 -51 to 2011 -12 is from 2004 -05 series and
2011 -12 to 2014 -15 is from 2011 -12 series. According to IMF World
Economic Outloo k (October -2016), GDP growth rate of India in
2016 is 7.6% and India is 4th fastest growing nation of the world.
Average growth rate from 1980 to 2016 stands at 6.32%, reaching
an all -time high of 10.26% in 2010 and a record low of 1.06% in the
1991.In previous methodology, Average growth rate from 1951 to
2014 stands at 4.96%, reaching an all -time high of 10.16% in 1988 -
89 and a record low of-5.2% in the 1979 -80. In 4 years, Growth
was negative.munotes.in

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212011 -2012 Series
Year Growth at 2011 -12 prices Growth at Current prices
GDP GVA GNI NNI GDP GVA GNI NNI
2016 -17 7.11 6.67 7.17 7.24 11.52 10.43 11.60 11.61
2015 -16 7.93 7.83 7.93 7.96 9.99 8.56 10.00 10.24
2014 -15 7.18 6.94 7.25 7.17 10.65 10.65 10.72 10.71
2013 -14 6.54 6.21 6.46 6.16 12.97 12.61 12.89 12.90
2012 -13 5.48 5.45 5.17 4.59 13.86 13.55 13.52 13.28
2.13SECTOR -WISE CONTRIBUTION OF GDP OF
INDIA
Indian economy is classified in three sectors —Agriculture
and allied (Primary sector), Industry (Secondary sector) and
Services (Tertiary sector). Agriculture sector includes Agriculture
(Agriculture proper & Livestock), Forestry & Logging, Fishing and
related activities.
Industry includes 'Mining & quarrying', Manufacturing
(Registered & Unregistered), Electricity, Gas, Water supply, and
Construction.
Services sector includes 'Trade, hotels, transport,
communication and services related to broadcasting', 'Financial,
real estate &professional services, 'Public Administration, defence
and other services'.
Services sector is the largest sector of India. Gross Value
Added (GVA) at current prices for Services sector is estimated at
73.79 lakh crore INR in 2016 -17. Services sector ac counts for
53.66% of total India's GVA of 137.51 lakh crore Indian rupees.
With GVA of Rs. 39.90 lakh crore, Industry sector contributes
29.02%. While, Agriculture and allied sector shares 17.32% and
GVA is around of 23.82 lakh crore INR.At 2011 -12 prices,munotes.in

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22composition of Agriculture & allied, Industry, and Services sector
are 15.11%, 31.12%, and 53.77%, respectively.
Sector -wise composition
At Constant Prices (2004 -2005) series
Year Primary
sectorSecondary
SectorTertiary
Sector
1950 -51 53.7 14.4 29.5
1960 -61 49.8 18.0 30.2
1970 -71 43.9 21.4 33.3
1980 -81 38.3 23.0 37.6
1990 -91 33.1 24.1 42.5
2000 -01 25.2 24.2 50.5
2010 -11 16.8 25.6 57.5
2015 -16 18.4 28.2 53.4
2016 -17 18.1 28.2 53.7
Source: Economic survey, 2016 -17
Trends in the Sector -wise con tribution:
We can observe the following broad trends in the sector -
wise contribution of GDP : -
1.Declining Agriculture
India’s economy is rooted in a strong agricultural sector
which constituted about 52% of its GDP in 1951. It truly was an
agrarian economy . Over the years, agriculture has slowly declined
as a percentage of the GDP. In the late 1980s, agriculture fell to
just below 30% of the GDP and after 2004, agriculture fell further to
under 20% of GDP. However, agricultural (which includes forestry,
fishing, livestock production and cultivation of crops) still holds huge
importance for the Indian economy. The sector employs about 50%
of the labour force, contributes a declining yet significant share of
17-18% to the GDP and constitutes about 10% of India ’sexports .munotes.in

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23In terms of produce, India’s is the among the world's largest
producers of tea, milk, pulses, cashew, spices, jute, rice, wheat,
fruits and vegetables, sugarcane, oilseeds and cot ton. The country
accounts for 2.07% of the global agricultural trade. There is
immense potential for improvement and growth in the agricultural
sector and initiatives by the government to boost long -term
investment should help realize those in the coming y ears.
2.Industry
The share of the industrial sector (which includes
construction, mining, manufacturing, electricity, gas and water) has
hovered between 24% -29% of the GDP for the last three decades
(from 1980 onwards). The sector employs just about 20% of the
labour force In India. The industrial sector has lagged behind in
India’s transformation from an agrarian economy to one being
dominated by the services sector.
The Index of Industrial Production (IIP) is a monthly
assessment by India's Ministry of S tatistics and Programme
Implementation (MOSPI) that measures the pulse of short -term
industrial activity in India. The IIP is composed of different sectors --
manufacturing, mining and electricity --and each sector has a
different allocation in the index. Man ufacturing contributes 75.52%
while mining and electricity contribute 14.16% and 10.32%,
respectively. The 75% allocation speaks about the importance of
manufacturing in the economy and the dominance of the industrial
sector. However, despite huge potentia l, the manufacturing sector
is still largely untapped, contributing only about 17% to the
GDP. The graph below shows the trend in the IIP over the years.
It’s been a journey of highs and lows.
The government is making efforts to push the industrial
sector by boosting manufacturing. Under Indian Prime Minister
Narendra Modi’s government, the “Make in India” initiative aims tomunotes.in

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24position India as a global manufacturing hub. The initiative hopes to
increase manufacturing by 25% (as measured in percentage of
GDP) over the next 10 years, a task easier said than done. If an
industrial sector, led by manufacturing, gains steam; it would create
millions of jobs, reduce dependence on imports, increase exports
and complement the services sector.
3.The Rise of the Ser vices Sector
Growth in the services sector in India started during the mid -
1980s, but it was the reforms of the 1990s that accelerated this
growth. The services sector is now the largest and fastest growing
sector of the economy, contributing more than 50% to the GDP.
India’s Central Statistics Office classifies the services sector into
four main industries: 1) restaurants, hotels and trade; 2) storage,
communication and transportation; 3) finance, insurance, business
services and real estate; and 4) social , personal and community
services.
The average share of the services sector in India’s GDP was
below 30% during the 1950s. During the 1960s and 70s, services
gradually crossed the 30% mark. The sector then hovered around
40% and 45% in the 1980s and 1990 s. After 2000, the contribution
of the services sector to the GDP crossed 50%. From 2000 to
2014, the services sector has grown at a compound annual growth
rateof 8.5%.
According to India’s Department of Industrial Policy and
Promotion, the services sect or received the maximum foreign direct
investment , amounting to $41,755 million (or 18%) of the total
foreign inflows from April 2000 to December 2014. While the
services sector has contributed to the country’s growth, critics point
out that the sector has generated relatively few jobs when
compared to its rising importance to the nation’s GDP. It employs a
little more than 30% of the country’s labour force.
The Bottom Line
According to the World Bank, “India carries great promise of
an acceleration in economic growth that is also inclusive and
sustainable.” The fundamentals of the Indian economy are strong. It
has reduced dependence on exports, boasts a high
domestic savings rate and claims a rising middle class and
consumer base. It also possesses enviabl edemographics: by 2020
India will be home to the largest working -age population in the
world. Nevertheless, the real demographic -dividend can only be
reaped if the government adequately invests in the skill
development and education of its youth. To compl ement these
basics, the government in power is pushing an ambitious economic
development target and seeks to improve the macroeconomic
environment and boost growth through manufacturing. However,munotes.in

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25India is still challenged by vast unorganized sector of busi nesses
who operate outside of legal and tax provisions and dodge data
collection. Tax evasion, poverty, structural bottlenecks, corruption,
delays in reforms and inadequate infrastructure are all challenges
to India's economy.
2.14 QUESTIONS
1.Explain th eMeaning & nature of Gross Domestic Product
(GDP) .
2.Discuss the k ey differences between GDP & GNP .
3.Explain the Concept of GDP Deflator .
4.Explain the concept of Purchasing Power Parity (PPP) .
5.Describe the problems of measuring GDP in PPP.
6.Discuss the Trends in India’s GDP growth
7.Explain the Sector -wise contribution of GDP in India .
8.Why the GDP growth rate is important? –Explain.
9.Discuss experience in GDP growth with reference to India.

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26Module 2
Unit -3
CONSUMPTION, SAVING AND
INVESTMENT
Unit Structure:
3.0 Objectives
3.1 Introduction : Meaning, Scope of Open & Closed Economy
3.2 Consumption Function
3.3 Saving Function
3.4 Investment Multiplier
3.5 Questions
3.0 OBJECTIVES
Introduction to National Income identities
To acquaint the students with National Income identities in
Open & Closed economy
to study the consumption function & its determinants
to understand how do Investment Multiplier work
To study leakages of multiplier pr ocess
3.1INTRODUCTION
The main difference between an open economy and a
closed economy is that in an open economy, the total value of its
consumption may be different from the total value of its GDP.GDP
is divided into four broad categories of spending: consumption (C),
investment (I), government purchases (G) and net exports (X –AT),
where X stands for exports and M for imports.
Sowecanexpress GDP as:
Y=C+I+G+( X –M)
This identity is called national income accounts identity for
an open econ omy. Consumption refers to household expenditure
on various goods and services. Goods are of three types: non -
durables (such as food and cloth), durables (such as cars and
refrigerators) and services (such as haircut, education and medical
care).
Investme nt refers to capital goods, which are purchased for
producing mainly consumer goods in the economy (although, in
reality, machines are also used to make machines). It may bemunotes.in

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27noted, at the outset, that investment does not include purchases of
shares and bon ds, which just reallocate existing assets among
different individuals. Investment refers to expenditure on new
capital, which can be used in the future.
Investment is of three main types: business fixed investment,
residential fixed investment and invento ry investment. Business
investment is the purchase (acquisition) of new plant, equipment
and machinery by firms.
Residential investment is the purchase of new houses by the
individuals. Inventory investment is the increase in the firm’s stock
of finished goods (although business firms also hold stocks of raw
materials). A fall in inventories implies negative investment and vice
versa.
Government purchases are the various goods and services
purchased by the central, state and local governments (such as
municipalities and panchayats) such as food, books, stationery,
railway wagons, and medicines as also services of government
workers. For example, when an individual is working in a
nationalised bank, the government is buying his service by paying
him salary.
Government purchases does not include transfer payments
made to individuals, such as pensions, interest on government
bonds, unemployment benefit, etc. Those who receive such
transfer payments do not provide anything to the government in
exchange.
This is why they are excluded from GDP. For example,
interest on government bonds is not a part of GDP because
government pays interest on bonds just by taxing people. So, there
is a transfer of income from taxpayers to bondholders but the total
production of g oods and services and thus, the flow of income
remains constant. There is just reallocation of existing income
through such transfers. However, interest paid by a company to its
debenture holders is a part of national income because the
company pays such i nterest from its sales revenue.
Net exports are the difference between exports and imports.
It is the difference between the value of goods and services
exported to the rest of the world and the value of goods and
services imported from the rest of the wo rld. They represent the net
exports by foreigners on domestically produced goods and
services. Such income generates income for domestic producers.
Thus, national income is the sum -total of income earned by
the people of a country through their contributi on to the productionmunotes.in

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28process. It not only includes income earned within the domestic
territory of a country but also any income earned abroad.
We may now refer to the macroeconomic identity for an
open economy.
TheNational Income Accounts Identity foranOpen Economy:
From the expenditure side, national income = total final expenditure
N. I. = C + I + G + X –M
Total final expenditure consists of expenditure that generates
income, or it can be thought of as sources of income.
Now letusconsider theexpression:
Y = C + S + T. The right hand side of this equation indicates the
use of the income generated in the economy (for consumption, for
saving, and for taxes).
Since uses ofincome must equal sources ofincome, wehave
thefollowing identity:
C+S+ T=C+I+G+X –M
or, S + T = I + G + X –M
or, S + T + M = I + G + X
This implies that the sum -total of leakages from the circular flow of
income = the sum -total of injections into the circular flow.
Another Interpretation oftheabove Identity:
Theabove equation can be expressed as:
I+G+X=S+T+M
or, I = S + (T –G) + (M –X)
Total investment = household saving + budget surplus + trade
deficit
or, S = I + (G –T) + (X –M)
or, S –I=( G –T) + (X –M)
or, the difference between S and I = government budget deficit +
trade surplus.
TheTwin Deficits:
In an open economy, a fiscal deficit shall spread to a current
account deficit (CAD). The CAD is the excess of I over S plus the
excess of G over T. So as G exceeds T, unless I falls or S rises ,t h e
CAD will widen.
The national income identity in an open economy
Y=C+I+G+N X
or, NX = Y –(C + I + G)
NX = Net Exports, Y= output, (C+I+G) = Domestic Spending;
Trade surpluses and deficitsmunotes.in

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29NX = EX –IM = Y –(C + I + G )
Trade surplus: output > spending and exports > imports
Size of the trade surplus = NX
Trade deficit: spending > output and imports > exports
Size of the trade deficit = –NX
International capital flows
Net capital outflow = S –I = net outflow of “loanable funds”= net
purchas es of foreign assets = the country’s purchases of foreign
assets -foreign purchases of domestic assets
When S > I, country is a net lender
When S < I, country is a net borrower
The link between trade & capital flows
NX = Y –(C + I + G) implies NX = (Y –C–G)–I=S –I
trade balance = net capital outflow
Thus, a country with a trade deficit (NX< 0) is a net borrower (S < I)
In any Open economy have three possibilities;
1.A country with trade Surplus. 2. A country with balanced trade.
3. a country w ith trade deficit. The relationship between saving,
investment and international flow of goods and capital is
summarised as follows: -
2.
Trade Surplus Balanced Trade Trade Deficit
Exports > Imports Exports = Imports Exports < Imports
Net exports > 0 Net exports = 0 Net exports < 0
Y>C+I+G Y=C+I+G YSavings >
InvestmentSavings =
InvestmentSavings <
Investment
Net Capital Outflow
>0Net Capital Outflow
=0Net Capital Outflow
<0
3.2CONSUMPTION FUNCTION
3.2.1Introduc tion:
Given the aggregate supply, the level of income or
employment is determined by the level of aggregate demand; the
greater the aggregate demand, the greater the level of income and
employment and vice versa.
Keynes was not interested in the factors d etermining the
aggregate supply since he was concerned with the short run and
the existing productive capacity. We will also not explain in detail
the factors which de termine the aggregate supply and will confine
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30Aggregate demand consists of two parts —consumption
demand and investment demand. In this article we will explain the
consumption demand and the factors on which it depends and how
it changes over a period of time. Consumption demand de pends
upon the level of income and the propensity to consume. We shall
explain below the meaning of the consumption function and the
factors on which it depends.
3.2.2TheConcept ofConsumption Function:
Propensity to consume is also called consumption
function. In the Keynesian theory, we are concerned not with the
consumption of an individual consumer but with the sum total of
consumption spending by all the individuals. However, in
generalizing the consumption behaviour of the whole economy, we
have to draw some useful conclusions from the study of the
behaviour of a normal consumer, which may be valid for all
consumers’ behaviour of the economy. Aggregate consumption
depends on consumption function or propensity to consume.
The economic term ‘consu mption’ means the amount spent
on consumption at a given level of income. ‘Consumption
function’ or‘propensity to consume’ means the whole of the
schedule showing consumption expenditure at various levels of
income. It tells us how consumption expenditu re increases as
income increases. The consumption function or propensity to
consume, therefore, indicates a functional relationship between the
aggregates, viz., total consumption expenditure and the gross
national income. It is a schedule that expresses relationship
between consumption and disposable income.
According to Keynesian theory, following are the factors that
influence consumption:
(a) The real income of the individual,
(b) The past savings, and
(c) Rate of interest.
3.2.3 Average and Marginal Propensities to Consume:
The average propensity to consume (APC) is a relationship
between total consumption and total income in a given period of
time. In other words, APC is the ratio of consumption to
income. Thus:CAPCYWhere C : Consumption
Y : Income
APC : Average propensity to consume
While, the marginal propensity to consume (MPC) measures
the incremental change in consumption as a result of a gi venmunotes.in

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31increment in income. In other words, MPC is the ratio of change in
consumption to the change in income.CMPCYWhere ΔC: Incremental change in consumption
ΔY: Incremental chan ge in income
MPC : Marginal propensity to consume
The normal relationship between income and consumption is
that when income increases, consumption also increases, but by
less than the increase in income. In other words, in normal
circumstances, mpc is less than one. It is drawn as a straight -line
with a slope of less than one. This slope indicates the percentage
of additional disposable income that will be spent. It is assumed
that the whole additional income is not spent, i.e., a certain amount
is spent and the remainder is saved. This can be further explained
with the help of following table and diagram:
Income Consumption Saving
100 75 25
120 90 30
140 105 35
180 135 45
220 165 55
Fig3.1Income consumption re lationship
In the above diagram, OL is the income line and OP is
income consumption curve. The income consumption line OP lies
below the income line OL. The MPC will be measured by the
tangent of the angle that income consumption curve makes with X -
axis.
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32The curve as we have drawn turns out to be straight line
rising from the origin, which means that MPC is constant
throughout. This, however, need not be so and the curve may well
become flatter as income rises, for as more and more consumption
needs h ave been satisfied, a greater share of an increase in
income than before may be saved. The dotted curve OM
represents such a relationship showing that as income rises, MPC
becomes smaller and smaller.
There is a level of disposable income (DI) at which t he entire
income is spent and nothing is saved. This point is often known
as‘point of zero savings’ .Below this level of DI, the consumption
expenditure will exceed the DI. There may be cases in which the
consumer has no income at all. In such cases, the income
consumption curve may not rise from the origin but from farther left
showing that when income is zero, consumption is not zero and
that the individual is living on his past savings.
3.2.4 Propensity to Save:
Fig3.2saving -income curve
Inthe above diagram, ON represents the saving -income
curve. Savings at a given level of income can also be read off from
the distance between a point on income -consumption curve and
corresponding point on income curve (See the figure of income -
consumption r elationship). The marginal propensity to save (MPS)
can be measured by the slope of income -saving curve
ON. Marginal propensity to save (MPS) is the increment in savings
caused by a given increment in income. The MPS is always equal
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33
Consumption demand depends on income and propensity to
consume. Propensity to con sume depends on various factors such
as price level, interest rate, stock of wealth and several subjective
factors. Since Keynes was concerned with short -run consumption
function he assumed price level, interest rate, stock of wealth etc.
constant in his theory of consumption. Thus with these factors
being assumed constant in the short run, Keynesian consumption
function considers consumption as a function of income. Thus
C= f(Y)
Inaspecific form, Keynesian function canbewritten as:
C=a+f ( Y ) where a and b are constants. While a is intercept term
of the consumption function, b stands for the slope of the
consumption function and therefore represents margi nal propensity
to consume.
Keynesian consumption function has been depicted by CC’
curve in Fig. 11.3in which along the X -axis national income is
measured and along the Y -axis the amount of consumption is
measured. In this figure, a line OZ making 45° an gle with the X -
axis, has been drawn. Because line OZ makes 45° angle with the
X-axis every point on it is equidistant from both the X -axis and Y -
axis.
Therefore, if consumption function curve coincides with 45°
line OZ it would imply that the amount of co nsumption is equal to
the income at every level of income. In this case, with the increase
in income, consumption would also increase by the same amount.
As has been said above, in actual practice consumption increases
less than the increase in income. The refore, in actual practice the
curve depicting the consumption function will deviate from the 45°
line. If we represent the above consumption schedule by a curve,
we would get the propensity to consume curve such as CC in
Fig.3.3.
It is evid ent from this figure that the consumption function
curve CC’ deviates from the 45° line OZ. At lower levels of income,
the consumption function curve CC lies above the OZ line,
signifying that at these lower levels of income consumption ismunotes.in

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34greater than the income. It is so because at lower levels of income,
a nation may draw upon its accumulated savings to maintain its
consumption standard or it may borrow from others. As income
increases, consumption also increases and at the income level
OY 0, consumption is equal to income.
Fig3.3Keynesian Linear Consumption function
Beyond this, with the increase in income, consumption
increases but less than the increase in income and therefore,
consumption function curve CC lies below the 45° line OZ beyond
Y0.A n important point to be noted here is that beyond the level of
income OY 0, the gap between con sumption and income is
widening. The difference between consumption and income
represents savings. Therefore, with the increase in income, saving
gap also widens and as we shall see later, this has a significant
implication in macroeconomics.
3.2.5 Keynes’ Law of Consumption:
Keynes propounded a law based on the analysis of
consumption function. This law is known as ‘Fundamental Law of
Consumption’ or‘Psychologi cal Law of Consumption’. It states that
aggregate consumption is a function of aggregate disposable
income.
Propositions of the Law:
This law consists of three propositions:
(a)When aggregate income increases, consumption expenditure
will also increase but by a somewhat smaller amount.
(b)When income increases, the increment of income will be divided
in same proportion between saving and consumption.
Consumption and saving go side by side. What is not
consumed is saved. Savings is, thus, the complem ent of
consumption.munotes.in

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35(c)As income increases, both consumption spending and saving
go up. An increment in income is unlikely to lead either to less
spending or less savings than before. It will seldom happen that
a person may decrease his consumption or his savings when he
has got more income.
3.2.6 Assumptions:
(a)Habits of people regarding spending do not change or that the
propensity to consume remains the same or stable.
(b)The economic conditions remain normal .There is no hyper -
inflation or war or other abnormal conditions.
(c)The economy is a free-market economy. There is no
government intervention.
(d)The important characteristic of the slope of consumption
function is that the marginal propensity to consume ( MPC )
will be less than unity. This results in low -consumption and
high-saving economy.
3.2.7 Implications:
According to Keynesian theory, the mpc is less than unity,
which brings out the following implications:
(a)Since consumption largely depends on income and
consumption function i s more or less stable, it is necessary
to increase investment fill the gap of declining consumption as
income increases. If this is not done, the increased output will
not be profitable.
(b)When the income increases, and the consumption are not
increased ,t h e r ei sa danger of over -production. The
government will have to step in to remedy the
situation. Therefore, the policy of laissez -faire will not work
here.
(c)If the consumption is not increased, the marginal efficiency
of capital (MEC) will diminis h.The demand for capital will
also diminish, and all the economic progress will come to a
standstill.
(d)Keynes’ Law explains the turning points in the business
cycle .When the trade cycle has reached the highest point of
prosperity, income has gone up .But since consumption does
not correspondingly go up, the downward cycle starts, for
demand has lagged behind. In the same manner, when the
business cycle has touched the lowest point, the cycle starts
upwards, because consumption cannot be diminished b eyond a
certain point. This is due to the stability of MPC.munotes.in

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36(e)Since the MPC is less than unity, this law explains the over-
saving gap .As income goes on increasing, consumption does
not increase as much. Hence saving process proceeds
cumulatively and there arises a danger of over -saving.
(f)This law also explains the unique nature of income
generation .If money is injected into the economic system, it
will increase consumption but to a smaller extent than increase
in income. This again is due to th e fact that consumption does
not increase along with increase in income.
3.2.8 Factors Influencing Consumption Function:
There are certain factors affecting the propensity to consume
in the long -run:
1. Objective Factors:
(a)Distribution of income: It is generally observed that the
average and marginal propensities to consume of the poor are
greater than those of the rich. This is because the poor has a lot of
unsatisfied wants and he is likely to seize every opportunity that
comes his way to satisf yt h e m . On the other hand, the rich have
already a high standard of living and relatively less urgent wants
remain to be satisfied, so that in their case, an addition to their
incomes is more likely to be saved than spent on consumption.
(b)Fiscal pol icy:Fiscal policy of the government will also
influence the consumption behaviour of an economy. A reduction
in taxation will leave more post -tax incomes with the people and
this will stimulate higher expenditure on consumptions. Similarly,
an increase in taxes will depress consumption.
(c) Changes in business expectations: Business expectations
by affecting the incomes of certain classes of people affect
consumption function.
(d)Windfall gains and losses: The windfall losses and gains
arising ou t of changes in capital values affect the ‘saving brackets’
mostly and not the spending sections. Hence, their influence on
consumption function is not so well marked.
(e)Liquidity preferences: Another factor is the people’s liquidity
preferences. Ifpeople prefer to keep their income in liquid ford,
consumption is reduced correspondingly.munotes.in

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37(f) Substantial changes in the rate of interest.
2. Subjective Factors:
(a)Individual motives to save:
(i) Building of reserves for unforeseen con tingencies as illness or
unemployment,
(ii) To provide for anticipated future needs such as daughter’s
wedding, education, etc.
(iii) To enjoy an enlarged future income by investing funds out of
current income, etc.
(b)Business motives:
(i) The desire to expand business,
(ii) The desire to face emergencies successfully,
(iii) The desire to have successful management,
(iv) The desire to ensure sufficient financial provision against
depreciation and obsolescence.
3.2.9 Measures for Raisin g Consumption:
1.Redistribution of income in favour of poor where propensity to
consume is greater.
2.Comprehensive social security measures like unemployment
doles, old -age pension, sickness insurance, etc.
3.Liberal wage policy, and
4.Credit f acilities for middle and poor classes for purchasing more
consumer goods.
3.2.10 Importance of Consumption Function:
1.Important tool of macro -economic analysis.
2.Value of the multiplier gives us a link between changes in
investment and changes in in come.
3.Consumption function invalidates the Say’s Law, which states
that supply creates its own demand, because this theory does
not hold accurate in the real world.
4.It shows the crucial importance of investment.
5.It explains the reasons of de clining MEC.
6.It explains the turning points of business cycle.
3.3SAVING FUNCTION
As mentioned above, consumption increases as income
increases but less than the rise in income. We will now explain
what happens to saving when income increases. Savi ng is defined
as the part of income which is not consumed because disposable
income is either consumed or saved.munotes.in

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38Thus,
Y=C+S
S=Y –C
where Y = Disposable income, C = Consumption, S = Saving
Like consumption, saving is also a function of income. Thus ,s a v i n g
function can be written as
S= f(Y)
Saving function is a counterpart of a consumption function,
Therefore, given a particular consumption, function, we can derive
the corresponding saving function. Let us take the Keynesian
consumption, namely, C = a + bY. We can derive saving function
corresponding to it.
Since Y = C + S
S=Y –C
Now, substituting the above Keynesian function for C in (i) we have
S=Y –(a + bY)
=Y–a–bY
=–a+Y –bY
=–a+( 1 –b) Y
Note that (1 –b) in the above savi ng function in (ii) is the
value of marginal propensity to save where b is the value of
marginal propensity to consume.
3.3.1Average propensity tosave:
An important relationship between income and saving is
described by the concept of average propensit y to save. (APS).
Average propensity to save is the proportion of disposable income
that is saved (i.e. not consumed). Mathematically
APS = Savings/Disposable Income = S/Y
Like the average propensity to consume (APC) average
propensity to save also genera lly varies as income increases. As
seen above, average propensity to consume (APC) falls as income
increases. This implies that average propensity to save will
increase as income rises.
Let us derive an important relationship between average propensity
toconsume and average propensity to save.
Restating below therelation thatincome iseither consumed or
saved:
C+S=Y
Dividing both sides by disposable income Y we have
C/Y + S/Y + Y/Y = 1munotes.in

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39Since C/Y is average propensity to consume and S/Y is average
propensity to save, we have
APC + APS = 1
or APS = 1 –APC
Fig3.4saving Function derived from Consumption function
3.3.2Marginal Propensity toSave (MPS):
Whereas average propensity to save indicates the proportion
of income that is saved, marginal p ropensity to save represents
how much of the additional disposable income is devoted to saving.
The marginal propensity to save is therefore change in savings
induced by a change in the disposable income.
Thus,
MPS = ΔS/ΔY
For example, ifdisposable income increases from rupees
10,000 to12,000 andthis causes planned savings toincrease
byRs.500crores, marginal propensity tosave is:
MPS = 500/2000 = 1/4 = 0.25munotes.in

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40Since the additional income is either consumed or saved, the sum
of marginal propensity to consume and marginal propensity to save
is equal to one.
MPC + MPS = 1
This can be mathematically proved as under
From C + S = Y, it follows that any change in income (AF) must
induce either change in consumption (AC) or change in saving
(AS). Thus.
ΔC + ΔS = ΔY
Dividing both sides by ΔY we have
ΔC/ΔY + ΔS/ΔY = ΔY/ΔY = 1
MPC + MPS = 1
The concept of marginal propensity to save is graphically
shown at the bottom of Fig. 6.6. It will be seen from this figure that
when disposable income increases from OY 1(say Rs. 10,000) to
OY 2(say Rs. 12,000), that is, ∆Y = Rs. 2000, the saving increases
by Y 2T, (Rs. 500), that is, ΔS is Rs. 500. Thus marginal propensity
to save (MPS) is
ΔS/ΔY = Y2T/Y 1Y2=5 0 0 / 2 0 0 0=1 / 4=0 . 2 5
Conclusion:
In the work of Keynes, Fis her, Modigliani and Friedman, we
have seen a progression of views on consumer behaviours. Keynes
proposed that C depends largely on current Y. Since then,
economists have argued that consumers face an inter -temporal
decision. Consumers look ahead to their future resources and
needs, implying a more complex Consumption function, than the
one proposed by Keynes. Keynes suggested a Consumption
function of the form: C = f (current Y).
Recent work suggests instead that C = f (Current Y, Wealth,
Expected Future Y, Interest Rates).
Economists continue to debate the relative importance of
these determinants of C. There remains disagreement on the effect
of interest rates and the prevalence of borrowing constraints. One
reason economists sometimes disagree about th e effects of
economic policy is that they are assuming different Consumption
functions.
3.4 INVESTMENT MULTIPLIER
3.4.1 Introduction
The theory of multiplier occupies an important place in the
modern theory of income and employment. The concept of
multip lier was first of all developed by F.A. Kahn in the early 1930s.
But Keynes later further refined it. F.A. Kahn developed the conceptmunotes.in

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41of multiplier with reference to the increase in employment, direct as
well as indirect, as a result of initial increase in investment and
employment. Keynes, however, propounded the concept of
multiplier with reference to the increase in total income, direct as
well as indirect, as a result of original increase in investment and
income.
In practice, it is observed that when investment is increased
by a certain amount, then the change in income is not restricted to
the extent of the initial investment, but it changes several times the
change in investment. In other words, change in income is a
multiple of the change in investm ent. Multiplier explains how many
times the income increases as a result of an increase in the
investment.
Multiplier (k) is the ratio of increase in national income ( ∆Y) due to
an increase in investment ( ∆I).
K=∆Y/∆I
Suppose an additional investment ( ∆I) of RS 4,000 crores in an
economy generates an additional income ( ∆Y) of Rs 16,000 crores.
The value of mu ltiplier (k), in this case will be:
k= 1 6 , 0 0 0 / 4 , 0 0 0=4
It means, income increased 4 times with a single increase in
investment.
3.4.2 Multiplier andMPC:
There exists a direct relationship between MPC and the
value of multiplier. Higher the MPC, more wil lb et h ev a l u eo f
multiplier, arid vice -versa. The concept of multiplier is based on the
fact that one person’s expenditure is another person’s income.
When investment is increased, it also increases the income of the
people. People spend a part of this in creased income on
consumption. However, the amount of increased income spent on
consumption depends on the value of MPC.
1. In case of higher MPC, people will spend a large proportion of
their increased income on consumption. In such case, value of
multip lier will be more.
2. In case of low MPC, people will spend lesser proportion of their
increased income on consumption. In such case, value of multiplier
will be comparatively less.
Thus, the value of multiplier depends upon the MPC
The algebraic relation between Multiplier and MPC can be
derived inthefollowing manner:
We know, at equilibrium, income (Y) is the sum total of
consumption (C) and investment (I).
Y=C+Imunotes.in

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42Similarly, any change in income ( ∆Y) will also be equal to (∆C + ∆I).
∆Y = ∆C + ∆I
Multiplier isdirectly related toMPC and inversely related to
MPS:
The value of multiplier depends upon the value of marginal
propensity to consume. Multiplier (k) and MPC are directly related,
i.e., when MPC is more, k is more and vice -versa. On the cont rary,
higher the MPS, lower will be the value of multiplier and vice -versa.
3.4.3Maximum Value ofMultiplier:
The maximum value of multiplier is infinity when the value of
MPC is 1. MPC = 1 indicates that the economy decides to consume
the whole of its a dditional income. Here, not even a bit of the
additional income is saved. It will lead to a continuous increase in
the consumption expenditure and value of multiplier will be infinity.
3.4.4Minimum Value ofMultiplier:
The minimum value of multiplier is one when the value of
MPC is zero. MPC = 0 indicates that the economy decides to save
the whole of its additional income and nothing is spent as
consumption expenditure. So, there will be no further increase in
income. As a result, the total increase in in come ( ∆Y) will be equal
to the increase in investment ( ∆I), i.e., ∆Y = ∆I Here, the value of
multiplier is equal to 1.
3.4.5Working ofMultiplier:
The working of multiplier is based on the fact that ‘One
person’s expenditure is another person’s income’. When an
additional investment is made, then income increases many times
more than the increase in investment. Let us understand this with
the help of an example.munotes.in

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431.Suppose, an additional investment of Rs 100 crores (AI) is
made to construct a flyover. This e xtra investment will generate
an extra income of Rs100 crores in the first round.
2.If MPC is assumed to be 0.90, then recipients of this additional
income will spend 90% of Rs 100 crores, i.e. Rs 90 crores as
consumption expenditure and the remaining amount will be
saved. It will increase the income by Rs 90 crores in the second
round.
3.In the next round, 90% of the additional income of Rs 90 crores,
i.e. Rs 81 crores will be spent on consumption and the
remaining amount will be saved.
4.This multiplier process will go on and the consumption
expenditure in every round will be 0.90 times of the additional
income received from the previous round.
Table No. 3.1
Thus, an initial investment of Rs 100 crores leads to a total
increase of Rs 1,000 crores in the income .A sar e s u l t ,M u l t i p l i e r( K )
=∆Y/∆I= 1,000/100 = 10
Diagrammatic Presentation ofMultiplier:
The multiplier can also be shown graphically using the AD
and AS approach. In Fig. 8.7, income is taken on the X -axis and
aggregate demand on the Y -axis. Suppos e, the initial equilibrium is
determined at point E where AD curve intersects the AS curve. The
equilibrium level of income is OY. Now, suppose that the
investment increases by ∆I / so that the new aggregate demand
curve (AD 1) intersects the aggregate supp ly curve (AS) at point ‘F’.
Thus, the new equilibrium level of income is OY 1. The income rises
from OY to OY 1, in response to an initial increase in investment
(∆I ). It is clear from the figure that the increase in income (YY1or
∆Y) is greater than increase in investment ( ∆I ). The value of
multiplier is given by
K=∆Y/∆Imunotes.in

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44
Fig3.5
3.4.6TheReverse Investment Multiplier:
The multiplier process also works for a fall in investment with
a subsequent fall in income. If MPC = 4/5 and investment fa lls by
Rs. 1000 crores national income will fall by Rs. 5000 crores. This
will reduce the level of saving by Rs. 1000 crores because MPS =
1/5. So the new level of equilibrium will be reached when S = I =
Rs. 4000 crore or where the desire to save and the desire to invest
are once again equal.
3.4.7 Assumptions of the Multiplier
The theory of the multiplier is based on the following assumptions: -
1.The consumer goods are available in sufficient quantities.
2.The multiplier period is absent.
3.There exists unempl oyment in the economy.
4.Resources required for production are available.
5.The MPC is constant.
6.There exists excess capacity in the consumer goods industries.
7.The economy is a closed economy.
8.There should be a net increase in investment.
3.4.8 Limitations of the Multiplier
In practice there are many difficulties due to which a given increase
in investment may be lower than the desired one: -
1.If there is a shortage of consumer goods, the income recipient
wont able to spend on consumption and hence MPC may fall &
lowers the multiplier.
2.The net increments in the investments are to be repeated in
regular intervals of time otherwise income will fall back to
original level.munotes.in

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453.The time lag between receipt of income & its expenditure (
multiplier period) should be minimu m otherwise value of the
multiplier will be lower.
4.Once the full employment level is reached, the alue o the
multiplier will not increase.
5.If there is shortage in availability of resources, the value of the
multiplier will be low.
3.4.9 Leakages in the wo rking Multiplier
Themost important leakages from thecircular flow ofincome
arethefollowing:
i.Saving:
It is the most important leakage. If MPC = 1 and MPS = 0 the
numerical value of the multiplier would approach infinity. This
means that if the entir e new income created by an act of in vestment
at each stage of the income generation pro cess were spent by the
people on buying consumer goods, then even a once -for-all
increase in investment would go on creating extra income until the
economy reached the stage of full employment. But MPC is rarely
equal to 1.In practice people hardly spend their entire income on
consumption goods. They save a certain portion. The portion they
save (i.e., do not spent) disappears from the circular flow, thus
reduc ing the value of the multiplier. Thus the stronger the MPS of
the people, the smaller will be the value of the investment multiplier.
ii.Debt Repayment:
James Duesenberry has pointed out people do not spend
their entire extra income on consumption good. They use ap a r to fi t
to repay their past debt. As a result, the value of the multiplier gets
reduced.
iii.Accumulation ofIdleCash Balances:
People often save money by keeping idle cash balances in
banks. This idle money does not come into circulation and is
unlikely to lead to an increase in consumption spend ing.
iv.Stock Exchange Transactions:
It is often observed that a major portion of the new income
generated in the economy is utilised to buy old bonds and
securities from others. Most people sell these long-term credit
instruments when in distress and in cur capital losses. So such
transactions are unlikely to raise society’s total consumption
appreciably.
v.Imports:
No country in the world is self -sufficient. Therefore, a
country has to spend some m oney on imports. However imports do
not add to domestic expenditure and is unlikely to have any income
and employment effect.munotes.in

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46To the extent we spend a certain portion of our new income
on im ported goods, money leaks out of the country. In other words,
thevalue of imports peters out of the income -stream, thus limiting
the value of the multi plier.
vi.Price Inflation:
During inflation money in come may rise but real income falls.
Thus real con sumption spending (which determines the value of the
multiplie r) will fall. In other words, a major por tion of increased
money income will be neutralised by price inflation, instead of
stimulating consumption and creating jobs and incomes in the
process.
vii.Taxes:
If the government taxes away a certain portion of the extra
income generated in the economy the value of the multiplier will fall.
So like savings, taxes also act as a leakage from the circular flow.
Taxes are contractionary in their effects in -as-much as they reduce
real consumption spending by reducing disposable income.
viii.Corporate Savings:
Moreover companies do not always distribute their entire net
profit (gross prof its less corporation tax) as dividend. They retain a
certain portion for expansion and diversification. To the extent they
follow the policy of saving a certain portion of their net profits the
consumption spend ing of shareholders fails to increase
correspondingly. Therefore the value of the multiplier will be less
than otherwise.
Conclusion:
There is no denying the fact that due to such leakages the
process of income genera tion slows down after some time. If such
leakages in income stream did not exist, the process of income
generation would come to a halt only when a state of full
employment was reached. In fact, the process of income
propagation could go on until there was the end of full employment
or the beginning of inflation.
3.4.10 Importance of Multiplier:
Keynes’ principle of multiplier has a great role in removing
the Great Depression of 1929 -34.These days governments are
actively interfere in the economic affairs of the community through
multiplier. Its importance is further explained as below:
1.The multiplier principle focuses on the importance of public
investment , which is the key to remove unemployment during
the days of depression. An investment of Rs. 1 million can
create income and employment worth many times, and can help
the government to remove unemployment from the country.munotes.in

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472.During the days of depression, the private entrepreneurs are
discouraged t o invest in the economy. Therefore, to fill this
gap, the government comes forward and undertakes the
investment in her own hands. Hence, the demand for
consumer goods increases and also the level of NI and
employment increases on account of the working of the
multiplier.
3.When the demand for goods increases and incomes rise owing
to government investment, the profit expectations of the
entrepreneurs go up and as a result the MEC rises.
4.When the government makes investment in public works to figh t
depression and unemployment, private investment is
encouraged on account of the operation of the multiplier. The
confidence of private investors is restored, and hence helps in
further removing the economic depression of the country.
Moreover, backgrou nd knowledge of the multiplier is of
paramount importance not only in analysing business cycle
movements but in formulat ing an appropriate counter -cyclical fiscal
policy which seeks to achieve economic stability.
3.5 QUESTIONS
1.Explain the meaning and sc ope of Closed and Open economy.
2.Discuss the concept of consumption function.
3.Explain the Keynes’ Law of consumption.
4.What are the factors influencing consumption function?
5.Differentiate between Marginal Propensity to Consume and
marginal Propensity to save .
6.Explain the working of investment multiplier.
7.What are the leakages in the working of multiplier process?
munotes.in

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48Unit -4
MARGINAL EFFICIENCY OF CAPITAL,
ACCELERATOR, SAVIN GS & CAPITAL
FORMATION IN INDIA
Unit Structure:
4.0 Objectives
4.1 Introduction
4.2 Meaning ofMarginal Efficiency ofCapital (MEC)
4.3 Relative Role pfM E C andthe Rate ofI n t e r e s t
4.4 Factors affecting Marginal Efficiency ofCapital (MEC)
4.5 Accelerator Principle
4.6 Meaning of Accelerator Principle
4.7 Assumption of Accelerator
4.8 Implications ofthe Accelerator Effect
4.9Saving and Capital Formation In India
4.10 Composition ofD o m e s t i cS a v i n g s
4.11 Questions
4.0 OBJECTIVES
Introduction to the concept of Marginal Efficiency of
Capital(MEC)
to study the relati onship between MEC and Rate of Interest
To acquaint the students with MEC schedule
To study the determinants affecting MEC
To study and understand the meaning and working of
accelerator
To study the role of savings in capital formation of India
4.0INTRO DUCTION
Businessmen and entrepreneurs are induced to make an
investment when the return on investment is attractive. Before
investing, businessmen compare the yield from the investment and
the cost incurred in making the investment. It is only when the
return is greater than cost, investment is made. Producing in a
capitalist economy, profit is the primary objective of business firmsmunotes.in

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49and manufacturing companies. So in order to maximize their profit,
they seek to invest in those ventures that yield higher p rofit. Keynes
introduced the concept of marginal efficiency of capital in order to
analyze the profitability of the prospect ventures.
4.2MEANING OF MARGINAL EFFICIENCY OF
CAPITAL (MEC)
MEC refers to the expected profitability of a capital asset. It
may be defined as the highest rate of return over cost expected
from the marginal or additional unit of a capital asset. First we must
go to the marginal unit of the capital asset and secondly its cost has
to be deducted from its return.
Now the MEC in its t urn, depends on two factors: the
prospective yield of the capital asset and the supply price of the
capital asset. The MEC is the ratio of these two factors. The
prospective yield of a capital asset is the total net return from the
asset over its life time .
Generally, marginal efficiency of capital or MEC refers to the
expected rate of profit or the rate of return from investment over its
cost. Marginal efficiency of a given capital asset is the highest
return that can be yielded from the additional unit o ft h a tc a p i t a l
asset. Keynes defined MEC as ‘The rate of discount which
makes the present value of the prospective yield from the
capital asset equal to its supply price’ .
Thus, Keynes’ marginal theory of capital is bases on two factors
that include
1. Prospective yield from capital assets
The term prospective yield is the aggregate net return the
investor expects to receive on the sale of capital assets after the
deduction of running costs incurred for the purchase of capital
assets considering its total expected life. Usually, when the total
expected life of the capital asset is divided into a series of periods,
generally years, the annual return is determined. This is
represented as Q 1,Q2,Q3…Q nand are termed as annuities.
2. Supply price of this as set
The investor has to consider the supply price of asset that he
is planning on investing. Supply price of asset refers to the cost
incurred for the acquisition of the capital asset. Here, the cost
incurred is for the purchase of or production of a new a sset and not
the price of any of the existing assets. The present value of a series
of expected income from the invested capital asset throughout its
life span is expressed asmunotes.in

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5012
2...11 1nnRR RSPrr r Where,
SP= Supply price of new capital asset;
R1+R2+…+Rn= Return received annually;
r= Rate of discount applied each year;
R/ (1+r) = Current value of annuity discounted at rate r.
The concept of marginal efficiency of capital can be illustrated with
a numerical.
For instance,
Expected lifespan of ca pital asset= 2 years
Supply price of capital asset= Rs. 3000
Expected Yield (first year) =Rs.1100
Expected Yield (Second year) = Rs.1210
Then, marginal efficiency of capital (r) is calculated as
SP= R1/( 1 + r )+R2/( 1 + r )2
2000/ (1+r) = 1100/ (1+e)2+1 2 0 0
Thus, r= 10%
Taking r= 1/10
SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10)2=2 0 0 0
From the above calculation, we can it may be observed that
1.When the expected yield increases to Rn, rate of discount
increases
2.Rate of discount or MEC decreases when su pply price of capital
asset increases with a given amount of expected annual return
on capital asset, and vice versa.
Thus, prospective yields have a direct effect on MEC
whereas, supply price has an inverse effect. This means that the
rate of return over cost may vary as a result of changes in cost or
change in the amount of return. Investors would be willing to make
investments only when the return from prospective capital
investment is greater than the supply price.
SCHEDULE OF MEC
According to J.M. Ke ynes , the behaviour of investment in
respect of new investment depends upon the various stock of
capital available in the economy at a particular period of time. As
the stock of capital increases in the economy, the marginal
efficiency of capital goes on d iminishing. The MEC curve is
negatively sloped as a shown in the figuremunotes.in

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51Investment
(Rs in Billion)Marginal Efficiency of Capital
(MEC)
20 10%
25 9%
40 7%
70 5%
100 2%
Fig4.1Volume of Investment
In the above table, it is shown when stock of capital is equal
to $20 billion, the marginal efficiency of capital is 10% while at a
capital stock of $100 billion, it declines to 2%. This investment
demand schedule when depicted graphically in figure 30.7 gives us
the investment demand curve which goe s on sloping downward
from left to right.
4.3 RELATIVE ROLE OF MEC AND THE RATE OF
INTEREST
TheMEC and the rate of interest are the two important
factors which affect the volume of new investment in a country. An
investor while making a new investment weighs the MEC of new
investment against the prevailing rate of interest. As long as the
MEC is higher than the rate of interest, the investment will be made
till the MEC and the rate of interest are equalized.munotes.in

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52For example, if the rate of interest 7%, the induced
investment will continue to be made till the MEC and the rate of
interest are equalized. At 7% rate of interest, the new investment
will be $40 billion. In case, the rate of interest comes down to 2%,
the new investment in capital assets will be $ 100 billion.
To finance investment, firms will either borrow or reduce
savings. If interest rates are lower, it’s cheaper to borrow, or their
savings give a lower return making investment relatively more
attractive.
Fig4.2
A cut in interest rates fro m 5% to 2% will increase investment
from 80 to 100.
The alternative to investing is saving money in a bank; this is
the opportunity cost of investment.
If the rate of interest is 5%, then only projects with a rate of
return of greater than 5% will be profi table.
How responsive is Investment to Interest Rates?
In Keynesian investment theory, interest rates are one important
factor. However, in a liquidity trap, investment may be
unresponsive to lower interest rates. In some circumstances,
demand for investme nt is very interest inelastic.
In a liquidity trap, business confidence may be very low.
Therefore, despite low -interest rates, firms don’t want to invest
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534.4FACTORS AFFECTING MARGINAL EFFICIENCY
OFCAPITAL (MEC)
The various factors that bring about shifts in MEC are short
run or endogenous factors and long rim or exogenous factors.
4.4.1Theshort runfactors are:
1.Expected demand:
If the demand for the product is expected to be high in
future, the MEC will be high and the investment will increase. On
the other hand if the demand for the product is expected to decline
in future the MEC will be low and investment will fall.
2.Costs andprices:
If the costs are expected to decline and if the pri ces are
expected to increase, the expectation of the producer will go up. On
the other hand if the costs are expected to go up and prices are to
decline the MEC will receive a set back and the investment will be
less.
3.Propensity toconsume:
If the prop ensity to consume is more than the volume of
investment will be more and vice versa.
4.Changes inincome:
An increase in the level of income will stimulate investment
while a decrease in the level of income will discourage investment.
5.Current state ofexpectation:
Businessmen while making expectations take into account
the current state of affairs regarding costs, prices, returns etc. If
they are high the MEC is bound to be high for new projects of
investment.
6.Level ofconfidence:
During period of optimism the businessmen over estimate
and boost the MEC of capital assets. During period of pessimism
they under estimate and reduce the MEC of capital assets.
4.4.2 The long runfactors which influence theMEC areas
follows:
1.Population growth:
Arapidly growing population means a rapid increase in the
demand for all types of goods and hence investment rises and
conversely, a decline in population will decrease the demand
investment.munotes.in

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542.Development ofnew areas:
When a new area is developed heavy i nvestments in all
fields such as agriculture, industries, electricity, housing etc., are to
be undertaken.
3.Technological factors:
New invention or new discovery may necessitate the
installation of new machineries in the industrial enterprise and
encour age investment.
4.Productive capacity oftheIndustry:
If the existing capacity is fully utilised then any further
increase in demand will be met with by making fresh investment on
new capital equipment.
5.Level ofcurrent investment:
If the existing l evel of investment is already high there will be
little scope for further investment and vice versa.
Thus the concept of marginal efficiency of capital is very
important for business world.
4.5 ACCELERATOR PRINCIPLE
4.5.1 Introduction
The multiplier des cribes the relationship between investment
and income, i.e., the effect of investment on income. The multiplier
concept is concerned with original investment as a stimulus to
consumption and thereby to income and employment. But in this
concept, we are n ot concerned about the effect of income on
investment. This effect is covered by the ‘accelerator’ .The
term ‘accelerator’ should not be confused with the accelerator in
cars. It does not make the investment to grow faster and faster.
The term ‘accelera tor’is associated with the name of J.M. Clark in
the year 1914. it has been proved a powerful tool of economic
analysis since then. Keynes, astonishingly, has altogether ignored
this concept. That is why, the concept of accelerator is not
considered th e part of Keynesian theory.
The multiplier and the accelerator are not rivals: they are
parallel concepts. While multiplier shows the effect of changes in
investment on changes in income (and employment), the
accelerator shows the effect of a change in co nsumption on private
investment.munotes.in

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554.6MEANING OF ACCELERATOR PRINCIPLE
The idea underlying the accelerator is of a functional
relationship between the demand for consumption goods and the
demand for machines which make them. The acceleration
coefficien t is the ratio between induced investments to a given net
change in consumption expenditures.
v=∆I / ∆C
Symbolically where v stands for acceleration coefficient; ∆I
denotes the net changes in investment outlays; and ∆C denotes the
net change in consumpt ion outlays. Suppose an additional
expenditure of Rs. 10 crores on consumption goods leads to an
added investment of Rs. 20 crores in investment goods industries,
then the accelerator is 2. The actual value of the accelerator can be
one or even less than t hat.
In actual world, however, increased expenditures on
consumption goods always lead to increased expenditures on
capital goods. Hence acceleration coefficient is usually greater than
zero. Where a good deal of capital equipment is needed per unit of
output, the acceleration coefficient is very much more than unity.
In exceptional cases, the accelerator can be zero also.
Sometimes it so happens that production of increased consumer
goods (as a result of a rise in their demand) does not lead to an
incre ase in the demand for capital equipment producing these
goods.
The principle of acceleration is basically a concept related to net
investment. Therefore, we must derive an expression linking the
accelerator with net investment. We know that gross investme nt
has two components: net investment plus replacement of capital
wearing out due to depreciation. We can write
Gross Investment = I gt=V ( Y t-Yt-1) +R
This means that the quantum of gross investment in period t
depends upon the value of acceleration effect s of the change in
income in the previous period and the need for replacement of
capital.
Inet=V(Y t-Yt–1)munotes.in

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56Thus, net investment in period t is which means that net investment
depends only on the rate of change of income and the accelerator
(V).
4.7ASSUMPTIONS OF THE ACCELERATOR
1.Under the principle of accelerator, it is assumed that there is no
excess capacity existing in the consumer goods
industries .No machines are lying idle and shift working is not
possible.
2.In capital goods industries, it has be en assumed that there
is an existence of surplus capacity. If there is no excess
capacity in capital goods industries, increased demand for
machines could not lead to increase in the supply of machines.
3.Output is flexible. The machine -making industry or capital
goods industry can increase its output whenever desired.
4.The size of the accelerator does not remain constant over
time. It value will be affected by the businessmen’s calculations
regarding the profitability of installing new plants to make more
machines on the basis of their probable working life.
5.The demand for machines will remain stable in the
future, although the increase in demand has suddenly cropped
up.
Working oftheAccelerator:
It is interesting to analyse the working of the Principle of
Acceleration.munotes.in

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57Accelerator depends primarily upon twofactors:
(i) The capital -output ratio, and
(ii) The durability of the capital equipment.
A numerical example will clarify the dependence of
acceleration value on the durability of the machine, capi tal-output
ratio being given.
The following table 4.1ismeant tomake two things clear
about theaccelerator:
(i) Given the same percentage change in consumption, the
percentage change in induced investment depends directly on the
durability of the machi ne. Greater is the life (durability) of the
machine, greater the value of the accelerator;
(ii) Accelerator does not depend upon the change in the absolute
level of consumption; it depends upon the rate of change of
consumption.
In Case I in the Table, w e assume that we need 100
machines to produce 1000 consumer goods (capital -output ratio
being 1:10). Further we presume that the life of the machine
(durability) is 10 years. Thus, after 10 years, the machine has to be
replaced and 10 machines have to be r eplaced in each period in
order to maintain the flow of 1000 consumer goods. This is called
‘Replacement Demand.’
Now suppose there are 10% rise in the demand for
consumer goods in period I (as shown in case I); the change in
consumption will be of 100 su ch goods and we will need 110
machines to produce these goods (at the constant capital -output
ratio of 1: 10). Thus, we need 20 machines in all, 10 machines
being the addition to the stock of capital and 10 machines for
replacement. Thus, a 10% rise in th e demand for consumer goods
leads to a 100% rise in the demand for investment goods
(machines). This is what the principle of acceleration is intended to
show. Accelerator shows that a small increase in consumption is
likely to result in manifold increase in investment (called induced
investment).
Value oftheAccelerator Depends ontheDurability ofthe
Investment Goods and the Rate ofChange ofConsumption
Expendituremunotes.in

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58Assumptions: (i)Capital -output ratio 1:10foralltheCases.
Table 4.1
Now in case II, where the life of the machine is 20 years,
other things being the same, a rise in the demand for consumer
goods in the first period leads to 200% increase in gross
investment.
Further, in case III, when the life of machine is 5 years, a
10% ri se in the demand for consumer goods results merely in an
increase of 50% in gross investment. It is, therefore, clear that:
Greater the durability (life) of the machine, the greater the
value of the accelerator and higher the acceleration effect; smaller
the durability, lower the value of the accelerator and lower are the
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59In case IV, where we presume the life of the machines to be
10 years and capital -output ratio constant at 1: 10 (i.e., we need
100 machines to produce 1000 goods), we find that a 10% rise in
demand in period I in consumption goods sector leads to 100%
increase in gross investment, whereas in period V, when the
demand for consumer goods does not rise and remains constant at
1000, there is a decline of 50% in gross inv estment.
Thus, we find that, even when there is no decrease in the
demand for consumer goods, there is likely to be a decline in gross
investment. The case demonstrates the sensitivity of investment to
a cessation of economic activity. It is to be noted t hat it is the falling
off in the rate of increase in consumption and not a decline in the
absolute level of consumption which causes the contraction in the
demand for machines.
Further, in case V, presuming the life of the machine to be
10 years, we find that we need machines to produce 1000
consumer goods. But when there is a fall in the demand for
consumer goods to the extent of 10% in period I, we need 90
machines to produce 900 consumer goods.
There is 100% fall in the net investment caused by 10% fal l
in consumption. If, however, the demand for consumer goods falls
by 20%, we would need 20% less machines and correspondingly
we can expect the rate of investment to fall by 200%. But there is a
saving grace. At the most what the producers can do is to pr oduce
no new machines at all, i.e., not to replace existing machines. They
may allow some of the existing plants and equipment to wear out.
Thus, when the economy is moving downwards, the fall in
investment becomes confined to the demand for replacement an d
that can at the most fall to zero.
In other words, value of the accelerator during downward
swing is limited by the inability of the demand for investment goods
to fall below the value of replacement (depreciation) demand.
4.8IMPLICATIONS OF THE ACCEL ERATOR EFFECT
Investment tends to be more volatile than economic growth
The rate of economic growth stays the same. Investment levels
will also stay the same
Investment spending can fall even when GDP is rising. This is
because if there is a fall in the r ate of economic growth firms
may invest less.
If GDP falls, investment spending can fall very significantly.munotes.in

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60Accelerator Coefficient. This is the level of induced investment
as a proportion of a rise in National income accelerator
coefficient = Investment/ change in income.
Limitations of the accelerator effect
Time lags in investment. Once a project is started, a firm will
tend to want to complete it –even if demand slows down.
Investment is affected by many other factors, such as investor
confidence and t he “animal spirits” of firms.
It depends whether firms are optimistic about their industry. For
example, a bookshop may be more nervous about investing in
increasing capacity because they fear changing conditions.
Whereas an online store may be more optimi stic about the long -
term future of their industry.
Despite these limitations, the principle of accelerator makes
the process of income propagation more realistic. It explains
volatile fluctuations in capital goods industries. However, in order to
measure the total effect of an initial investment on income we must
combine the accelerator and the multiplier analysis. The combined
analysis is known as Super -Multiplier. It serves as a useful tool for
business cycle analysis and as a helpful guide to stabiliza tion
policy.
4.9SAVING AND CAPITAL FORMATION IN INDIA
4.9.1Domestic Savings inIndia:
In India, domestic saving has been considered as one of the
major sources of capital formation. The Central Statistical
Organisation (CSO) has been preparing the e stimates of domestic
saving for the entire planning period of the country.
Saving has been defined by CSO, “The excess ofcurrent
income over current expenditure andisthebalancing item on
theincome and outlay accounts ofproducing enterprise and
house holds, government administration and other final
consumers.”
For the estimation of domestic savings, the whole economy
is broadly classified into three institutional sectors.
These include:
(a) Household,
(b) Private corporate and
(c) Public or Govt. sect or
Thesaving ofthehousehold sector canbemeasured by:
(i) Total financial saving and
(ii) Saving in the form of physical assets.munotes.in

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61The financial saving includes possession of currency, net
deposits, investment in shares, debentures and government
securi ties and small savings whereas, the physical assets include
machinery, equipment, construction, inventories etc. held by
individuals.
Secondly, the saving of the private corporate sector
constitutes the net saving of non -government, non -financial
companie s, private financial institutions and co -operative
institutions as revealed from the profit and loss accounts placed in
the balance sheet of these companies.
Thirdly, the saving of the public sector includes the net
savings of both departmental and non -departmental enterprises
and savings of administrative departments shown as the excess of
current receipts over current expenditures of the government.
Rate ofSaving:
Rate of saving is measured as a proportion of GDP at
market prices. The rate of saving i nI n d i ai n1 9 5 0 -51 was 10.2 per
cent of the GDP. Over the next twenty years, its trend varied
marginally, to touch a rate of 16.3 per cent in the year 1972 -73.
During the decade of 1970s, there was a significant improvement in
the savings rate which rose t o 26.0 per cent in 1979 -80. In light of
this, the late 1970s was referred to as the golden era in the Indian
savings scene. These rates of saving were not, however, sustained
as it dropped substantially during the 1980s: it fell to 18.2 per cent
in 1984 -85. In the subsequent years, although it recovered
somewhat to reach 22 per cent in 1992 -93 arid reached its late
1980s level of 26.9 per cent in 1995 -96, it declined again to below
25 per cent mark in late 1990s. The saving rate began to increase
steadily i nt h e2 0 0 0 sw i t ht h eT e n t hP l a na v e r a g e( f o r2 0 0 2 -07)
registering 31.4 per cent.
India's Gross Savings Rate was measured at 30.0 % in Mar
2017, compared with 31.3 % in the previous year. India Gross
Savings Rate is updated yearly, available from Mar 1951 to Mar
2017, with an average rate of 18.8 %. The data reached an all -time
high of 36.8 % in Mar 2008 and a record low of 8.0 % in Mar 1954.
CEIC calculates Gross Domestic Savings Rate from annual Gross
Domestic Savings and annual Nominal GDP. Central Stati stics
Office provides Gross Domestic Savings in local currency and
Nominal GDP in local currency based on SNA 2008, at 2011 -2012
prices. Gross Domestic Savings Rate prior to 2012 is based on a
combination of SNA 2008 and SNA 1993, at 2004 -2005 prices.
Gros s Domestic Savings Rate is annual frequency, ending in March
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62Thegrowth insaving isattributed tofactors like:
i. Rising per capita income;
ii. Continued deepening of the financial system; and
iii. The diminishing share of agriculture in GDP.
4.9.2Savings in India and selected countries in world.
India’s savings performance has been quite impressive but it
is much lower than that of China, Malaysia & Singapore. But it is
much higher than many advanced and emerging market
economies. Furth er, the gross domestic savings rates of India,
China and Singapore continue to show an upward trend.
Gross Domestic Savings in India & selected countries ( % of GDP)
Country 1990 2005 2009
India 22.8 33.5 33.8
China 39.1 47.6 52.1
Indonesia 32.3 29.2 33.8
Malaysia 34.5 42.8 36.0
Pakistan 11.1 15.2 111.4
Thailand 33.8 30.3 32.4
Singapore 44.0 47.1 N.A.
United
States16.3 14.1 11.4
World 23.2 21.7 18.9
Source: Reserve Bank India
India’s savings performance over five year plans:
Five Year Plan Gross Domestic Saving Rate ( %)
First Plan ( 1951 -56) 9.2
Second Plan ( 1956 -61) 10.6
Third Plan (1961 -66) 12.1
Fourth Plan ( 1969 -74) 14.7
Fifth plan (1974 -1979) 18.6
Sixth Plan (1980 -85) 17.9
Seventh Plan (1985 -90) 20.0
Eight Plan (1992 -97) 22.9
Ninth Plan (1997 -2002) 23.6
Tenth Plan (2002 -2007) 31.3
Eleventh Plan (2007 -12) 33.7
Table No. 4.2Source: RBI, Report of the working group on
savings during the twelfth FYP(2012 -17)
In above table, India’s Gross domestic Saving rate has
increased over the five year plans from 9.2 % in 1950 -51 to 33.7%munotes.in

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63in 2007 -12. After 1991, the introduction of economic reforms and
financial liberalisation were the main reasons for growth in savings
rate.
4.10COMPOSITION OF DOMESTIC SAVINGS
The Gross Domestic savings of India consist of savings of
public, private corporate and household sectors. Their trends are
shown in the following table 12.3:-
Trends in savings rates ( % of GDP at current Market Prices)
1950 -
511990 -
912007 -
082011 -
122015 -
16
Gross Domestic Sav ings 9.5 18.5 36.8 34.6 32.3
Public Sector 2.1 1.8 5.0 1.5 1.3
Private Sector 0.9 2.6 9.4 9.5 11.9
Household Sector 6.5 22.9 22.4 23.6 19.2
4.10.1Capital Formation in India: Trends and Composition
Capital formation or investment is the kingpin of eco nomic
development. Or one can also say that an important element in the
growth process of developing countries like India is the rate of
saving or the saving -income ratio.
Gross capital formation (GCF) refers to the aggregate of
gross additions to fixed a ssets (i.e., fixed capital formation) and
change in stocks during the counting period. Fixed assets comprise
construction and machinery and equipment (including transport
equipment and breeding stock, draught animals, dairy cattle and
the like). Constructi on for military purposes (other than construction
or alteration of family dwellings for military personnel) defence
equipment, increase in the stocks of defence materials and durable
goods in the hands of the households are excluded from the scope
of capit al formation.
It is because the accumulation of capital perhaps the most
important source of growth in such countries depends on the rate of
savings.
Savings -and investment are, thus, crucial to capital
formation. One of the basic goals of Indian plannin gi st h es t e p -up
of the rate of capital formation. In fact, the rate of capital formation
or investment has risen substantially during nearly six decades
(1951 -2007) of planning.
Gross domestic savings increased from 8.9 p.c. of GDP in
1950 -51 to 24.8 p.c. of GDP in 2006 -07. Net domestic capital
formation increased from 5.2 p.c. to 28.4 p .c. during this time. Tablemunotes.in

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644.4shows growth of domestic savings and capital formation in the
period 1950 -2007.
Table No. 4.4
In the 1980s, the performance of the Indian economy in
relation to saving -investment rate was respectable by international
standards and was certainly high for a market economy and in an
unregimented society like India. A t present, gross domestic savings
stands out around 35 p.c., though less than the level attained in the
late 70s. Meanwhile, capital -output ratio of 2.6 in the 1950s rose to
almost 6.21 in the late 1970s. This high capital -output ratio
indicates declining p roductivity of investment (largely due to an
inefficient pattern of investment and under -utilisation of production
capacity), which largely explains India’s unimpressive growth
performance.
Thus, saving -investment problem of the country in the
1970s, on a closer scrutiny, appears to be unsatisfactory.
Obviously, the country could not register a higher growth rate.
Still then, gross and net saving rates standing around 35 p.c. and
27 p.c. in 2007 were definitely on the high side and comparable to
the advan ced nations of the world. Needless to say, adequate
domestic saving is not an end in itself. What is required is how this
increased saving is invested.
It is said that high rates, of investment are critical for rapid
growth. Investment rate in the Eighth Plan averaged 24.4 p.c. and it
remained almost unchanged in the Ninth Plan. After then it rose
and in the Tenth Plan (2002 -07), it accelerated to nearly 36 p.c. It is
hoped by the planners that such high ratio of investment would be
helpful to attain the g rowth rate of 9 p.c. during the Eleventh Plan
(2007 -2012).munotes.in

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654.10.2Gross Fixed Capital Formation
The trends and composition of gross fixed capital formation
in India is given in the following table: -
Capital Formation ( as % of GDP at current market pric es)
Item 1990 -
91 to
1999 -
20002000 -
01 to
2003 -
042004 -
05 to
2007 -
082011 -
122014 -
152015 -
16
Gross Fixed
Capital
Formation23.1 24.0 30.8 34.3 30.8 29.3
1.Public
Sector8.6 6.7 7.6 7.3 7.5 7.4
2.Private
sector6.7 5.5 11.9 11.2 12.3 21.9
3.Household
sector7.9 11.8 11.3 15.7 11.0 --
Table no. 4.5Source: Economic Survey 2013 -14 to 2016 -17
The gross fixed capital formation averaged 23.5 % over the
period 1990 -91 to 2003 -04. It rose to 30.8 % during 2004 -05 to
2007 -08 and further to 34.3 % in 2011 -12 and declined to 30.8% in
2014 -15.
Investment by Private corporate sector: The rise in private
sector investment is due to impact of reforms introduced by govt. in
1990s. The private sector has improved its productivity and
efficiency with the help of technol ogy to face global competition.
Investment by Public corporate sector: The dominance of public
sector investment declined in the post reform period as compared
to its dominant position in pre reform period due to non -acceptance
of changing global situatio n except few PSUs.
Investment by Household sector: Household investment consists
of physical assets, household construction, their possession of
machinery and equipment and valuables. It increased on account of
rise in per capita income and savings.
Conc lusion: The gap between domestic savings and domestic
investment is financed by net capital inflows from abroad. Thus the
household financial savings need to be raised to keep the saving -
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664.11QUESTIONS
1.Explain the concept of Marginal efficiency of Capital.
2.Discuss the relationship between MEC and Rate of interest.
3.What are the factors affecting Marginal Efficiency of Capital?
4.Explain Principle of Acc eleration.
5.Explain the trends and composition of Capital formation in India.
6.Discuss the trends and composition of Savings in India.

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67Module 3
Unit -5
GOVERNMENT
Unit Structure:
5.0 Objectives
5.1 Introduction
5.2 Policing -ISPolicing aPublic Good?
5.3 Why are Public Goods anE x a m p l e of Market Failure?
5.4 Public Revenue
5.5 Public Expenditure
5.6 Questions
5.0 OBJECTIVES
Introduction to Public Goods andMerit Goods
To acquaint the students with concepts of tax and non -tax
revenue
To study the merits & demerits of direct & Indirect taxes
To understand Impact, shifting and Incidence of Tax.
To study causes of growth if public expenditure
5.1INTRODUCTION
Public goods are defined as products where, for any given
output, consumption by additional consumers does not reduce the
quantity consumed by existing consumers. There are very few
absolutely public goods, but common example s include law, parks,
street -lighting, defence etc. As there is no marginal cost in
producing the public goods, it is generally argued that they must be
provided free of charge, because otherwise the people who benefit
less than the cost of using the publi c good, will not use it. That will
lead to a loss of welfare. Also the goods are mostly non -excludable,
that means that if once provided everybody can use them, which
when charged will lead to "free -riding". So these goods will not be
provided by free mark ets as there is no way to charge for the
usage, the solution is, that state must provide these goods and
finance them from taxes collected from everybody.
In Economics, a public good is a good that is both non-
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68effectively excluded from use and where use by one individual does
not reduce avai lability to other.
The characteristics of pure public goods are the opposite of private
goods:
1.Non-excludability: The benefits derived from pure public goods
cannot be confined solely to those who have paid for it. Indeed
non-payers can enjoy the benefits of consumption at no
financial cost –economists call this the 'free-rider' problem. With
private goods, consumption ultimately depends on the ability to
pay.
2.Non-rival consumption: Consumption by one consumer does
not restrict consumption by other consu mers –in other words
the marginal cost of supplying a public good to an extra person
is zero. If it is supplied to one person, it is available to all.
3.Non-rejectable: The collective supply of a public good for all
means that it cannot be rejected by peop le, a good example is a
nuclear defence system or flood defence projects.
There are relatively few examples of pure public goods
Examples include flood control systems, some of
thebroadcasting services provided by the Door -Darshan, public
water supplies, street lighting for roads and motorways, lighthouse
protection for ships and also national defence services.
5.2POLICING -IS POLICING A PUBLIC GOOD?
The general protection that the police services provide in
deterring crime and investigating crimina l acts serves as a public
good. But resources used up in providing policing means that fewermunotes.in

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69resources are available elsewhere. Private protection services such
as private security guards, privately bought security systems and
detectives are private goods because the service is excludable and
rival in consumption and people and businesses are often prepared
to pay a high price.
5.3WHY ARE PUBLIC GOODS AN EXAMPLE OF
MARKET FAILURE?
Pure public goods are not normally provided by the private
sector because they would be unable to supply them for a
profit.
It is up to the government to decide what output of public
goods is appropriate for society.
To do this, it must estimate the social benefits from making
public goods available.
5.3.1What is meant by the Free Rider Problem?
Because public goods are non -excludable it is difficult to
charge people for benefitting form a good or service once it
is provided.
The free rider problem leads to under -provision of a good
and thus causes market failure.
5.3.What a re Quasi -Public Goods ?
A quasi -public good is a near -public good i.e. it has many but not all
the characteristics of a public good. Quasi -public goods are: -
1.Semi -non-rival: up to a point, extra consumers using a
park, beach or road do not reduce the spac ea v a i l a b l ef o r
others. Eventually beaches become crowded as do parks
and other leisure facilities. Open access Wi -Fi networks
become crowded.
2.Semi -non-excludable: it is possible but often difficult or
expensive to exclude non -paying consumers. E.g. fenci ng a
park or beach and charging an entrance fee; building toll
booths to charge for road usage on congested routes.
The air waves –a public good or quasi -public good?
The airwaves used by mobile phone companies, radio
stations and television companies a re owned by the
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70Do they count as a pure public good? One person's use of
the airwaves rarely limits how other people can benefit from
utilising them.
At peak times, the airwaves become crowded.
The government also controls the issue of licenc es needed
to operate mobile phone services using the airwaves in the
India. In 2000, they auctioned off five licences for 3rd
generation mobile phone services and raised billion rupees
in doing so. In 2016, the government auctioned off super -fast
4G mobile phone spectrums .
5.3.3 The case for government intervention with public goods
Overcoming the Free -Rider: -
1.Direct provision of a public good by the government can help to
overcome the free -rider problem which leads to market failure.
2.The non-rival nature of consumption provides a strong case for
the government rather than the market to provide and pay for
public goods.
3.Many public goods are provided more or less free at the point of
useandthen paid for out of general taxation or another general
form of charge such as a licence fee.
4.State provision may help to prevent the under -provision and
under -consumption of public goods so that social welfare is
improved.
5.If the government provides p ublic goods they may be able to do
so more efficiently because of economies of scale.
6.Merit goods on the other hand are products generally not
distributed by means of the price system, but based on merit or
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71buy the wrong amount of them. These goods can be supplied
by free market, but not on the right quantity. Merit goods are, for
example, education and to some extent the health -care. They
are provided by state as "good for you”.
7.Merit goods are those goods and services that the government
feels that people will under -consume, and which ought to
besubsidised or provided free at the point of useso that
consumption does not depend primarily on the ability to pay for
the good or service.
8.The conc ept of a merit good introduced in economics by
Richard Musgrave (1957, 1959) is acommodity which is judged
that an individual or society should have on the basis of some
concept of need, rather than ability and willingn ess to pay.
Why does the government provide merit goods and services?
1.To encourage consumption so that positive externalities of merit
goods can be achieved for example free inoculation against
infectious diseases.
2.To overcome the information failure s linked to merit goods.
3.On grounds of equity –because the government believes that
consumption should not be based solely on the grounds of
ability to pay for a good or service.
5.4PUBLIC REVENUE
5.4.1Meaning ofPublic Revenue:
Public finance is a c oncept that includes Public expenditure,
public debt and public revenue and income. Public revenue is
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72meet requirements of expenses of public. The income of the
government through all sources is called public income or public
revenue .
The revenues from different sources received by the
government are called public revenues. Some are regularly
collected whereas some are irregularly collected. Revenues are not
repayable. Some of them are obtaine d from the sale of public
utilities whereas some are obligatory payments to the government.
Public revenue generally refers to government revenue. Some
important sources or concepts that are included in public revenue
consist of taxes, fees, sale of public goods and services, fines,
donations, etc.
5.4.2The main sources of public revenue are: Tax and Non -
tax revenue Sources of Public Revenue
A) Tax Revenue:
The chief source of public revenue is Tax. To define tax, it is
said that tax is a mandatory im position of duty on public authority
by government organizations to meet requirements of general
public as a whole.
Therefore, with the above defined term, some points are highlighted
as below:
i)A Tax is a compulsory duty levied by the government. If any
individual refuses to comply with tax payments, he can be
punished or penalized
ii)Tax basically involves some understanding and sacrifice on the
basis of a tax payer .
iii)Tax is a duty and not a penalty .
iv)Most part of revenue income is generated from tax by the
central government.
5.4.3Broad classification of taxes is: Direct and Indirect
Taxes
1.Direct taxes:
Direct taxes are levied on wealth and income of individuals
or organizations. These taxes are personal income tax, corporatemunotes.in

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73tax, and gift or wealth tax. The impact of direct taxes is on the same
person.
Direct taxes are developing in nature and the tax rate
increases along with the tax base.
Progressive direct taxes are involved in falling income
discrimination especially in rising countri es.
Following major direct taxes are stated:
1. Personal Income Tax:
Personal income tax is duty imposed on an individual or
group of individuals after specific permissible deductions.
2. Corporate Tax:
Corporate tax is a duty that has to be paid on th ep r o f i t s
registered corporate firms.
Corporate tax is direct tax because the company is given legal
entity.
Present corporate tax rates are:
1.For Indian Organization –30% + 7.5% surcharge.
2.For Foreign organization –40% + 2.5% surcharge.
In the year 2009 -2010, Corporate Tax added to 40% of the
Total Tax Revenue .
3.Other Direct Taxes:
List of other direct taxes include, Wealth tax, Interest tax, gift
tax, Expenditure tax, etc .
The share of these taxes is unimportant.
2. Indirect taxes
Indirect t axes are imposed on goods & commodities. These
taxes include sales tax, excise duty, service tax, customs duty,
VAT, etc. The impact of indirect taxes may be implied on different
people.
In direct taxes are not progressive but regressive in nature.
Here, the burden to pay duties is indirectly or directly bearded by
the consumer irrespective of their income level. Indirect taxes are
of utmost importance for countries that are developing and face low
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74Major Indirect Taxes:
a) Excise Duty :
These taxes are levied on manufactured goods and consumable
goods in India
Excise duty is the chief and single largest source to generate
revenue income
Rates of excise duty faces a declining trend
b) Customs Duty:
This duty is imposed on exports of se lective range and imports with
revenue point of view, Custom duty has less importance .Peak rate
of custom levy is 10%
c) Service Tax:
This tax is imposed by specific category of firms, agencies or
persons .Rate of service taxes have been increased progre ssively .
d) Goods and Service Tax
Goods and service tax includes range of all taxes like excise duty,
service tax, goods tax, VAT, etc .It covers goods and service
charges in mostly all sectors .It generally simplifies the complexity
of charges on good an d services .
5.4.4Non-Tax revenues
Non Tax Revenue comprises all revenues apart from taxes
accumulated to the Government.
Non tax revenues are funds that are generated from internal
sources .
Important sources of Non tax revenues include :-
a) Special A ssessment:
This can be called as betterment charge .This tax is imposed
to a certain category of members of a community who are generally
benefited from governmental activities or public functions like
constructions of road, railways, parks, etc .Therefore ,g o v e r n m e n t
imposes special charges on such properties .
b) Surplus of Public Enterprises
The government has arranged public sector enterprises that
are concerned in commercial activities. The surpluses generated of
these enterprises are a significant sou rce of non -tax revenue.
These incomes are in the form of profits that are known as
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75c) Fees :
A fee is a significant source of managerial non -tax revenue
charged by Government authorities for depiction services to the
members of the pub lic.There is no compulsion to pay fees. All
those utilize services may pay fees. Fees may be charged for
getting licenses, passports or registrations, filing of court cases, etc.
d) Fine and Penalties
These are general sources of administrative non tax
revenues .These may be applied on public for non -compliance with
certain rules and regulations. These are not considered as the
major source of revenue for the government .
e) Grants and Gifts
Grants are financial support .
These are provided to public auth ority to perform certain
social activities .These are generated by higher public authority to
lower ones .e.g. World bank gives grants to State bank .There is no
repayment compulsion .Gifts and donations are voluntarily made by
individuals, organizations o rf o r e i g ng o v e r n m e n t st ot h eC e n t r a l
Government. These gifts are made by natural feeling in case of
disasters or natural calamities .Gifts are not considered as a source
of income .
Therefore, tax plays an important part in generating
government revenue. N on-taxrevenue is important in developing
revenue .
5.4.5Distinction between Direct and Indirect Taxes
1.A direct tax is not intended to be shifted, whereas an indirect tax
is so intended.
2.Taxes on commodities are generally called indirect taxes as
they completely or partially shifted consumers. But it should be
remembered that all the commodity taxes are not indirect
taxes. A tax is said to be indirect if its burden is shifted finally to
the consumer.
3.Direct tax is the tax in which the commodity is tax ed by the
government, yet its price remains unaffected or changed. In this
case the tax is not shifted to consumer and the tax will be called
direct tax. If the tax is shifted, the tax is indirect, otherwise
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76Merits and Demerits of Direct a nd Indirect Taxes
Merits of Direct Tax:
1.Equitable , i.e., the principle of progression is applied
2.Economical , i.e., the cost of collection is small
3.Certain , i.e., the direct tax can be calculated with a fair degree
of precision
4.High degree of elasticity ,i.e., the direct tax can be raised
much easily
5.Civic consciousness , direct tax creates civic consciousness
among tax -payers
6.Reduction of inequalities , i.e., the objective of direct tax is to
reduce economic inequalities by taxing higher income earners
at pr ogressive tax rates.
Demerits of Direct Tax:
1.Inconvenient: for the tax payer to pay and file the income
tax return
2.Unpopular tax system
3.Tax evasion is common
4.Arbitrary tax rates
Merits of Indirect Tax:
1.Convenient: for the tax payer to pay and it requires no filing
of returns
2.No tax evasion
3.Unified tax rate
4.Beneficial social effects (in case of harmful drugs and
intoxicants)
5.Capital formation
6.Re-allocation of resources
7.Wide coverage
Demerits of Indirect Tax:
1.Uncertain
2.Regressive
3.No civic consciousness
4.Inflationary
5.Loss of economic welfare
Thus direct and indirect taxes form major sources of Public
revenue.
5.4.6Impact, Shifting and Incidence of Tax
Taxation is the process through which the government raises its
revenue. The government charges various t axes among them
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77Meaning ofIncidence:
The problem of the incidence of a tax is the problem of who
pays it. Taxes are not always borne by the people who pay them in
the first instance. They are sometimes shifted on to other people.
They are sometimes shifted on to other people. Incidence means
the final resting place of a tax. The incidence is on the man’ who
ultimately bears the money burden of the tax.
The impact of the tax :is on the person who pays it in the first
instance and the incidence is on the one who finally bears it. If an
excise duty is imposed on sugar, it is paid in the first instance by
the sugar manufacturers; the impact is on them. But the duty will be
added to the price of th e sugar sold, which, through a series of
transfers, will ultimately fall on the consumer of sugar. The
incidence is, therefore, on the final consumer.
Itis,thus, easy todistinguish between the impact and
incidence oftaxation:
1. Impact refers to the i nitial burden of the tax, while incidence
refers to the ultimate burden of the tax.
2. Impact is at the point of imposition, incidence occurs at the point
of settlement.
3. The impact of a tax falls upon the person fr6m whom the tax is
collected and the incidence rests on the person who pays it
eventually. For example, suppose a tax —excise duty —is
imposed on soap.
Its impact is on the producers, in the first instance, as they
are liable to pay it to the government. But, the producers may
succeed in c ollecting it from the consumers by raising the price of
soap by the amount of tax. In that case, consumers eventually pay
the tax and so the incidence falls upon them.
4. Impact may be shifted but incidence cannot. For, incidence is the
end of the shiftin g process. Sometimes, however, when no shifting
is possible, as in the case of income tax or such other direct taxes,
the impact coincides with incidence on the same person.
Shifting of Tax :
Tax shifting refers to the transfer of the burden of tax from th e
impact to the incidence. This may be through forward shifting or
backward shifting.
Incide nce is Different from Shifting :
Incidence is final resting place of a tax while shifting is process of
transferring money burden of tax to someone else. Shifting finally
ends in incidence. When a person on whom tax is levied tries to
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78partly, or may not succeed at all. Shifting of tax can take place in
two directions, forward and backward. If tax is shifted, from seller to
consumer, it is a case of forwarding shifting. Forward shifting refers
to an instance whereby a seller transfers the tax charge to the
consumer. In such an instance the consumer bears the tax burden
by paying a higher price for a good or service. In this case, the
incidence is the impact is the seller but he transfers the tax burden
to the buyer (incidence).
Backward shifting :takes place when consumers do not purchase
commodities at increased prices. Sellers are then forced to cut
down prices and bear burden of tax themselves. Backward shifting
is thus performed by buyers. Backward shifting employs a reversal
approach whereby a seller, for example, buys goods or services at
a lower price from the supplier.
Importance ofinciden ce:
The study of incidence is very -important. The tax system is not
merely aimed at raising a certain amount of revenue, but the aim is
to raise it from these sections of the people who can best bear the
tax. The aim, in short, is to secure a just distribu tion of the tax
burden.
This obviously cannot be done unless an effort is made to trace the
incidence of each tax levied by the State. We must know who pays
it ultimately in order to find out whether it is just to ask him to pay it,
or whether the burden imposed on him is according to the ability of
the tax -payer or not.
Factors determining Tax Incidence
(a)Elasticity: While considering incidence we consider both
elasticity of demand and elasticity of supply. If the demand for the
commodity taxed is elastic, the tax will tend to be shifted to the
producer but in case of inelastic demand, it will be largely borne by
the consumer. In case of elastic supply, the burden will tend to be
on the purchaser and in the case of inelastic supply on the
producer.
(b)Price: Since shifting of the tax burden can only take place
through a change in price, price is a very important factor. If the tax
leaves the price unchanged, the tax does not shift.
(c) Time: In short run, the producer cannot make any adjust ment
in plant and equipment. If, therefore, demand falls on account of
price rise resulting from the tax, he may not be able to reduce
supply and may have to bear the tax to some extent. In the long
run, however, full adjustment can be made and tax shift ed to the
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79(d)Cost: Tax raises the price; rise in price reduces demand and
reduced demand results in the reduction of output. A change in the
scale of production affects cost and the effect will vary according as
the industry is decreasing, in creasing or constant costs
industry. For instance, if the industry is subject to decreasing cost,
a reduction in the scale of production will raise the cost and hence
price, shifting the burden of the tax to the consumer.
(e)Nature of tax: The inciden ce of taxation will definitely depend
on the nature of tax. For example, an indirect tax’s burden is fall on
the consumer.
(f) Market form: Another factor determining the incidence of
taxation is the market form. Under perfect competition, no single
producer or single purchaser can affect the price; hence shifting of
tax in either direction is out of the question. But under monopoly, a
producer is in a position to influence price and hence shift the tax.
Commodity Tax:
1.Taxes on commodities may take several forms:
(a)Tax on manufacture or production of a commodity called
excise duties,
(b)Tax on sale of a particular commodity known as sales
tax, and
(c)Import or export of commodities known as custom
duties.
2.The commodity tax is tended to be shif ted to the consumer
and from consumer to the producer
3.Tax on production tends to raise the price and will therefore
be normally borne by the consumer
4.But the consumption tax is likely to check consumption and
tends to be shifted backward to the producer.
5.Therefore, the tax on commodity will be partly borne by the
producer and partly borne by the consumer .
6.The portions of commodity tax to be borne by the producer
and consumer depends on the degree of elasticity of
demand and supply:
Elasticity Incidence
Elastic demand More tax burden on the supplier / producer
Inelastic demand More tax burden on the buyer / consumer
Elastic supply More tax burden on the buyer / consumer
Inelastic supply More tax burden on the supplier / producer
7.As a rule, the consume rb e a r sas m a l l e rp a r to ft h et a xw h e n
the demand is more elastic than the supply
This may happen that the price may not rise at all. This is
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80supply of the commodity or substitute. In this case, the tax burden
will fall on the producer.
5.5PUBLIC EXPENDITURE
Public expenditure refers to Government expenditure i.e.
Government spending. It is incurred by Central, State and Local
governments of a country.Public expenditure can be defined as,
"The expenditure incurred by public authorities like central, state
and local governments to satisfy the collective social wants of the
people is known as public expenditure."
Throughout the 19th Century, most governments followed
laissez faire economic polic ies & their functions were only restricted
to defending aggression & maintaining law & order. The size of
public expenditure was very small. But now the expenditure of
governments all over has significantly increased. In the early
20th Century, John Maynar dK e y n e sa d v o c a t e dt h er o l eo fp u b l i c
expenditure in determination of level of income and its distribution.
In developing countries, public expenditure policy not only
accelerates economic growth & promotes employment
opportunities but also plays a useful role in reducing poverty and
inequalities in income distribution.
5.5.1Classification of Public expenditure
Classification of Public expenditure refers to the systematic
arrangement of different items on which the government incurs
expenditure. Differen t economists have looked at public
expenditure from different point of view. The following classification
is a based on these different views.
1. Functional Classification
Some economists classify public expenditure on the basis of
functions for which the y are incurred. The government performs
various functions like defence, social welfare, agriculture,
infrastructure and industrial development. The expenditure incurred
on such functions fall under this classification. These functions are
further divided i nto subsidiary functions. This kind of classification
provides a clear idea about how the public funds are spent.
2. Revenue and Capital Expenditure
Revenue expenditure are current or consumption
expenditures incurred on civil administration, defence forc es, public
health and education, maintenance of government machinery. This
type of expenditure is of recurring type which is incurred year after
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81Public expenditure has been classified into various
categories. Firstly, Government expenditure has been classified
into revenue expen diture and capital expenditure. Revenue
expenditure is a current or consumption expenditure incurred on
civil administration (i.e., police, jails and judiciary), defence forces,
public health and education. This revenue expen diture is of
recurrent type which is incurred year after year.
On the other hand, capital expenditures are incurred on
building durable assets, like highways, multipurpose dams,
irrigation projects, buying machinery and equipment. They are non -
recurring type of expenditures in the form of capital investments.
Such expenditures are expected to improve the productive capacity
of the economy. Capital expenditure is incurred on building durable
assets. It is a non -recurring type of expenditure. Expenditure
incurred on building multipurpose river projects, highways, steel
plants etc., and buying machinery and equipment is regarded as
capital expenditure.
Comparison between Revenue Expenditure and Capital
Expenditure
Revenue Expenditure Capital Expenditure
1.It is incurred for normal
running of government
departments and maintenance.1. It is incurred for acquisition of
capital assets.
2. It does not result in creation of
assets.2. It results in creation of assets .
3. It is recurring in nature and
incurred regularly .3. It is non -recurring in nature .
4. It is short period expenditure. 4. It is generally a long period
expenditure .
5. For example, expenditure on
medicines and salaries of
doctors for rendering services.5. For example, construction of
a hospi tal building is capital
expenditure .
3. Transfer and Non -Transfer Expenditure
A.C. Pigou , the British economist has classified public expenditure
as :-
1.Transfer expenditure
2.Non-transfer expenditure
Transfer Expenditure :-
Transfer expenditure relates to the expenditure against
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82Such expenditure includes public expenditure on : -
1.National Old Age Pension Schemes,
2.Interest payments,
3.Subsidies,
4.Unemployment allowances,
5.Welfare benefits to weaker sections, etc.
By incu rring such expenditure, the government does not get
anything in return, but it adds to the welfare of the people,
especially belong to the weaker sections of the society. Such
expenditure basically results in redistribution of money incomes
within the soci ety.
Non-Transfer Expenditure :-
The non -transfer expenditure relates to expenditure which
results in creation of income or output. The non -transfer
expenditure includes development as well as non -development
expenditure that results in creation of output directly or indirectly.
1.Economic infrastructure such as power, transport, irrigation,
etc.
2.Social infrastructure such as education, health and family
welfare.
3.Internal law and order and defence.
4.Public administration, etc.
By incurring such expenditure, the government creates a
healthy conditions or environment for economic activities. Due to
economic growth, the government may be able to generate income
in form of duties and taxes.
5.5.2Productive and Unproductive Expenditure
This classification was made by Classical economists on the basis
of creation of productive capacity.
Productive Expenditure :-
Expenditure on infrastructure development, public
enterprises or development of agriculture increase productive
capacity in the economy and bring income to the government. Thus
they are classified as productive expenditure.
Unproductive Expenditure :-
Expenditures in the nature of consumption such as defence,
interest payments, expenditure on law and order, public
administration, do not create any product ive asset which can bring
income or returns to the government. Such expenses are classified
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835.5.3Development and Non -Development Expenditure
Modern economists have modified this classification into
distinction between devel opment and non -development
expenditures.
Development Expenditure :-
All expenditures that promote economic growth and development
are termed as development expenditure. These are the same as
productive expenditure.
Non-Development Expenditure :-
Unproducti ve expenditures are termed as non development
expenditures.
5. Grants and Purchase Price
This classification has been suggested by economist Hugh Dalton.
Grants :-
Grants are those payments made by a public authority for
which their may not be any quid -pro-quo, i.e., there will be no
receipt of goods or services. For example, old age pension,
unemployment benefits, subsidies, social insurance, etc. Grants are
transfer expenditures.
Purchase prices :-
Purchase prices are expenditures for which the governme nt
receives goods and services in return. For example, salaries and
wages to government employees and purchase of consumption
and capital goods.
6. Classification According to Benefits
Public expenditure can be classified on the basis of benefits
they co nfer on different groups of people.
1.Common benefits to all : Expenditures that confer common
benefits on all the people. For example, expenditure on
education, public health, transport, defence, law and order,
general administration.
2.Special benefits to all: Expenditures that confer special
benefits on all. For example, administration of justice, social
security measures, community welfare.
3.Special benefits to some : Expenditures that confer direct
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84welfare. For example, old age pension, subsidies to weaker
section, unemployment benefits.
7. Hugh Dalton's Classification of Public Expenditure
Hugh Dalton has classified public expenditure as follows : -
1.Expenditures on political executives :i.e. ma intenance of
ceremonial heads of state, like the president.
2.Administrative expenditure :to maintain the general
administration of the country, like government departments and
offices.
3.Security expenditure :to maintain armed forces and the police
forces.
4.Expenditure on administration of justice : include
maintenance of courts, judges, public prosecutors.
5.Developmental expenditures :t op r o m o t eg r o w t ha n d
development of the economy, like expenditure on infrastructure,
irrigation, etc.
6.Social expenditures : on public health, community welfare,
social security, etc.
7.Public debt charges : include payment of interest and
repayment of principle amount.
5.5.4Causes of rising Public expenditure:
There are several factors that have led to enormous
increase in public expenditure through the years
1) Defence expenditure -due to modernization of defence
equipment by navy, army and air force to prepare the country for
war or for prevention causes -for-growth -of-public -expenditure.
2) Population growth –It increa ses with the increase
inpopulation, more of investment is required to be done
bygovernment on law and order, education, infrastructure, etc.
investment in different fields depending on the different age group
is required.
3) Welfare activities –welfare ,m i d -day meals, pension provisions
etc.
Provision of public and utility services –provision of basic public
goods given by government (their maintenance and installation)
such as transportation.
Accelerating economic growth –in order to raise the stand ard of
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85Price rise –higher price level compels government to spend
increased amount on purchase of goods and services. [6]
Increase in public revenue –with rise in public revenue
government is bound to increase the public expenditure.
International obligation –maintenance of socio economic
obligation, cultural exchange etc. (these are indirect expenses
of government)
4) Wars and social crises –fighting amongst people and
communities, and prolonged drought or unemployment,
earthquake, hurricanes or tornadoes may lead to increase in public
expenditure of a country. This is because it will involve
governments to re -plan and allocate resources to finance the
reconstruction.
5) Creation of super national organizations –E.g., the United
Nations, NATO, European community and other multinational
organizations that are responsible for the provision of public goods
and services on an international basis, have to be financed out of
funds subscribed by member states, thereby adding to their public
expenditure.
6) Foreign aid –Acceptance by the richer industrialised countries
of their responsibility to help the poor developing countries has
channelled some of the i ncreased public expenditure of the donor
country into foreign aid programmes.
7) Inflation –This is the general rise in price level of goods and
services. It increases the cost of all activities of the public sector
and thus a major factor in growth in m oney terms of public
expenditure.
Thus, in modern era, government’s responsibility has been
continuously increasing resulting in rising public expenditure.
5.5.5Trends in Revenue and Capital Expenditure of Central
government of India
Per cent in GDP
Heads of
Expenditure2010 -112014 -152015 -162016 -172017 -18
1. Revenue
Expenditure13.4 11.8 11.2 11.1 10.9
2. Capital
Expenditure2.0 1.6 1.8 1.9 1.8
Total
Expenditure
(1+2)15.4 13.4 13.0 13.0 12.7
Source: Economic Survey of India 2016 -17munotes.in

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861.The revenue expenditure of the central government has been
increased from Rs. 144.10 billion in 1980 -81 to Rs. 15,476
billion in 2015 -16.
2.The share of revenue expenditure in the total expenditure of
the central government increased from 63.3% in 1980 -81 to
86.7% in 2015 -16.
Revenue ex penditure of central government in India ( Rs. in
Billion)
Heads of Expenditure 1980 -81 1990 -91 2015 -16
Revenue Expenditure of
which144.10 735.15 15476.73
a)Defence
expenditure32.78 108.74 1432.36
b)Interest
payments26.04 214.98 4426 .20
c)Subsidies 20.28 121.50 2578.01
3.The major part of the revenue expenditure consists of defence
expenditure, interest payments and subsidies. They together
account for 54.5% of total revenue expenditure.
The share of capital expenditure in the total e xpenditure has
come down from about 37% in 1980 -81 to about 13% in 2015 -16.
5.6QUESTIONS
1.What is the difference between Public goods and Merit goods?
2.Public goods are an example of market failure –Explain why?
3.Explain in detail the classification of Pu blic revenue.
4.What are the different types of direct taxes?
5.What are the various types of Indirect taxes?
6.Explain the merits and demerits of taxation.
7.What is Impact, shifting and incidence of tax?
8.Explain classification of public expenditure.
9.What are the causes of rising public expenditure in India?
munotes.in

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87Unit -6
SUBSIDIES, DEFICITS AND GOODS &
SERVICES TAX (GST)
Unit Structure:
6.0 Objectives
6.1 Subsidies
6.2 Deficit financing
6.3 Goods and Services Tax (GST)
6.4 Questions
6.0 OBJECTIVES
Introduction to different types ofSubsidies
To acqu aint the students with importance of Subsidies in India
To study the different types of deficits in budget
To understand revenue, budgetary, Fiscal & primary deficits
To study the reforms introduced through GST
6.1SUBSIDIES
Subsidy is a transfer of mone yf r o mt h eg o v e r n m e n tt oa n
entity. It leads to a fall in the price of the subsidised product. The
objective of subsidy is to bolster the welfare of the society. It is a
part of non -plan expenditure of the government. Major subsidies in
India are petroleum subsidy, fertiliser subsidy, food subsidy,
interest subsidy, etc. The Indian government has, since
independence, subsidized many industries and products, from
petrol to food. Loss -making state -owned enterprises are assisted
by the government and farmers a re given access to free electricity.
Overall, a 2005 article by International Herald Tribune stated that
subsidies amounted to 14% of GDP. As much as 39% of
subsidized kerosene is stolen.
On the other hand, India spends relatively little on education,
health, or infrastructure. Urgently needed infrastructure investment
has been much lower than in China. According to the UNESCO,
India has the lowest public expenditure on higher education per
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886.1.1 Different types of subsidies
1.Cash Subsidy: Providing food or fertilizer to consumer at lower
price.
2.Interest or credit subsidies
3.Tax subsidies
4.In kind subsidies
5.Procurement subsidies
6.Regulatory subsidy
6.1.2Classification of Subsidy
Merit I: Elementary educati on, primary health centres, prevention
and control of diseases, social welfare and nutrition, soil and water
conservation, and ecology and environment.
Merit II :Education (other than elementary), sports and youth
services, family welfare, urban developme nt, forestry, agricultural
research and education, other agricultural programmes, special
programmes for rural development, land reforms, other rural
development programmes, special programmes for north -eastern
areas, flood control and drainage, non -conven tional energy, village
and small industries, ports and light houses, roads and bridges,
inland water transport, atomic energy research, space research,
oceanographic research, other scientific research, census surveys
and statistics, meteorology.
Non-Merit:All others.
Aggregate central budgetary subsidies in 1998 -99 are estimated to
be Rs. 79828 crore, amounting to 4.59 per cent of GDP, and
constituting 53.40 per cent of the net revenue receipts of the centre,
which is the highest draft of subsidies on r evenue receipts recorded
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89Apart from the above, the subsidies can also be divided
intobroad subsidies andnarrow subsidies . The most common
forms of subsidies are those to the producer or the consumer.
Producer/Production subsidies ensure producers are better off by
supplying market price support, direct support, or payments to
factors of production. Consumer/Consumption subsidies commonly
reduce the price of goods and services to the consumer.
6.1.3Difference between Subsidies and Taxes
Subsidies are the opposite of taxes because government
gives money to individuals or firms, instead of collecting money
from individuals or firms. A subsidy in its simplest form is a negative
tax–a reverse flow (transfer) from the government to the public –
or an income/consumption supplement for individuals. Further,
Subsidies, like taxes, may thus be lump sum, proportional (ad
valorem or specific) or progressive. Subsidies are as much an
economic tool as are taxes to facilitate smooth functioning of the
economy.
Subsidies are commonly used by governments to promote
general welfare (eg. housing, education, sustenance). However,
they can also be used as tools of political and corporate cronyism
or to erect barriers to trade.
6.1.4 Difference between Subsidy and Transfer Payments
Transfer payments refer to the payments that are made
without any exchange of goods or services. The generally result in
the redistribution of income. A subsidy is a type of transfer
payment. Other examples are welfare expenditures and so cial
security contribution by the government in pension schemes.
Estimation of Subsidy on Public Goods, Merit Goods and Non -Merit
classification
The estimation of the subsidies is done by the standard
classification into public, merit and non -merit goods. Ab r i e f
description of the same is given below:
Public Goods
Public good is a good in that individuals cannot be effectively
excluded from use and where use by one individual does not
reduce availability to others. Examples of public goods include
fresh air, national defence, flood control systems, public transport
and street lighting. Since these services are available to all, they
are normally characterised by non -rivalry and non -excludability in
consumption. Since these services are available to all ci tizens,
they do not exclude anyone .Thus, such goods cannot be priced
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90Merit Goods
Merit goods are those goods whose consumption leads
topositive externalities .T h i si m p l i e st h a tw h e nam e r i tg o o d is
consumed, the public benefit is greater than the private benefit.
For example, vaccination against a contagious disease is a merit
good .Similarly, other merit goods are environmental protection
and minimum level of education (primary education), for a ll.The
social benefit resulting from these goods/services is much greater
than the sum of private benefits to individual consumers. This is
because these goods contain elements of ‘externality’ beneficial to
the society as a whole. Other examples of merit goods are roads
and bridges, flood control and research pertaining to agriculture,
space, atomic energy, etc. The availability of benefits in the form
of externality justifies the subsidies on these goods.
Non-Merit Goods
The non -merit goods are those go ods whose consumption
leads to negative externalities . In consumption of such goods,
the benefit of subsidies provided on such goods accrues to the
individual consumers. In case of non -merit goods, the cost of
providing the commodity/service to the society is higher than the
price fixed for providing it to the consumer . These subsidies result
in the transfer of benefits to the individual consumer in a number
of ways as follows:
Cash subsidies –Providing food or fertilisers to the consumer
at prices lower than those at which the government procures the
commodities.
Interest or credit subsidies :L o a n sg i v e na tr a t e sl o w e rt h a n
market rates. This takes the form of concessional credit to small
scale industries or priority sector loans to individuals to buy a
taxi, an auto -rickshaw or to set up some small enterprise by
buying some equipment.
Tax subsidies : Tax exemption of medical expenses,
postponing collection of tax arrears
In-kind subsidies: Provision of free medical services though
government dispensaries, provision of equipment to physically
handicapped persons.
Procurement subsidies: Purchase of food -grains at an
assured price which is intended to be higher than the prevailing
market price.
Regulatory subsidies : Fixation of prices of goods produced by
thepublic sector at less than the cost with a view to providing
inputs to industry or helping certain other categories of
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91available to industry, providing electricity to farmers at a rate
much lowe r than the cost.
6.1.5 Budgetary Subsidies
The subsidies which are provided in the Budget are
budgetary subsidies. The estimation of budgetary subsidies are
computed as excess of the cost of providing a service over the
recoveries from the service .T h e s e costs are taken as the sum of
the following:
Revenue expenditure on the concerned service;
Annual depreciation on cumulative capital expenditure for the
creation of physical assets in the service; and
Interest costs of the cumulative capital expenditure, equity
investment in public enterprises, and loans given for the service
concerned including those to public enterprises.
6.1.6Direct and Indirect Subsidies
Direct subsidies are given in terms of cash grants, interest -
free loans and direct benefits. The direct subsidies boost the
purchasing power of the beneficiary and may help in raising the
standard of living. In case of agriculture, direct subsidies help the
farmers to purchase required inputs from markets. Proper
identification of beneficiaries is a big challenge in disbursement of
direct subsidies. Indirect subsidies are given in terms of tax
rebates, insurance premium, low interest loans, depreciation write
offs etc. The cheap loans provided to farmers for agriculture is an
example of indirect farm subsidy.
6.1.7 Effects of subsidies
Economic effects of subsidies can be broadly grouped into: -
1.Allocative effects: these relate to the sectoral allocation of
resources. Subsidies help draw more resources towards the
subsidised sector
2.Redistributive ef fects: these generally depend upon the
elasticities of demands of the relevant groups for the subsidised
good as well as the elasticity of supply of the same good and
the mode of administering the subsidy.
3.Fiscal effects: subsidies have obvious fiscal eff ects since a large
part of subsidies emanate from the budget. They directly
increase fiscal deficits. Subsidies may also indirectly affect the
budget adversely by drawing resources away from tax -yielding
sectors towards sectors that may have a low tax -revenue
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924.Trade effects: a regulated price, which is substantially lower
than the market clearing price, may reduce domestic supply and
lead to an increase in imports. On the other hand, subsidies to
domestic producers may enable them to offer interna tionally
competitive prices, reducing imports or raising exports.
6.1.8 Subsidies may also lead to perverse or unintended
economic effects. They would result in inefficient resource
allocation if imposed on a competitive market or where market
imperfectio ns do not justify a subsidy, by diverting economic
resources away from areas where their marginal productivity would
be higher. Generalised subsidies waste resources; further, they
may have perverse distributional effects endowing greater benefits
on the b etter off people. For example, a price control may lead to
lower production and shortages and thus generate black
markets resulting in profits to operators in such markets
andeconomic rents to privileged people who have access to the
distribution of the g ood concerned at the controlled price.
Subsidies have a tendency to self -perpetuate. They create
vested interests and acquire political hues. In addition, it is difficult
to control the incidence of a subsidy since their effects are
transmitted through th e mechanism of the market, which often has
imperfections other than those addressed by the subsidy. On 29
June 2012, C Rangarajan, Chairman of the Prime Minister's
Advisory Council in view of present difficult economic position,
advocated cutting down of f uel and fertiliser subsidies to keep the
fiscal deficit within the budgeted level of 5.1 per cent.
6.1.9Future of Subsidies in India
The study brings to the fore the massive magnitude of
subsidies in the provision of economic and social services by the
government. Even if merit subsidies are set aside, the remaining
subsidies alone amount to 10.7% of GDP, comprising 3.8% and
6.9% of GDP, pertaining to Centre and State subsidies
respectively. The average all -India recovery rate for these non -
merit goods/s ervices is just 10.3%, implying a subsidy rate of
almost 90%.
The macroeconomic costs of unjustified subsidies are
mirrored in persistent large fiscal deficits and consequently higher
interest rates. In addition, unduly high levels of subsidisation
reflec ted in corresponding low user charges produce serious micro -
economic distortions as well. Its prime manifestations include
excessive demand for subsidised services, distortions in relative
prices and misallocation of resources. These are discernible in the
case of certain input based subsidies. These problems are further
compounded where the subsidy regime is plagued by leakages
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93The agenda for reform sshould therefore focus on:
Reducing the overall scale of subsid ies
Making subsidies as transparent as possible
Using subsidies for well -defined economic objectives
Focusing subsidies to final goods and services with a view to
maximising their impact on the target population at minimum
cost
Instituting systems for peri odic review of subsidies
6.2DEFICIT FINANCING
Deficit financing is the budgetary situation where expenditure
is higher than the revenue. It is a practice adopted for financing the
excess expenditure with outside resources. The expenditure
revenue gap is financed by either printing of currency or through
borrowing.
Nowadays most governments both in the developed and
developing world are having deficit budgets and these deficits are
often financed through borrowing. Hence the fiscal deficit is the
ideal i ndicator of deficit financing.
In India, the size of fiscal deficit is the leading deficit indicator
in the budget. It is estimated to be 3.9 % of the GDP (2015 -16
budget estimates). Deficit financing is very useful in developing
countries like India beca use of revenue scarcity and development
expenditure needs.
Various indicators of deficit in the budget are:
1.Budget deficit = total expenditure –total receipts
2.Revenue deficit = revenue expenditure –revenue receipts
3.Fiscal Deficit = total expend iture –total receipts except
borrowings
4.Primary Deficit = Fiscal deficit -interest payments
5.Effective revenue Deficit -= Revenue Deficit –grants for the
creation of capital assets
6.Monetized Fiscal Deficit = that part of the fiscal deficit
covered by borro wing from the RBI.
Simply budget deficit is printing money to finance a part of the
budget. In India, there is no budget deficit at present. Hence one
there is no budget deficit entry in Government’s budget. Another
absent deficit identity is monetized fiscal deficit. This is borrowing
by the government from RBI to finance the budget. Such a
borrowing practice is not adopted in India from 1997 onwards.
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946.2.1Types of Budgetary Deficit
The different types of budgetary deficit are explained in
following points : -
1. Revenue Deficit
Revenue Deficit takes place when the revenue expenditure
is more than revenue receipts. The revenue receipts come from
direct & indirect taxes and also by way of non-tax revenue .The
revenue expenditure takes place on account of administrative
expenses, interest payment, defence expenditure & subsidies.
Table below indicate revenue deficit of the central
government of India.
From the above table it is clear that revenue deficit was Rs.
18,562 crores in 1990 -91 and Rs. 94,644 crores in 2005 -06. As
proportion of GDP, revenue deficit increased from 1.5% in 1980 -81
to 3.3% in 1990 -91and declined to 2.7% in 2005 -06. The decline is
due to the passing of the Fiscal Responsibility and Budget
Management Act in 2002.
2. Budgetary Deficit
Budgetary Deficit is the difference between all receipts and
expenditure of the government, both reven ue and capital .T h i s
difference is met by the net addition of the treasury bills issued by
theRBIand drawing down of cash balances kept with the RBI. The
budgetary deficit was called deficit financing by the government of
India. This deficit adds to money supply in the economy and,
therefore, it can be a major cause of i nflationary rise in prices.
Budgetary Deficit of central government of India was Rs. 2,576
crores in 1980 -81, it went up to Rs. 11,347 crores in 1990 -91 to Rs.
13,184 crores in 1996 -97.
The concept of budgetary deficit has lost its significance
after the presentation of the 1997 -98 Budget. In this budget, the
practice of ad hoc treasury bills as source of finance for
government was discontinued. Ad hoc treasury bills are issued by
the government and held only by the RBI. They carry a low rate of
interest a nd fund monetized deficit. These bills were replaced by
ways and means advance. Budgetary deficit has not figured in
union budgets since 1997 -98. Since 1997 -98, instead of budgetary
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953. Fiscal De ficit
Fiscal Deficit is a difference between total expenditure (both
revenue and capital) and revenue receipts plus certain non -debt
capital receipts like recovery of loans, proceeds from disinvestment.
In other words, fiscal deficit is equal to budgetary deficit plus
governments market borrowings and liabilities. This concept fully
reflects the indebtedness of the government and throws light on the
extent to which the government has gone beyond its means and
the ways in which it has done so. in 1980 -81, fi scal deficit was Rs.
7,733 crores. Between 1980 -81 and 1990 -91 it increased 5 times to
Rs. 37,606 crores. Since the introduction of economic reforms in
1991 -92, the government has tried to restrict the growth of fiscal
deficit. As percentage of GDP fiscal deficit declined from 6.2% in
2001 -02 to 4.1% in 2005 -06.
4. Primary Deficit
The fiscal deficit may be decomposed into primary deficit
and interest payment. The primary deficit is obtained by deducting
interest payments from the fiscal deficit. Thus, prim ary deficit is
equal to fiscal deficit less interest payments. It indicates the real
position of the government finances as it excludes the interest
burden of the loans taken in the past.
Table below indicate primary deficit as a Percentage of GDP.
Prim ary deficit of the central government of India was 16,108 crores
in 1990 -91, it reduced to 14,591 crores in 2005 -06.
5. Monetised Deficit
Monetised Deficit is the sum of the net increase in holdings
of treasury bills of the RBI and its contributions to th e market
borrowing of the government. It shows the increase in net RBI
credit to the government. It creates equivalent increase in high
powered money or reserve money in the economy.
Conclusion
Allthese budgetary deficit reveal fiscal imbalance. Fiscal
imbalance & budget deficit result in harmful consequences like
mounting inflation, deficit in balance of payment , etc. It has also
adversely affect the growth of the economy. The government must
introduce fiscal correction policies to overcome the deficit budget
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966.3GOODS AND SERVICES TAX (GST)
6.3.1Genesis :
The idea of moving towards GST was first mooted by the
then Union Finance Minister in his Budget speech for 2006 -07.
Initially, it was proposed that GST would be introduced from 1st
April 2010.The Empowered Committee of State Finance Ministers
(EC) which had formulated the design of State VAT was requested
to come up with a roadmap and str ucture for GST. Joint Working
Groups of officials having representatives of the States as well as
the Centre were set up to examine various aspects of GST and
draw up reports specifically on exemptions and thresholds, taxation
of services and taxation of i nter-State supplies. Based on
discussions within and between it and the Central Government, the
EC released its First Discussion Paper (FDP) on the GST in
November, 2009. This spelt out features of the proposed GST and
has formed the basis for discussion b etween the Centre and the
States so far.
The introduction of the Goods and Services Tax (GST) is a
very significant step in the field of indirect tax reforms in India. By
amalgamating a large number of Central and State taxes into a
single tax, GST will m itigate ill effects of cascading or double
taxation in a major way and pave the way for a common national
market. From the consumer’s point of view, the biggest advantage
would be in terms of reduction in the overall tax burden on goods,
which is currently estimated to be around 25% -30%. It would also
imply that the actual burden of indirect taxes on goods and services
would be much more transparent to the consumer. Introduction of
GST would also make Indian products competitive in the domestic
and internat ional markets owing to the full neutralization of input
taxes across the value chain of production and distribution. Studies
show that this would have a boosting impact on economic growth.
Last but not the least, this tax, because of its transparent and se lf-
policing character, would be easier to administer. It would also
encourage a shift from the informal to formal economy. The
government proposes to introduce GST with effect from 1st July
2017.
GST is one indirect tax for the whole nation, which will ma ke
India one unified common market. GST is a single tax on the supply
of goods and services, right from the manufacturer to the
consumer. Credits of input taxes paid at each stage will be
available in the subsequent stage of value addition, which makes
GST essentially a tax only on value addition at each stage. The
final consumer will thus bear only the GST charged by the last
dealer in the supply chain, with set -off benefits at all the previous
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97GST is one indirect tax for the whole nation, which w ill make India
one unified market.
GST is a comprehensive value added tax on goods and
services
In a GST regime, goods and services are not differentiated for
taxation
Destination based consumption tax
Multi -point taxation along the supply chain of goods o f services
6.3.2Some of the key features of GST are listed as below :
1.Dual Tax Structure
Centre and State both will levy tax on every transaction
related to supply of goods/ services
Tax to be levied by Centre and States to be called Centre
GST (‘CGST’) and State GST (‘SGST’)
2.Inter -State Transactions and the IGST Mechanism:
The Centre would levy and collect the Integrated Goods and
Services Tax (IGST) on all inter -State supply of goods and
services. The IGST mechanism has been designed to ensure
seaml ess flow of input tax credit from one State to another. The
inter-State seller would pay IGST on the sale of his goods to the
Central Government after adjusting credit of IGST, CGST and
SGST on his purchases (in that order). The exporting State will
transf er to the Centre the credit of SGST used in payment of IGST.
The importing dealer will claim credit of IGST while discharging his
output tax liability (both CGST and SGST) in his own State. The
Centre will transfer to the importing State the credit of IGST used in
payment of SGST.
3. Destination -Based Consumption Tax: GST will be a
destination -based tax. This implies that all SGST collected will
ordinarily accrue to the State where the consumer of the goods or
services sold resides.
4. Computation of GST on the basis of invoice credit
method: The liability under the GST will be invoice credit method
i.e.cenvat credit will be allowed on the basis of invoice issued by
the suppliers.
5. Payment of GST: The CGST and SGST are to be paid to the
accounts of the central and states respectively.
6. Goods and Services Tax Network (GSTN): An o t -for-profit,
Non-Government Company called Goods and Services Tax
Network (GSTN), jointly set up by the Central and State
Governments will provide shared IT infrastructure and services to
the Central and State Governments, tax payers and other
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987. INPUT TAX CREDIT (ITC) SET OFF :ITCfor CGST & SGST
will be taken for taxes allowed against central and state
respectively .
8. GST on Imports : Centre will levy I GST on inter -State supply of
goods and services. Import of goods will be subject to basic
customs duty and IGST.
9. Maintenance of Records :At a x p a y e ro re x p o r t e rw o u l dh a v et o
maintain separate details in books of account for availment,
utilization or refund of Input Tax Credit of CGST, SGST and IGST.
10. Administration of GST :Administration of GST will be the
responsibility ofthe GST Council , which will be the apex policy
making body of the GST. Members of GST Council comprised of
the Central a ndState ministers in charge of the finance portfolio.
11. Goods and Service Tax Council: The GST Council will be a
joint forum of the Centre and the States. The Council will make
recommendations to the Union and the States on important issues
like tax rates, exemption list, threshold limits, etc. One -half of the
total number of Members of the Council will constitute the quorum
of GST council.
6.3.3The benefits of GST can be summarized as under:
A.Forbusiness andindustry
1.Easy compliance :A robust a nd comprehensive IT system
would be the foundation of the GST regime in India. Therefore,
all tax payer services such as registrations, returns, payments,
etc. would be available to the taxpayers online, which would
make compliance easy and transparent.
2.Uniformity of tax rates and structures : GST will ensure that
indirect tax rates and structures are common across the
country, thereby increasing certainty and ease of doing
business. In other words, GST would make doing business in
the country tax neutral, irrespective of the choice of place of
doing business.
3.Removal of cascading : A system of seamless tax -credits
throughout the value -chain, and across boundaries of States,
would ensure that there is minimal cascading of taxes. This
would reduce hidden cost s of doing business.
4.Improved competitiveness :Reduction in transaction costs of
doing business would eventually lead to an improved
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995.Gain to manufacturers and exporters : The subsuming of
major Central and Stat e taxes in GST, complete and
comprehensive set -off of input goods and services and phasing
out of Central Sales Tax (CST) would reduce the cost of locally
manufactured goods and services. This will increase the
competitiveness of Indian goods and services in the
international market and give boost to Indian exports. The
uniformity in tax rates and procedures across the country will
also go a long way in reducing the compliance cost.
B.ForCentral andState Governments
1.Simple and easy to administer :Multiple indirect taxes at the
Central and State levels are being replaced by GST. Backed
with a robust end -to-end IT system, GST would be simpler and
easier to administer than all other indirect taxes of the Centre
and State levied so far.
2.Better controls o nl e a k a g e :GST will result in better tax
compliance due to a robust IT infrastructure. Due to the
seamless transfer of input tax credit from one stage to another
in the chain of value addition, there is an in -built mechanism in
the design of GST that would incentivize tax compliance by
traders.
3.Higher revenue efficiency :GST is expected to decrease the
cost of collection of tax revenues of the Government, and will
therefore, lead to higher revenue efficiency.
C.Fortheconsumer
1.Single and transparent t ax proportionate to the value of
goods and services: Due to multiple indirect taxes being levied
by the Centre and State, with incomplete or no input tax credits
available at progressive stages of value addition, the cost of
most goods and services in the country today are laden with
many hidden taxes. Under GST, there would be only one tax
from the manufacturer to the consumer, leading to transparency
of taxes paid to the final consumer.
2.Relief in overall tax burden: Because of efficiency gains and
preven tion of leakages, the overall tax burden on most
commodities will come down, which will benefit consumers.
6.3.4Various GST Tax Slabs in India
No Tax
Goods -No taxes will be levied on goods like sanitary
napkins, deities made of stone, marbles or wood, Rakhismunotes.in

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100without any precious metals like gold, silver, raw material
used in brooms, Saal leaves and fortified milk ,fruits,
vegetables, bread, salt, bindi, curd, sindoor, natural honey,
bangles, handloom, besan, flour, eggs, stamps, printed
books, judicial papers, and newspapers.
Services -All hotels and lodges who carry a tariff below ₹
1,000 are exempted from taxes under GST.
GST Tax Slab of 5%
Goods -The goods which will attract a taxation of 5% under
GST include skimmed milk powder, fish fillet, froz en
vegetables, coffee, coal, fertilizers, tea, spices, pizza bread,
kerosene, ayurvedic medicines, agarbatti, sliced dry mango,
insulin, cashew nuts, unbranded namkeen, lifeboats ,
Ethanol -Solid biofuel pellets -Handmade carpets and other
handmade textile floor coverings (including namda/gabba) -
Hand -made braids and ornamental trimming in the piece
Services -Small restaurants along with transport services
like railways and airways, Standalone ACs non -ACs
Restaurants and those which serve liquor, Takeaway Food,
Restaurants in hotels with a room tariff less than ₹7,500 (no
input credit for these restaurants), will come under this
category.
GST Tax Slab of 12%
Goods -Items coming are the tax slab of 12% include frozen
meat products, butter, cheese, ghee, p ickles, sausage, fruit
juices, namkeen, tooth powder, medicine, umbrella, instant
food mix, cell phones, sewing machine, man -made yarn, -
Handbags including pouches and purses; jewellery box,
Wooden frames for painting, photographs, mirrors etc,
Ornamental framed mirrors, Brass Kerosene Pressure
Stove, Art ware of iron, etc.
Services -Business class air tickets will attract a tax of 12%
under GST .
GST Tax Slab of 18%
Goods -As mentioned above, most of the items are part of this
tax slab. Some of the ite ms are flavo ured refined sugar,
cornflakes, pasta, pastries and cakes, detergents, washing and
cleaning preparations, safety glass, mirror, glassware, sheets,
pumps, compressors, fans, light fitting, chocolate, preserved
vegetables, tractors, ice cream, sa uces, soups, mineral water,
deodorants, suitcase, brief case, vanity case, oil powder,
chewing gum, hair shampoo, preparation for facial make -up,
shaving and after -shave items, washing powder, Refrigerators,
Water Heaters, Washing Machines, Televisions (up to 68 cm),munotes.in

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101Vacuum Cleaners, Paints, Hair Shavers, Hair Curlers, Hair
Dryers, Scent Sprays, Lithium -ion batteries, detergent, stones
used in flooring, marble & granite, sanitary -ware, leather
clothing, wrist watches, cookers, stoves, cutlery, telescope,
goggles, binoculars, oil powder, cocoa butter, fat, artificial fruits,
artificial flowers, follage, physical exercise equipment, musical
instruments and their parts, stationery items like clips, some
diesel engine parts, some parts of pumps, electrical board s,
panels, wires, razor and razor blades, furniture, mattress,
cartridges, multi -functional printers, door, windows, aluminium
frames, .
Services -Restaurants located inside hotels with tariffs of
`7,500 and above, outdoor catering(input tax credit to be
available) , Actual bill of hotel stay below `7,500, IT and
Telecom services and financial services along with branded
garments will be part of this tax slab.
GST Tax Slab of 28%
Goods -Over 200 goods will be taxes at a rate of 28%. The
goods which will be part of this category under GST are
sunscreen, pan masala, dishwasher, weighing machine,
paint, cement, vacuum cleaner. Other items include
automobiles, hair clippers, motorcycles.
Services -As mentioned above, five -star hotels, whose
actual bill of hotel stay above `7,500, racing, movie tickets
and betting on casinos and racing will come under this
category.
6.3.5Evaluation of (GST)
One year into the goods and services tax (GST) regime,
early -day jitters have given way to general acceptance that th is
may not be the most perfect single tax system, but it’s working.
There are many issues that remain to be addressed, but the fact
that some of the knotty ones have been resolved gives rise to
confidence that even these will be sorted out. Here’s how the past
year panned out.
1.Inflation rate didn’t rise :G S T ,i tw a sw i d e l yf e a r e d ,w o u l d
cause inflation to rise, as with many countries that launched a
single tax regime. That hasn’t happened in India. The recent spike
in consumer inflation has been due to high food and fuel prices,
unrelated to GST. What helped? The much -criticised multi -slab
structure. It ensured the levy was as close as possible to the
existing rate, which meant the incidence of tax didn’t rise. The
second factor was the anti -profiteerin ga u t h o r i t y .T h o u g ht h eb o d y
was set up after the GST rollout, the prospect of its establishment
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1022.Single national market : Long queues of trucks at state borders
disappeared as check posts were dismantled, creating a seamless
national market. These barriers had restricted movement of goods
across the country, leading to huge delays and increasing
transaction costs for the logistics sector, eventually translating into
higher costs for consumers.
3.One tax nationally : A consumer in Kanyakumari now pays the
same tax on an item as one in Jammu & Kashmir. GST has also
allowed businesses to streamline distribution systems —production,
supply chain, storage —to make them more efficient, having
previous ly been forced to design them keeping state taxes in mind.
4.Formalisation kicks off, tax base begins to widen :O n eo ft h e
expected benefits was that GST would encourage formalisation of
the economy. Evasion would stop making sense, thanks to
transparent digital processes and incentive of input credit and
invoice matching. With number of registrations crossing 10 million,
it seems more businesses are signing up for GST. Rise in the
Employees’ Provident Fund Organisation subscriber base provides
further ev idence of the same More people filing income tax returns
could also have something to do with GST.
5.Everyone wins : As many as 17 taxes and multiple cesses were
subsumed into GST, aligning India with global regimes. Central
taxes such as excise duty, ser vices tax, countervailing duty and
state taxes —including value added tax, Octroi and purchase tax
—were all rolled into one. The new regime provided for free flow of
tax credits and did away with cascading due to tax on tax, boosting
company financials and resulting in reduced prices for consumers.
It also ensured a single law for the whole country with uniform
procedures and rules, which reduces compliance burden and
business complexity. The government sacrificed revenues, but
improved compliance should cover any gap.
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103The government should bring down the slabs from four to
three as collections have been above the mark and accordingly rate
moderation should be warranted, encouraging certain sectors
boosting the economy.
Undoubtedly, GST has received positive as well as negative
responses as befits its characterisation as a toddler. However,
further steps will bring out the true sense of One Nation One Tax.
6.4QUESTIONS
1.Explain the meaning and types of subsidies.
2.Write a note on Classification of subsidies.
3.Explain economic effects of subsidies.
4.Discuss the meaning and types of deficit financing.
5.Write a brief note on Goods and Services Tax.
6.Explain the impact and evaluation of GST.




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104Module 4
Unit -7
EXTERNAL SECTOR
Unit Structure :
7.0 Objectives
7.1 Concept of Balance of Payments
7.2 Structure of Balance of Payments
7.3 Types of Disequ ilibrium in Balance of Payments
7.4 Causes of Disequilibrium
7.5 Measures to correct d isequilibrium
7.6 Source of Data
7.7 Questions
7.0 OBJECTIVES
To study the concept of Balance of Payments
To understand the concept of Balance of Payments
To study different types of disequilibrium in Balance of
Payments
To study various causes lea ding to disequilibrium in Balance of
Payments
To Understand the measures to correct disequilibrium in BOP
7.1 CONCEPT OF BALANCE OF PAYMENT
The Balance of Payment is defined as “a systematic
record of all economic transactions between the residents of a
country and residents of foreign countries during a certain
period”.
Systematic record refers to the system of double entry book
keeping system.
Economic transactions include all such transactions that involve
the transfer of title or ownership.
The term ‘resident’ refers to the nationals of the reporting
country. For example, tourists, diplomats, military personnel,
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105companies operating in the reporting country do not fall in the
category of res idents.
The time -period is generally one year.
Usefulness of the Concept of Balance of Payment.
The Balance of Payment data is useful in policy formulation for
the external sector.
To study the strengths and weaknesses of a country in the field
of int ernational trade.
Inter-temporal study helps in knowing the Balance of Payments’
position of the country.
Study of other countries’ Balance of Payments’ position helps in
identifying threats and opportunities that exist in the
international arena for a giv en country.
Study helps in converting weaknesses into strengths and
threats into opportunity.
It helps in knowing changes in the composition and directio no f
foreign trade (See tables 15.1 and 15 .2).
Table 7.1-Composition of India’s Exports (% Change)
Category 1960 -61 2015 -16 2016 -17
Agriculture and allied exports 44.2 12.6 12.3
Manufactured Goods 45.3 73.5 73.6
Source : IES 2017 -18, Volume 2, Table 7.3 B, p. A109
Table 7.2-Direction of Indian Exports (percentage change)
Region 2004 -05 2016 -17
Europe 23.6 19.3
America 20.1 19.9
Asia 47.9 49.9
Africa 6.7 8.4
CIS and Baltics 1.3 1.0
Source: IES 2017 -18, Volume 2, Table 7.4B, p.A118
It indicates future consequences of the post trade performance
of a country. Regular and large d eficit shows growing
international indebtedness and regular large surplus indicates
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1067.2ACCOUNTING STRUCTURE OF BALANCE OF
PAYMENTS ACCOUNTS
The Balance of Payments accounts are divided into two
categories namely current and ca pital accounts. Payments made
by residents of the reporting country to foreigners are called debits
and payments made by the residents of the rest of the world to the
reporting country are called credits.
Current Account. The current account contains en tries related to
export and import of merchandise and service that change the
current level of consumption or national income of the country.
Capital Account. The capital account contains entries relating to
movement of short term and long term capital both in and out of the
country along with gold and foreign exchange reserves leading to
increase or decrease of a country’s total stock of capital.
Table 7.3
Balance of Payments Accounts (A hypothetical example)
Credit (Receipts)
(in Rs. Crore)Debit( P a y m e n t s )
(in Rs. Crore)
(A) Current Account
1. Goods Exported
8008. Goods imported
1200
2. Services Exported
4009. Services imported
800
3. Incomes from investme nt
in the foreign country. 40010. Incomes to foreigners on
investment in the reporting
country.800
4. Unilateral receipts.
80011. Unilateral payments.
400
Total
2400Total
3200
(B) Capital Account
5. Long term borrowing 800 12. Long term lending 320
6. Short term borrowing 400 13. Short term lending 240
7. Sale of gold/assets 400 14. Purchase of gold/assets 200
15. Errors and o missions 40
Total 4000 Total 4000
Current Account. The current account of the Balance of
payments of a country consists of real economic transactions of
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107countries. While impo rts reduce national income, exports lead to
rise in national income.
Entries at Serial Numbers 1 to 4 and 8 to 11 are real or income
creating transactions.
The current account has two types of income creating
transactions i.e. trade or merchandise account and the invisible
account.
The trade account consists of exports of goods. Thus, the
income earned from goods exported (Rs.800 Crore) is shown as
the credit entry and the import payment (Rs.1200 Crore) is
shown as the debit entry.
The invisible account c onsists of all other transfer payments in
the form of incomes. Income earned through the export of
services is insurance, banking, interest on loans, tourist
expenditure, transport charges etc. The reporting country has
earned Rs.400 Crore from the expor t of services and has spent
Rs.800 Crore for receiving these services from foreign
countries.
The second entry in the invisible account is income from
investment in the foreign countries through interest/dividend.
This amounts to Rs.400 Crore on the credi t side and Rs.800
Crore on the debit side.
The third entry in the invisible account shows unilateral receipts
on the credit side and unilateral payments on the debit side.
These payments and receipts consist of gifts and charities
which are given and rece ived freely without the obligation to
repay. Thus, receipts or payments because of goods exported
or imported constitute the visible account or the trade account.
All other income earning transactions constitute invisible
accounts.
According to the Inte rnational Monetary Fund, the following
transactions have been accepted as invisible transaction:
1.Travel because of business, education and health.
2.Insurance premium and payment of claims.
3.Investment income including interest, rents, dividends and
profits.
4.Transnational transportation of goods, warehousing during
transit and other transit expenses.
5.Income from services such as advertising, commissions,
pensions, patent fees, royalties, subscription to periodicals,
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1086.Repayment of commercia l credits.
7.Donations, migrant remittances, legacies.
8.Contractual amortization and depreciation of direct investment.
Capital Account:
The capital account of Balance of Payment consists of those
items which affect the existing capital stock of the country. The
broad categories of capital account items are short term and long
term capital movements both in and out of the country and changes
in the gold and exchange resources.
Short term capital movements include purchase of short term
securities such as tr easury bills, commercial bills and
acceptance bills, speculative purchase of foreign currency and
cash balances held by foreigners.
Long term capital movements include direct investments in
shares or bonds or real estate or physical assets such as plant
building, equipment etc., portfolio investment in government
securities, and securities of firms etc. and amortization of
capital.
Export of capital is a debit item whereas export of merchandise
is a credit item because of export of merchandise leads to infl ow
of foreign exchange which adds to the national income of the
reporting country and export of capital leads to outflow of foreign
exchange which leads to withdraw from the foreign exchange
resources of the reporting country.
Gold and foreign exchange res erves are maintained to impart
stability to the exchange rate of the home currency and to make
payments to the creditors in case there are payment deficits on
all other accounts.
Assistance provided by IMF, World Bank etc. is shown in the
capital account. Countries like the US and the UK show a
separate official settlement account in addition to current and
capital accounts. The official settlement account records the
change in the foreign exchange reserves and reserves of
monetary gold held by the moneta ry authority.
Increase in reserves is debit items and decrease is credit item.
Balance of Payment and Balance of Trade:
Balance of Payment is a wide concept than Balance of
Trade. Balance of payment includes all the entries on account of
trading in goo ds, services, capital flow etc. Balance of trade refers
to only the difference between the value of imports and exports of
merchandise or visible items whereas balance of payment covers
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109The n et balance on the visible items i.e., merchandise
exports and imports are called balance of trade. If exports are
greater than imports, the Balance of Trade is positive and vice
versa. The balance on current account is carried over to the capital
account . A deficit in Balance of Trade is made good by external
borrowing or assistance which will have a matching surplus entry in
the capital account thus balancing the accounts.
Balance of Payments Always Balance:
The Balance of Payment accounts is maintaine do nt h e
basis of double entry book system where total debits will always
equal total credits. Hence in the accounting sense, the balance of
payment will always balance. However, imbalances do exist in
different account heads as shown in the table. The balance of
trade reflects a deficit of Rs.400 Crore (Rs.800 –1200). Net
negative exports of goods indicate unfavorable balance of trade.
On the invisible account, the balance of services and the balance of
investment income also show a deficit of Rs.400 Crore each.
However, there is a surplus of Rs.400 Crore on account of net
unilateral receipts. Thus, there is a deficit of Rs.400 Crore each on
the visible as well as the invisible account. The net balance which
is the sum of net visible exports and ne t invisible exports is the
balance on current account. In this case, there is a deficit on the
current account amounting to Rs.500 Crore. You will notice that
the deficit on current account is made good on the capital account.
The balance of loan transa ctions and the balance of monetary gold
flow i.e., net borrowing and net monetary gold flow shows a positive
balance of Rs.640 crore and Rs.200 crore. Errors and omissions of
Rs.40 crore is entered to make the deficit of Rs.800 crore on
current account ma tch with the surplus of Rs.840 crore on the
capital account. The items errors and omissions indicate the value
of certain discrepancies in estimation resulting in situation where
debits are not exactly equal to the credits. A negative value
indicates tha tr e c e i p t sa r eo v e r -stated or payments are understated
or both. Similarly, a positive value indicates that receipts are
understated or payments are overstated or both. If such errors are
large and persistent, they indicate serious weakness in recording o f
transactions. Thus, on account of double entry book keeping
system, the balance of payments will always balance. Any
negative balance in the current account is made corrected by a
surplus balance on the capital account and vice versa. Therefore,
balan ce of payment always balances from the accounting point of
view.
DISEQUILIB RIUM IN THE BALANCE OF PAYMENTS:
Equilibrium or disequilibrium in the balance of payments
refer to the balance on those heads of the account which do not
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110drawings from the reserves of foreign currencies held by the
Central government etc. Excluding these items, if there is neither
deficit nor surplus in the balance of payments, it is known to be in
equilibrium. Oth erwise, it will be in disequilibrium. The deficit in the
balance of payment can be financed by drawings from the IMF, use
of Special Drawing Rights and drawings from the reserves of
foreign currencies. In 1999 -2000, the deficit on the current account
was financed by the surplus on the capital account of India’s
balance of payment. Nonetheless, India’s balance of payment
remains unfavorable and in disequilibrium because of a deficit on
the current account. It thus means that when there is neither
surplus nor deficit on the current account, the balance of payment
is said to be in equilibrium. A more important concept of balance of
payment is the concept of basic balance. It is based on
autonomous items in the balance of payment. Autonomous items
are tho se items which cannot be easily changed or influenced by
the government because they are determined by long term factors.
Autonomous transactions take place on their own because of
people’s desire to consume more or to make higher profits. For
instance, both export and import of goods and services which are
items on the current account are undertaken to make profit or
consume more goods and services. Exports and imports take
place irrespective of other transactions included in the balance of
payment acco unts. It is for this reason they are called autonomous
transactions. Autonomous transaction also includes long term
capital movements both on private and government account
contained in the capital account. If exports are equal to imports,
there will be no other transaction but if they are not equal, it will
lead to short term capital movements in the form of international
borrowing and lending. These capital movements are undertaken
for bridging the deficit in the balance of trade. Since the short -term
capital flows are accommodating or compensatory in nature, they
are called induced transactions. Induced transactions include
borrowing from the International Monetary Fund or Central Banks of
other countries, drawings from Special Drawing Rights accoun t.
Induced transactions are excluded from the concept of basic
balance. Thus, when autonomous transactions are equal and there
is no need for induced transactions, the balance of payment is in
equilibrium. This equilibrium in the balance of payment is a state of
balance which can be sustained without government intervention.
The concept of basic balance therefore can be stated as:
(X–M) + LTC = 0
Where, X stands for exports.
M stands for imports, and
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111Ife x p o r t sa r eg r e a t e rt h a ni m p o r t s( X>M ) ,l o n gt e r mc a p i t a l
movement will be negative and equal to net exports (X n)w h i c h
means there will be net capital outflow. Similarly, if exports are less
than imports (X < M), long term capital movement will be pos itive
and equal to net imports (M n) which means there will be an inflow of
capital to bridge the deficit in the current account.
7.3TYPES OF DISEQUILIB RIUM IN THE BALANCE OF
PAYMENTS
The balance of payment is unfavorable when a country’s
autonomous pay ments are greater than its autonomous receipts.
Autonomous payments arise out of import of goods and services
and export of capital, whereas autonomous receipts result from the
export of goods and services and import of capital. Thus, the
balance of paym ent is unfavorable when total imports are greater
than total exports. However, imports and exports are determined
by several factors. Imports of a country depend upon domestic
demand for foreign goods, the prices of imports and the prices of
their domest ic substitutes and people’s preference for foreign
goods. Exports of a country depend upon foreign demand for its
goods and services, price competitiveness and quality and
exportable surplus. As all economies operate under dynamic
conditions, factors whi ch determine imports and exports keep
changing and the changes differ in their duration and intensity from
time to time and form country to country. The changes which occur
because of disturbances in the domestic economy and other
economies create conditio ns of disequilibrium in the balance of
payment. There are different reasons for different disequilibria and
these are given below.
1.Cyclical Disequilibrium:
Business cycles or fluctuations in the economic activities of trading
nations are the cause of cyc lical disequilibrium in the balance of
payments. These fluctuations occur in prices, production,
employment and incomes which causes periodic fluctuations in
international trade. During the prosperity phase of the business
cycle, prices of goods rise and incomes fall which affects
international trade and balance of payments. A country with elastic
demand during the prosperity phase will experience fall in imports.
Conversely, if the demand is inelastic, demand for imports will rise
during prosperity. F urther, during depression, when prices decline
and incomes rise, countries with elastic demand for imports will
experience rise in imports and those with inelastic demand will
experience a fall in imports. A country in the prosperity phase will
thus exper ience a surplus and that of a country in depression will
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1122.Structural Disequilibrium:
Structural disequilibrium occurs due to structural changes taking
place in certain sectors of the economies of the trading countries.
Structural chang es may change the demand and supply of imports
and exports. For example, because of a fall in the foreign demand
for Indian garments, garment production will fall in India. If there is
a freedom of exit, the resources employed in garment industry can
beredirected to other profitable avenues. In the absence of
freedom of exit, exports will fall and if there is no matching fall in the
imports, there will be disequilibrium in the balance of payments.
Export demand remaining constant there may be fall in t he
exportable surplus or supply of exports because of industrial
frictions or some other extraneous factors resulting in structural
disequilibrium in the balance of payments.
Increase in the marginal propensity to import because of
increasing domestic i ncomes will have a twofold adverse effect on
the balance of payments. First the import demand will rise and
second the demand for domestic goods will also increase leading to
a fall in the exportable surplus. According to Ragner Nurkse,
international dem onstration effect can lead to structural
disequilibrium in balance of payments. Because of growing contact
of the developing countries with the advanced countries,
developing countries try to imitate the consumption pattern of the
advanced countries. Thu s, the demand for imports rises without a
matching rise in exports. This also results in a change in the
production pattern of poor countries resources are diverted to
manufacture import substitutes of consumer goods by adopting
sophisticated production m ethods and imported technology.
Capital imports compounds the problem of foreign exchange
outflow creating structural disequilibrium.
3.Short Run Disequilibrium:
Short run disequilibrium in the balance of payments refers to
temporary deficit or surplus las ting for a short period. It is caused
by unexpected contingencies such as favorable or unfavorable
monsoons, industrial peace or disharmony, short term borrowing
and lending in the internal market. For instance, failure of
monsoons in a rain fed agricultur al country like India would
necessitate large scale import of food grains leading to unfavorable
balance of trade. However, the situation may be corrected in the
subsequent year if the monsoon is normal. Hence, the
disequilibrium is temporary for that per iod. A temporary
disequilibrium may also be caused because of bumper agricultural
crop leading to higher exports and a surplus on the merchandise
account. Similarly, wide -spread industrial disharmony in a country
which is involved in the exports of manufa ctured goods would
experience a decline in the exportable surplus and thus face a
deficit in the balance of payments. In the same manner, short termmunotes.in

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113borrowing or lending in the international market may cause a short
period disequilibrium in the capital ac count. However, short period
deficits and surpluses are subject to automatic correction because
of the operation of market forces and the international payment
mechanism.
4.Long Run Disequilibrium:
Long run disequilibrium in the balance of payments is al so known
as secular or fundamental disequilibrium. It refers to persistent
deficit or surplus in the balance of payment of a country. If there is
a persistent deficit, it would lead to progressive depletion of the
stock of gold and foreign exchange reserv es of the country leading
to exchange instability and foreign exchange crisis. For example,
the foreign exchange crisis of 1991 in India was a case of long run
or fundamental disequilibrium in the balance of payments. The
International Monetary Fund has used the term ‘fundamental
disequilibrium’ to describe a long run disequilibrium caused by
persistent deficit in the balance of payment of a country.
Fundamental or secular disequilibrium is caused by unchecked
persistent short run disequilibrium in the balance of payments. The
causes of fundamental disequilibrium are deep seated in the
economy. Some of the causes are persistent rise in population, low
rate of capital formation, technological changes, instability in the
export prices of primary goods an d import restrictions by advanced
countries. The IMF expects a member country facing secular
disequilibrium to consult the Fund so that it can advise or assist in
taking appropriate measures to correct the situation. It is important
to correct fundamenta l disequilibrium immediately to ensure one’s
survival in the international economy.
7.4 CAUSES OF DISEQUILIBRIUM
Short run or long run disequilibrium in the balance of
payments of a country is caused by numerous factors which may
operate simultaneously or singularly. Different countries may
experience different types of disequilibrium with different
contributing factors at different points of time. The generalized
causes of disequilibrium in the balance of payment can be
explained as follows:
1.Busines sCycles
Business cycles are an important cause of cyclical
disequilibrium in the balance of payments of a country. Difference
in timing and occurrence of trade cycles in the trading countries
also causes cyclical disequilibrium. Further, the intensity of
prosperity and depression in different countries can cause cyclical
disequilibrium. Difference in income and price elasticity of demand
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114disequilibrium. For instance, if the prosperity p hase of a country
like United Kingdom is more intense than that of United States,
then United Kingdom will have a deficit in the balance of payment
and United States will enjoy a surplus. This is because of the fact
that the demand for imports in United K ingdom will be relatively
greater than the demand for imports in United States.
2.Large Developmental Expenditures:
In case of developing countries, the main cause of
disequilibrium in the balance of payments is their persistently
growing developmental and investment expenditures and these
countries continually depend upon the advanced countries for their
capital imports and the dependence seems to be inherently
continuous on account of the developmental gap between the
advanced countries and the developing countries. The result of this
developmental gap is unfavorable terms of trade which causes
persistent current account deficits in the balance of payment of
developing countries. Further the developing countries are largely
agricultural economies involved in the process of industrialization.
Progressive industrialization contributes to increasing demand for
primary products resulting in their price rise and reduced exportable
surplus. Unfavorable terms of trade on account of primary goods
exports and red uced exports surplus on account of growing
domestic demand for primary products compounds the problem of
deficit resulting in structural disequilibrium and sometimes
fundamental disequilibrium in the long run.
3.Changing Demand for Exports:
Economic self su fficiency appears to be an important aim of
every country developing and advanced. The developed or the
advanced countries aim to be self sufficient in primary products,
particularly the food articles and as a result their demand for
imports of primary go ods gets reduced over time. This results in a
fall in the exports of developing countries and adversely affecting
their balance of payments. Similarly, the developing countries also
try to be economically self sufficient in terms of their capital
requirem ents, thus reducing their capital imports. However, on
account of the developmental gap and technological backwardness
along with unfavorable terms of trade, the developing countries
have regular net negative exports and therefore a persistent
disequilibri um in their balance of payments.
4.High Growth Rate of Population:
The rate of growth of population in high income countries is
0.6 per cent per annum whereas in the case of low income
developing countries, it is as high as two per cent per annum (see
page 279 of WDR 2000 -2001). A high population growth not only
demands higher imports but also contributes to a persistent rise inmunotes.in

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115the demand for primary products resulting in secular disequilibrium
in the balance of payments.
5.Heavy External Borrowings:
A coun try with a persistent and sometimes rising deficit on
the current account without adequate inflow of foreign exchange on
the capital account may have to take recourse to external
assistance and commercial borrowings. Heavy external borrowing,
particularly external commercial borrowing necessitates debt
servicing in the form of principal and interest payments. Deficit in
the balance of payment would continue as long as the country
borrows more than what it lends to other countries.
6.Inflation:
Inflation is a chronic problem in developing countries and
India is a classic example of an inflation infected country. Inflation
assumes significance in the context of balance of payments when
the domestic inflation rate is much higher than what is prevalent
amongst your trading partners. In such a situation, import demand
will be higher along with higher demand for domestically produced
goods and services. This will reduce the exportable surplus and
lead to a deficit in the balance of payment. Further, on account of
higher domestic prices, the demand for exports will fall
necessitating a depreciation or devaluation of the home currency.
Devaluation of the home currency will help exports to rise and
imports to fall. However, imports will fall only if they are pric e
elastic. In case of developing countries, import demand being
relatively inelastic, the deficit in the balance of payment continues
after a brief reprieve.
7.International Demonstration Effect:
According to Ragner Nurkse, increasing interaction between
the developing and the advanced countries results in an
international demonstration effect. International demonstration
effect refers to the phenomenon of imitation by the developing
countries of the conspicuous consumption pattern of the advanced
countrie s. The developing countries have a high marginal
propensity to consume. On account of the international
demonstration effect, higher MPLC translates into higher imports
without matching exports. The developing countries also try to
replicate the product ion pattern of advanced countries by importing
sophisticated capital goods and know -how. Thus, international
demonstration effect not only leads to higher import of consumer
goods but also capital goods all contributing to deficit in the balance
of paymen ts.
8.Flight of Capital:
Countries with full convertibility both on current account as
well as capital account are particularly exposed to the danger ofmunotes.in

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116capital flight in the event of a currency crisis. The Mexican
currency crisis of 1994 -95 and the east -Asian crisis of 1997 are two
examples of capital flight. Countries with huge exposure to foreign
capital flows in the form of portfolio investment and short term
capital borrowing are highly susceptible to speculative attack on
their home currencies leadin g to foreign exchange crisis. For
instance, net inflow into Mexico in 1993 was $60 billion and during
the Mexican crisis of 1995, net outflow reached $75 billion. A
speculative attack on a currency takes place when foreign and
domestic depositors suddenl y shift their funds out of domestic
banks into foreign currency. These attacks take place because
investors receive information that affects the attractiveness of
keeping money in a country whose economic characteristics
appears to be doubtful.
9.Imposit iono fN o n -tariff Barriers:
Non-tariff barriers in the form of quantitative restrictions or
import quotas, countervailing duties in the name of social clause,
ban on certain items of import in the name of child labor content are
imposed by the advanced count ries on developing countries which
adversely affect their export performance. Under the multi -fibre
agreement, comprehensive quota restrictions on import of clothing
and textiles into the advanced countries were imposed. Similarly,
the social clause whic hw a sm o v e db yt h eU n i t e dS t a t e st ob e
incorporated in the Marrakesh Declaration in 1994 proposed to levy
a countervailing duty on imports from developing countries in order
to offset the low labor costs prevailing in these countries. The
comparative cost advantage enjoyed by the developing countries
on account of low labor cost was sought to be neutralized under the
guise of a humanitarian concern that the developing countries
adopt proper standards of living for the workers and pay better
wages. The ‘s ocial clause’ was withdrawn on account of strong
opposition from the developing countries. Non -tariff barriers in the
form of quotas, countervailing duties, child labor content etc
adversely affect the exports of developing countries and thereby
their bala nce of payments.
10.Globalization of the World Economy:
Globalization refers to the process of economic integration of
the member countries of the World Trade Organization. In the year
1999, one hundred and thirty four countries were members of the
WTO. Gl obalization is sought to be achieved through reduction of
trade barriers, free flow of capital between the member nations and
free flow of technology. Since the terms and conditions of the world
trade under aegis of WTO is set by the powerful countries of
Europe and the Americas, the developing countries are found to be
at disadvantage in the globalizing world economy. The imposition
of non -tariff barriers on the exports from developing countries
discussed earlier, have been adversely affecting the balanc eo fmunotes.in

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117payments of these countries. In the emerging global village, the
developing countries have very little bargaining power to bring
about a level playing field in world trade. With inelastic capital
imports and elastic exports and with the free flow of finance capital,
the developing countries are found to be more vulnerable in the
context of their balance of payments position.
7.5MEA SURES TO CORRECT DISEQUILIBRIUM
A fundamental disequilibrium in the balance of payments of
a country needs timely cor rection. If the balance of payment of a
country shows persistent and growing deficit, the country must
initiate measures to improve its foreign exchange resources. The
foreign exchange reserves can be improved by import reduction
and by increasing export s. Both would require adjustment through
exchange rates and trade controls. The adjustment mechanism
used to correct disequilibrium in the balance of payments consists
of monetary and non -monetary measures. Deflation, exchange
depreciation, devaluation and exchange control are the monetary
measures whereas import duties, import quotas or quantitative
restrictions and export promotion drives are the non -monetary
measures. Effective implementation of monetary measures helps
to increase exports and reduce imports. They function though the
price mechanism and hence they influence indirectly. Non -
monetary measures are direct in their impact. For instance, import
duties and quantitative restrictions in the form of quotas directly
reduce imports and export pr omotion measures directly increase
exports.
(A)Monetary Measures to Correct Disequilibrium in the
Balance of Payments.
1.Deflation
Deflation is a deliberate attempt by the monetary authorities
of the country to bring down the general price level. The gene ral
price level is brought down by reducing money supply with the help
of both quantitative and qualitative measures of credit control. A
country with a deficit in the balance of payment will increase the
bank rate which will be followed by higher interes t rates charged by
the commercial banks. As a result, investment demand will fall
resulting in the fall in employment income. Lower income will lead
to reduced demand for domestic goods and service and fall in their
prices. Lower prices would help increa se the demand for exports
and decrease the demand for imports. Further, lower domestic
demand will increase the exportable surplus and lower domestic
incomes will reduce the propensity to import, thus correcting the
deficit in the balance of payment. Howe ver, deflation as a monetary
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118be successful only in the case of a regime of fixed exchange rates.
For instance, under a flexible exchange rate system, the country
which tries to boost exports by deflationary measures may have to
face an appreciation in the external value of its currency vis -à-vis
the foreign currency. Thus gains made by reduced prices may be
offset by an appreciation in the exchange rates thus nullifying the
whole exer cise. Further, the effective impact of a deflationary
policy depends upon the elasticity of imports and exports. If the
elasticity of demand for imports and exports are greater than unit, a
mild deflation will be sufficient. In case, the elasticity of de mand for
exports and imports is less than unity, a strong dose of deflation
would be required. However, a deflationary spiral will adversely
affect domestic employment, output and incomes. Thus a
deflationary policy to correct disequilibrium won’t be la c orrect
prescription because such a policy would be paradoxical to
development requirements of developing economies.
2.Exchange Depreciation
Exchange depreciation is said to have taken place when
there is a fall in the external value of the currency of a country.
However, exchange rate depreciation being de -facto and as a
result of market mechanism, is possible only under a regime of
flexible exchange rates. For instance, let us assume that the US
Dollar is exchanged for Rs.40. If the Indian demand for American
exports rose more proportionately than the American demand for
Indian exports, there will be a negative trade balance in India’s
balance of payments reflecting a higher demand for US dollars.
Higher demand for US dollars will result in the appre ciation of the
dollar and depreciation of the rupee and the new exchange rate let
us assume will be Rs.45 to a US dollar. The depreciation of the
Indian rupee will help increase the demand for Indian exports
because Indian exports have become cheaper. Si milarly, an
opposite effect takes place on the demand for imports which have
now become dearer. The demand for imports or US exports falls
and the deficit in the balance of payments is reduced.
Exchange rate depreciation is also not free without its
limitations. Exchange rate depreciation will be successful in
reducing and correcting the disequilibrium in the balance of
payments only if the demand for imports and exports is relatively
elastic and if it is relatively inelastic, a bigger depreciation will be
required to bring about a fall in imports and a rise in exports.
Further, if your trading partner in our example, i.e., the US allows its
currency to depreciate as a retaliatory measure, the entire Indian
effort to depreciate its currency will be in va in. Yet another adverse
impact on the depreciating country will be unfavorable terms of
trade. If the import content in exportable goods is high, the price of
exports will rise thus nullifying the depreciation exercise. Finally,
exchange depreciation may result in an inflationary spiral onmunotes.in

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119account of rise in domestic price level and increase in nominal
incomes.
3.Devaluation
Devaluation of the home currency is an alternative to
depreciation. It is a generally adopted method by countries facing a
defici t in the balance of payments. Devaluation is an official
recognition of the fall in the external value of the home currency.
While depreciation is de -facto, devaluation is de -jure. The
International Monetary Fund allows devaluation only when the
country is trapped in a fundamental disequilibrium. The impact of
devaluation will be the same as that of depreciation i.e. the exports
will become cheaper and the imports dearer, thus bringing about a
correction in the balance of payment. However, devaluation as a
measure to correct persistent deficit in the balance of payment will
be successful only under certain conditions. Firstly, the elasticity of
demand for exports and imports should be greater than unity.
Otherwise, devaluation will further worsen the de ficit in the balance
of payments. Secondly, if the country exercising devaluation
exports non -traditional items with a large international demand, it
will gain on account of improved terms of trade. However, if the
export consists of primary goods and th ei m p o r t st h a to f
manufactured goods, then the terms of trade will become
unfavorable, thereby worsening the balance of payment situation.
Thirdly, after devaluation, the country should be able to maintain
domestic price stability. If devaluation leads to domestic price rise,
the purpose of devaluation will be defecated. However, the
domestic cost price structure of a country may change if the
domestic output of import substitutes is not increased resulting into
the price rise. Further, if the reduction of exportable goods is not
increased and if the rise in demand for exports is met by reducing
the supply in the domestic market, prices will rise in the domestic
market and make exports less profitable. Fourthly, if the import
content of the exportable go ods is high and if the country is capital
deficit and certain to import capital goods at a higher price, cost of
production will go up making imports less attractive to foreign
countries. Further, if the price rise in certain category of goods has
chain e ffect leading to a rise in the general price level, organized
labor will demand compensation in the form of dearness allowance
and there will be cost push inflation in the country. However, if
devaluation is combined with deflationary measures in the dome stic
economy, domestic price stability can be maintained with a certain
degree of success. Fifthly, devaluation by a country, facing deficit
in the balance of payments should not be countered by competitive
devaluation by foreign countries or foreign coun tries should not off -
set the impact of devaluation by imposing tariff and non -tariff
barriers. Finally, devaluation will be effective only if export
promotion and import discouraging measures are simultaneously
implemented. However, devaluation has its n egative side. It is amunotes.in

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120sign of the economic weakness of a country and has the potential
to induce price rise in the domestic economy. Further, it leads to a
rise in cot of debt servicing and if the macro -economic
management of the country is not sound and the country may have
to take recourse to devaluation from time to time as in the case of
India.
4.Exchange Control
Exchange control refers to restrictions imposed by the
Central bank of a country on the use of foreign exchange to correct
the disequilibri um in the balance of payments. When an exchange
control is adopted, the Central bank collects all the foreign
exchange earnings and releases foreign exchange only for
unavoidable and essential imports. Exchange control as a
monetary measure is superior t o deflation, depreciation and
devaluation because it directly controls the demand and supply for
foreign exchange. The exporters are required to surrender all their
foreign exchange earnings to the Central bank and the imports
have to obtain permission fo r import of goods. The foreign
exchange resources with the Central bank are distributed amongst
imports according to the quotas fixed. Exchange control is
therefore a very effective method of correcting deficit in the balance
of payment of a country. How ever, exchange control is not a
permanent solution to long run disequilibrium because it only
suppresses demand for imports and does not cure the causes of
deficit.
(B)Non-Monetary Measures of Correcting Disequilib rium in the
Balance of Payments
A judicious mix of monetary and non -monetary measures
needs to be simultaneously implemented in order to correct
disequilibrium in the balance of payments. Both surplus and deficit
in the balance of payments call for correction. In the case of a
persistent surplus, the measures adopted to correct a deficit will
have to be turned on their heads or reversed. For instance, a
country with a favorable balance of payments will face an
appreciation in the external value of its currency. In that case, the
Central bank will have to encourage imports and discourage
exports by pursuing cheap money policy and revaluation of the
currency.
Non-monetary measures help in correcting disequilibrium in
the balance of payments without changing the exchange rates. In
case of a deficit in the balance of payments, the non -monetary
measures aim at promoting exports and discouraging imports. The
following non -monetary measures can be used to correct deficit in
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1211.Export Promotion Measures
Export promotion helps to improve the foreign exchange
reserves of a country and thus corrects the deficit. The government
may implement export promotion measure such as export
subsidies, tax concessions to exporters, marketing facilities, export
incentives, loans to exporters on a priority basis , setting up of
export zones land 100% export oriented units, organization of trade
fairs in foreign countries etc. Exportable surplus should be created
of those goods which have a high demand in the foreign countries
by expanding product ion capacities and by discouraging domestic
consumption of such goods.
2.Import Control Measures
Import duties, import quotas and import substitution are the
three important measures of import control. These measures are
complementary to export promotion measures to correct the deficit
in the balance of payments. Import duty is a fiscal instrument used
to control imports. They result in increase in the price of imported
goods leading to a fall in import demand and reduction in the deficit.
Import quota is a direct method of correcting disequilibrium in the
balance of payments. Import quotas have the immediate impact in
limiting imports as the marginal propensity to import becomes zero
as the quota limit is reached. Import quota is a quantitative
measur e of import restriction and hence they are highly effective
than import duties. The third measure to control imports is through
import substitution. Import substitution requires setting up of
industries which can produce import substitutes inside the cou ntry.
However, import substitution industries needs to be set up with
indigenous capital and technology and the goods so produced must
be comparable in quality.
Conclusion.
Both monetary and non -monetary measures used to correct
disequilibrium in the bal ance of payments are known to be an
adjustment mechanism. Adjustment through changes in exchange
rates relates to exchange rate depreciation and devaluation.
Adjustment through changes in income and price relates to
deflation and adjustment through contr ols relates to exchange
controls and trade controls. Exchange controls refer to rationing of
foreign exchange and trade controls involve export promotion and
import control measures.
The non -monetary measures are considered more effective
in correcting a deficit in the balance of payments. Import duties,
quantitative restrictions in the form of import quotas and import
promotion measures are found to be more effective in correcting a
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1227.6SOURCES OF DATA
1.www.rbi.org.in (RBI bulletins and Reports).
2.Indian Economic Survey various years
http://indiabudget.nic.in
3.http://finmin.nic.in
7.7QUESTIONS
1.Explain the concept and usefulnes so ft h es t u d yo fB a l a n c eo f
Payments.
2.Explain the structure of balance of payments.
3.The balance of payments always balances. Explain.
4.Explain the types of disequilibrium in the balance of payments.
5.Explain the causes of disequilibrium in the balance of pa yments.
6.Explain the monetary measures used to correct disequilibrium in
the balance of payments.
7.Explain the non -monetary measures used to correct
disequilibrium in the balance of payments.
munotes.in

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123Unit -8
EXCHANGE RATE DETERMINATION
PREVIEW
Unit Structure :
8.0 Objectives
8.1 The Foreign Exchange Market
8.2 Exchange Rate Determination
8.3 Merits & Demerits of Flexible Exchange Rate System.
8.4 Fixed Exchange Rate System.
8.5 Merit s & Demerits of Fixed Exchange Rate System.
8.6 Managed Exchange Rate and Exchange Rate Management
8.7 Significance of Foreign Exchange Reserves
8.8 Concept of Foreign Exchange and its Components
8.9 Sources of Data
8.10 Questions
8.0 OBJECTIVES
To understand the concept of Foreign Exchange Market
To study the determination of exchange rate
To study the merits and demerits of Flexible Exchange rate
System
To understand the concept of Fixed Exchange rate system
To study the merits and demerits of Fixed Exchange Rate
system
To understand the concepts of Managed Exchange rate and
Exchange Rate Management
To study the significance of Foreign exchange reserves
To understand the concept of Foreign exchange and its
components
8.1 THE FOREIGN EXCHANGE MARKET
The foreign exchange market is the international market in
which foreign currencies are bought and sold. It is an arrangement
for buying and selling of foreign currencies in which exporters sell
the foreign currencies and importers buy them. Theplayers in themunotes.in

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124foreign exchange market are exports and importers, travelers
land investors, traders, speculators and brokers and
commercial banks and central banks of different countries of
the world. The US Dollar was exchanged for 47.05 Indian rupees
on02ndJune 2006. The rupee –dollar exchange rate was
therefore Rs.47.05 for one US Dollar or One Indian rupee would
fetch 0.02 US Dollars .O n 3 1stMay 2019, the INR -USD exchange
rate was Rs. 69.68 for one USD or one INR would fetch 0.014
USD. The Rupee –Pound Sterling exchange rate on 02ndJune
2006 was Rs.87.90 which means the Pound Sterling –Rupee
exchange rate would be UK Pound Sterling 0.01 for one Indian
rupee. On 31stMay 2019, the Rupee -Pound Sterling exchange rate
was Rs. 87.66 which means th at the Indian Rupee had marginally
appreciated against the UK Pound Sterling. In the foreign
exchange market, there are two different rates for buying and
selling of foreign currencies. These differences arise due to
transaction cost in dealing with forei gn currencies.
Broadly there are two systems of exchange rate
determination. They are known as fixed and flexible or floating
exchange rate systems. Under the fixed exchange rate system,
the foreign exchange rate is fixed by the government. The fixed
exchange rate was established in the year 1944 under an
agreement reached at Bretton Woods in New Hampshire, USA.
Under this system, at the fixed exchange rate if there is
disequilibrium in the balance of payments giving rise to either
excess demand or sup ply of foreign exchange, the Central Bank of
the country has to buy and sell the required quantities of foreign
exchange to eliminate the excess demand or supply. The system
of exchange rate in which the exchange value of a currency is
determined by the m arket forces of demand and supply of
foreign exchange is known as flexible or floating exchange
rate system. The flexible exchange rate system came into
existence after the fall of the fixed exchange rate system in 1977 .
The changes in the exchange value of a currency in the foreign
exchange market are known by the terms appreciation and
depreciation. For instance, if the rupee –dollar exchange rates
become Rs.48.05 in a few days hence, the rupee would be said to
have depreciated against the dollar. Co nversely, if the rupee –
dollar exchange rates become Rs.46.05 then the rupee would be
said to have appreciated against the dollar. The changes in the
exchange rate are determined by the market forces in a flexible
exchange rate system. In the case of fi xed exchange rate system,
the central bank has to buy or sell foreign exchange so that the
exchange rate is maintained at the pegged or fixed level.
However, the fixed exchange rate could be changed through
devaluation or revaluation only with permission from the IMF
in case of fundamental disequilibrium in the balance of
payments. Thus, if a country was running large and persistentmunotes.in

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125deficit in her balance of payments, it was allowed to devalue its
currency in order to improve the balance of payment positi on.
Conversely, if a country was running large and persistent
surpluses in the balance of payments, it was allowed to
revalue its currency so that correction is made. The IMF
maintains funds which are contributed by member countries and
gives loans to me mber countries from its reserves when they face
temporary deficit in the balance of payments. If a member country
has a persistent deficit in the balance of payment, the IMF would
permit such a country to devalue its currency in order to correct the
defic it so that a relatively stable or fixed exchange rate system was
maintained for the promotion of world trade. In order to maintain
the exchange rate at a given level, the central banks of
different countries were required to maintain reserves of
foreign c urrencies. The international reserve currencies are the
US dollar, UK Pound Sterling, German Deutsche marks and the
Japanese Yen.
8.2FREE MARKET EXCHANGE RATE
DETERMINATION
The free market exchange rate of a currency is determined
by the market forces of demand for and supply of foreign exchange.
If there are two countries, India and the USA, the exchange rate of
their currencies (rupee and dollar) will be determined by American
demand for Indian exports and Indian demand for American
exports. Indian demand for American exports means Indian
demand for US dollars. Similarly, American demand for Indian
exports means American demand for Indian rupees.
Demand fo r Foreign Exchange (US Dollars) : The demand for
US dollars in India is a function of the dem and for US goods and
services by Indian firms and individuals. There is a direct
relationship between demand for US exports from India and the
demand for US dollars. The demand for dollars may also arise
due to Indian citizens and firms wanting to purch ase assets in the
United States give loans or send gifts to friends in the United
States. The demand for dollars can be realized by exchanging
rupees for dollars with the central bank. The demand curve for US
dollars will be downward sloping as the deman df o rU Sd o l l a r sw i l l
be inversely proportionate to the rupee dollar exchange rate.
Higher the exchange rate, lower will be demand for US dollars and
vice versa. The demand for US dollars is shown by the demand
curve DD in Fig.16 .1 below.
Supply of Fore ign Exchange (US Dollars) :The supply of US
dollars results from the demand for Indian exports from USA. The
supply of US dollars will be directly proportional to the supply ofmunotes.in

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126exports from India to the United States. The supply of US dollars
may also a rise from the demand for US citizens and firms to
purchase assets in India or to give loans and gifts to people in
India. The supply of US dollar is derived from the demand for
Indian rupees or the demand for Indian exports. The supply curve
of dollars i n terms of rupees is posi tively sloping as shown in
Fig.16 .1 below. Higher the rupee dollar exchange rate, higher will
be the supply of US dollars and vice versa.
The Equilibrium Exchange Rate (Re/$) :The equilibrium
exchange rate will be determined by the intersection of demand for
and supply curve of dollars. Su ch an equilibrium point in Fig. 8.1 is
point ‘E’ and the equilibrium exchange rate is OR with OQ quantity
of demand and supply of US dollars. At a higher price of dollars i.e.
OR 1the quantity supplied of dollars is greater than the quantity
demanded by ‘ab’. Excess supply of dollars will push the prices
down back to the equilibrium level. Similarly, if the exchange rate is
OR 2, there will be excess demand for US dollars and demand for
dollar s will exceed its supply by ‘cd’ causing the exchange rate to
go up and stabilize at the equilibrium exchange rate OR.
Fig.8.1: Equilibrium Exchange Rate
Appreciation and Depreciation in the Exchange Rate :The
changes in t he exchange rate are caused by changes in the factors
that determine the demand for and supply of foreign exchange. For
example, an increase in US national income will cause an increase
in the demand for Indian exports which will lead to an increase in
the supply of dollars in the foreign exchange market. The supply
curve will shift thus to the right as S 1S1as shown in Fig. 8.2 below.
The increase in the supply of dollars because of an increase in the
demand for Indian exports will lower the exchange r ate of dollars in
terms of rupees from OR to OR 1. Thus, the dollar will depreciate
and to that extent the rupee will appreciate. The new equilibriummunotes.in

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127exchange rate will be determined by point E 1. The depreciation of
dollar by RR 1is caused by the excess s upply of dollars equal to EF.
Fig.8.2: Appreciation of Exchange Rate
Further, an increase in the national income of India may
cause an increase in the demand for US exports to India. Such an
increase will lead to increase in demand for dollars. Th e increase
in demand for dollars is shown by a rightward sh ift of the demand
curve in Fig. 8.3. Because excess demand for dollars over supply
at the equilibrium exchange rate OR, the dollar price rises or
appreciates and the new equilibrium exchange rate OR 1is
determined.
Fig.8.3: Depreciation of Exchange Ratemunotes.in

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1288.3MERITS OF FLEXIBLE OR F REE MARKET
EXCHANGE RATE SYSTEM
1.Absence of Under and Over -valuation. Fixed exchange rate
system has the drawback of under and over valuation which is
not the case under flexible exchange rate system. Whenever
there is a deficit in the balance of payment under flexible
exchange rate system, the currency will depreciate. As a result,
exports will increase and imports will decrease and the deficit
will be corrected automatically.
2.Expansion of Multilateral Trade. Flexible exchange rates help
in the expansion of multilateral trade because it maintains the
exchange rates at their market determined levels through
continuous market adjustments.
3.Exchange Rate Fluctuatio ns Takes Place in a Narrow Band.
Changes in exchange rate occur only when economic
conditions underlying demand for and supply of foreign
currencies change. Random fluctuations around the normal
exchange rates would be smoothened out through operations
by private speculators. According to Bo Soderston, “if the
currency appreciated above its equilibrium value, if its price fell
in terms of foreign currency, speculators would buy the currency
and it depreciated, speculators would sell the currency.
There by they would smooth out fluctuations land help to keep
the exchange rate stable, if the underlying conditions changed,
however the price of foreign exchange would also change.”
4.It is Consistent with the Policy of Laissez -faire. Flexible
exchange rate s ystem is a market determined system and
therefore based on Adam Smith’s philosophy of laissez -faire.
Under the fixed exchange rate system, the rates are fixed out of
consideration of non -economic objectives such as retention of
market structure or influen cing income distribution.
5.Automatic Adjustments in Balance of Payments. Flexible
exchange rates automatically restore balance of payment
equilibrium by appreciation and depreciation of currencies. The
Government is therefore free from the problems of ad justment.
Demerits of flexible or free market exchange rates
1.Problems of Instability and Uncertainty. Flexible exchange
rates create the problem of uncertainty and instability in foreign
exchange transactions. Instability hampers foreign trade and
capital movements between the countries.
2.Adverse Impact on Foreign Trade. Due to uncertainty,
decisions regarding exports and imports cannot be takenmunotes.in

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129properly and hence it affects the volume and growth of foreign
trade.
3.Encourages Speculative Activity. Speculative activity has a
destabilizing effect on exchange rates and large scale
speculative activity may divert resources from the real sector to
the monetary sector of the economy.
4.Inflationary Impact on a Deficit Country. Deficit in the
balance of pa yments of a country would bring about a
depreciation of the currency. As a result import prices will rise
and prices of industrial products would also rise. Deficit
countries may have to face the problem of cost -push inflation.
8.4FIXED EXCHANGE RATE SYSTEM
The exchange rate which is fixed by the government is
known as fixed exchange rate system. This system came into
existence in July 1944 under an agreement arrived at a small town
in New Hampshire called Bretton Woods. The economists who
designe d the fixed exchange rate system were Harry White from
the United States and JM Keynes from the United Kingdom. This
system is also known as the dollar standard because all other
countries agreed to fix their exchange rates against the dollar.
According to the agreement, the International Monetary Fund was
established to administer the fixed exchange rate system. The
United States was required to fix a par value for dollars in terms of
gold. As the US dollar was linked with gold other national
currencies with fixed exchange rate were fixed or pegged with a
certain gold value. The US government was committed to maintain
the convertibility between gold and dollars at fixed rates and other
countries agreed to maintain the convertibility of their currencies
with the US dollar. The United States fixed the convertible rate at $
35 per ounce of gold. The fixed exchange rate could be changed
through devaluation or revaluation only with permission from the
IMF in case of fundamental disequilibrium in the balance of
payments. Thus if a country was running large and continuous
deficit, it was allowed to devalue its currency in order to improve the
balance of payment position. The IMF maintains funds which were
contributed by member countries and gives loans to me mber
countries from its reserves when they face temporary deficit in the
balance of payments. If a member country has a persistent deficit
in the balance of payment, the IMF would permit such a country to
devalue its currency in order to correct the defic it so that a relatively
stable or fixed exchange rate system was maintained for the
promotion of world trade. For instance, the Government of India
devalued the Indian rupee by 36.5 per cent in 1966 and by 20 per
cent in 1991. In both these years, India faced serious balance ofmunotes.in

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130payment problems. In order to maintain the exchange rate at a
given level, the Central Banks of different countries were required
to maintain reserves of foreign currencies. The international
reserve currencies are the US dollar, UK pound sterling, German
Deutsche marks and the Japanese Yen.
Fixed exchange rate systems are maintained with the help of
the central banks i.e. the central bank of a country has to buy and
sell foreign exchange so that the fixed rate of exchange is
maintained and fluctuations caused by market conditions are
neutralized. The role of the central bank in maintaining f ixed
exchanges is shown in Fig.16 .4 below. Let us assume that the
government of India is committed to maintain the exchange rate of
its cur rency at OR. Now suppose the American demand for Indian
goods declines sharply. Such a decline in demand will reduce the
supply of US dollars and the supply curve will shift towards the left
and the new supply curve will be S 1S1. The demand curve DD for
dollars remaining constant at the fixed exchange rate OR, the
quantity supplied of dollars falls to RM and ME is therefore the
excess demand for dollars. If the central bank does not intervene
the equilibrium exchange rate will be determined at OR 1.T h e US
dollar will appreciate in terms of rupees and in order prevent the
dollar from appreciating or the rupee from depreciating from the
original exchange rate OR, the Reserve bank will have to sell
dollars from its reserves by the amount ME and restore the demand
supply equilibrium.
Fig.8.4: Central Bank’s Intervention to maintain Fixed
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1318.5MERITS OF THE FIXED EXCHANGE RATE
SYSTEM
1.Exchange Rate Stability. Short term fluctuations in the
demand for and supply of foreign exchange can be effectively
managed with the intervention of the central banks in countries
having fixed exchange rate system and thus imparting stability
in the exchange rate. Stability in the exchange rate is essential
for sustained and orderly development of intern ational trade and
the international economy. It eliminates the element of
speculation and uncertainty and thus promotes economic
growth and world trade.
2.Encourages Capital Movement and Prevents Capital Flight.
On account of the absence of uncertainty i n the exchange rate,
the risks involved in foreign investment both portfolio and direct
are eliminated. Thus fixed exchange rates helps in promoting
foreign investment and reallocation of investible surpluses in
their best possible use across the countrie sb r i n g i n ga b o u t
maximum economic growth. It also protects the exchange rate
from speculative attacks and prevents flight of foreign capital.
The Mexican crisis of 1994 and the East -Asian crisis of 1997 -98
are examples of currency crises compounded by ca pital flight.
3.Prevents Speculation in the Foreign Exchange Market.
Under a flexible exchange rate system, the speculators in the
foreign exchange market may take advantage of the fluctuations
in the exchange rate. Real flows will be replaced by monetar y
flows i.e. buying and selling of foreign exchange. Speculative
buying and selling becomes destabilis9ng particularly when the
foreign exchange rates are manipulated to make unfair
speculative gains. Manipulative speculative gains not only
hinders inter national trade in goods and services but also
hampers the economic interests of the countries whose
currencies are brought under speculative attack. Fixed
exchange rate eliminates the possibility of speculation and
brings about stability in the exchange r ate.
4.It is Anti -inflationary in Effect. Fixed exchange rates are
consistent with domestic price stability. Governments therefore
cannot pursue expansionary monetary and fiscal policies
without a tab on inflation. Thus reckless monetary expansion
and un productive public expenditure will be under control to
impart price stability. A rise in domestic prices will reduce the
demand for exports and increase the demand for imports
causing a deficit in the balance of payments. This will
necessitate running dow n the foreign exchange reserves to
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132persists, the country will have to resort to devaluation. Hence
domestic price stability becomes essential under a fixed
exchange rate regime.
5.Encourages Globali zation or Integration of the World
Economy. Fixed exchange rates encourage prudential macro -
economic management so that price differential amongst the
countries remain constant or gets reduced overtime to bring
about purchasing power parity amongst the co untries of the
world. Fixed exchange rate is therefore similar to a single world
currency which promotes across the border mobility of capital,
goods and services and helps in integrating the world economy.
6.Encourages the Growth of Domestic Capital and M oney
Markets. Due to fixed exchange rates, there will be price
stability and interest rate stability. Interest rate stability will
promote the growth of both money and capital markets. In case
of flexible exchange rates, there may be interest rate
differentials between the countries on account of changes in the
exchange rate. Thus if the domestic interest rates are high,
entrepreneurs may borrow from countries where interest rates
are low. As a result, the domestic money and capital markets
will not g row in a steady manner.
DEMERIT SO FF I X E DE X C H A N G ER A T ES Y S T E M
1.Macro -economic Objectives of Full Employment and Price
Stability are bartered for maintaining Fixed Exchange
Rates. When a country has a surplus in the balance of
payment, it can make adjus tment by increasing the prices.
Such an action imposes heavy social costs on the country in
terms of sacrificing the objectives of price stability and full
employment.
2.Maintenance of Large Foreign Exchange Reserves.
Countries with balance of payment def icits need to maintain
large foreign exchange reserves to avoid devaluation.
Maintenance of large reserves of foreign exchange imposes a
burden on the monetary authorities both in terms of
management of the reserves and the cost of managing the
reserves.
3.Mal-allocation of Resources. Fixed exchange rate system
requires exchange control system which is generally
complicated. Exchange controls lead to mal -allocation of scarce
resources.
4.Comparative Advantage is not clear. The comparative
advantage of a country is not very clear. For example, themunotes.in

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133exchange rate may be so low that a product may seem to be
cheap to the other country. The country may therefore export
that commodity in which it has no comparative advantage.
5.The Exchange Rate Cannot Remain Fi xed for a Long Time.
Fixed exchange rate cannot remain fixed for a long time.
Balance of payment problems and fluctuations in international
commodity prices may compel countries to bring changes in
exchange rates.
6.Balance of Payment Disequilibria Contin ues. The fixed
exchange rate system fails to solve the problem of balance of
payment disequilibria. It can be tackled only temporarily. In the
long run, permanent solution lies in monetary, fiscal and real
measures.
7.Dependence on International Financia lI n s t i t u t i o n s . Under
the fixed exchange rate system, a country has to depend upon
international financial institutions for borrowing and lending of
foreign currencies.
8.Problems of International Liquidity. In order to expand trade,
a country must have adequate international liquidity. In order to
maintain fixed exchange rates, a country must have large
reserves of foreign currencies to avoid balance of payment
disequilibrium. Further, excessive international liquidity may
lead to excess demand and cre ate the problem of international
inflation.
8.6MANAGED EXCHANGE RAT ES AND EXCHANGE
RATE MANAGEMENT
A floating exchange rate or a flexible exchange rate is a type
of exchange rate regime wherein a currency’s value is allowed to
fluctuate according to th e foreign exchange market. A currency that
uses a floating exchange rate is known as a floating currency. The
opposite of a floating exchange rate is a fixed exchange rate. There
are economists who think that, in most circumstances, floating
exchange rates are preferable to fixed exchange rates. As floating
exchange rates automatically adjust, they enable a country to:
dampen the impact of shocks, and foreign business cycles, and to
preempt the possibility of having a balance of payments crisis. In
cases of extreme appreciation or depreciation, a central bank will
normally intervene to stabilize the currency. Thus, the exchange
rate system of floating currencies is known as managed float .A
central bank might, for instance, allow a currency price to float
freely between an upper and lower bound, a price "ceiling" and
"floor". Management by the central bank may take the form ofmunotes.in

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134buying or selling large lots in order to provide price support or
resistance.
India followed a fixed exchange rate system until the
adoption of new economic policy in 1991. However, after the
adoption of floating exchange rate policy in 1991, the exchange
rate of rupee versus the dollar became volatile. The foreign
exchange rate of Indian rupee began to fluctuate greatly with
changing market conditions. In order to prevent both depreciation
and appreciation on a large scale, the Reserve Bank of India has to
take appropriate monetary measures to maintain stability in the
foreign exchange rate of rupee. The exchange rate of Indian rupe e
is freely determined by the market forces of demand for and supply
of US dollars. The disequilibrium in the foreign exchange market
causes changes in the exchange rate. For example, in August
2000, the rupee depreciated against the US dollar because of
higher demand for US dollars. Higher demand for US dollars was
caused by factors such as higher import demand by Indian
corporates, capital outflow to the US by FIIs on account of rising
interest rates in the US and increase in demand for US dollars by
Indian banks . Since export income and capital inflows were not
good enough to match rising demand for dollars, the rupee
depreciated against the US dollar. In order to stop the downfall of
the rupee, the Reserve Bank of India raised the bank rate from 7
per cent to 8 per cent thereby forcing the commercial banks to
increase their lending rates. The Cash Reserve Ratio was raised
from 7 to 7.5 per cent so that liquidity in the banking system was
reduced. The Reserve Bank was able to increase the cost of c redit
and reduce the availability of credit simultaneously so that domestic
demand for US dollars is reduced. The higher interest rates in
India would also discourage FIIs and Indian corporates to invest
abroad. This will help to reduce the demand for do llars and prevent
the fall of the Indian rupee. The Reserve Bank of India can also
take recourse to releasing foreign exchange reserves to prevent the
depreciation of the rupee. The release of more dollars by RBI will
increase the supply of US dollars in the foreign exchange market
and will correct the disequilibrium thereby stabilizing the exchange
rate of rupee.
However, if the rupee appreciates, it will raise the prices of
Indian exports and make them uncompetitive. As a result exports
will be discou raged. This was the situation in 2003 -04 when due to
the huge inflow of foreign exchange into India, supply of US dollars
increased tremendously. As a result, the value of US dollars fell
and the Indian rupee appreciated. The exchange rate of US $
which had gone down to about Rs.48 rose to Rs.43.50 in early
2004. In order to prevent the appreciation of the Indian rupee, the
RBI intervened and started buying US dollars from the market. As
a result, demand for US $ in the market increased bringing aboutmunotes.in

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135rise in the value of US dollar in terms of rupees. Thus with the
intervention of the RBI the value of the Rupee was stabilized.
8.7SIGNIFICAN CE OF FOREIGN EXCHANGE
RESERVES
The foreign exchange reserves of a country consist of
foreign currency assets, gold holdings and special drawing rights
held by the Central Bank. The net result of the external
transactions of a country is indicated by changes in the foreign
currency reserves and special drawing rights (SDR). The SDR is
an international reserve as set created by the IMF to supplement the
reserve assets of member nations. It was introduced in the year
1969. It is pegged to the value of a standard basket of four
currencies of the leading members of the IMF. Most countries of
the world have adopted managed flexible exchange rate system. In
this system, exchange rate is targeted by the Central Bank and in
order to maintain the targeted exchange rate, Central Bank needs
to intervene in the foreign exchange market by buying and selling
the foreign curre ncy assets.
Maintaining foreign exchange reserve is important because it
imparts stability to monetary and exchange rate policies. If the
exchange rate is volatile and fluctuates widely, it will impart very
little confidence in the domestic currency of a country. Further, the
Central bank will have to adjust its monetary policy on a regular
basis to bring about stability in the exchange rate. Unstable
exchange rates therefore leads to unstable monetary policy and
traders would lose confidence in the e conomy of a country.
Adequate foreign exchange reserves facilitate the Central Bank to
intervene in the foreign exchange market when the currency
appreciates or depreciates in an unusual manner.
The amount of foreign exchange reserves that should be
held by a country depends upon the geographical size and national
income of a country. Other important factors are current account
deficit, capital account vulnerability, vulnerability of exchange rate
flexibility and opportunity cost. The reserves held by a country
should be sufficient to pay for about six months imports. Robert
Triffin studied twelve leading countries during the period 1950 to
1957 and concluded that a country must hold at least 35 per cent of
foreign exchange reserve as a ratio of annual i mport. India today
has a foreign exchange import cover of more than 12 months.
Countries may go through short term business cycles and there
may be a surge in imports during the upswing. Similarly, imports
may suddenly decline during the down swing. In b oth the cases,
the international value of the domestic currency will change. The
Central Bank would need foreign exchange reserves to stabilize the
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136In India, the report of the Committee on Capital Account
Convertibility (CAC) constituted by the Reserve Bank of India under
the chairmanship of Mr. SS Tarapore laid down four conditions to
determine the adequacy of foreign exchange reserves. The first
condition is to have sufficient foreign exchange reserves to pay for
six months of import. Th e second condition is that the country must
have reserves to pay for three months import and fifty per cent of
annual debt service payments. The third condition is that the short
term debt and portfolio stock should not be more than sixty per cent
of the level of reserves and the fourth condition is that the net
foreign exchange assets to currency in circulation to be maintained
at seventy per cent with a minimum of forty per cent.
8.8CONCEPT OF FOREIGN EXCHA NGE RESERVES
AND ITS COMPONENTS
The foreign exchange reserve of a country consists of
foreign currency assets held by the Central Bank, Gold holdings by
the Central Bank and Special Drawing Rights (SDRs). For instance,
India’s foreign exchange reserve also consists of gold, SDRs and
foreign currency assets. Gold is not used for current transactions.
It does not say anything about the balance of payment situation of
the country. The net result of the external transactions of a country
is indicated by changes in the foreign currency reserves and
special drawing rights.
GOLD
As on 20thApril 2018, the value of gold was USD 21,484
million. On 19thApril, 2019, the value of gold went up to USD
23,303 million. In percentage terms, gold reserves went up by
8.47% during the year.
SPECIAL DRAWING RIGHTS
In the 1960s, the need to increase international monetary
reserves was felt by the advanced capitalist countries. In 1968, the
leading nations agreed to give the IMF the power to create SDRs or
new international reserves or paper gold. In 1969, the SDR was
created by the IMF to supplement the reserve assets of member
nations. Between 1970 and March 2016, the IMF has created
204.1 billion SDRs which are equal to USD 285 billion. These
SDRs have been allocated to member countries. SDRs can be
exchanged for freely usable currencies. The value of the SDR s
based on la basket of five major currencies: the US Dollar, Euro,
the Chinese Renminbi (RMB), the Japanese Yen and UK Pound
Sterling as of 01stOctober 2016. Unlike regular IMF loans, the
SDRs drawn by member nation need not be paid back to the Fund.
The basket of currencies is reviewed every five years to ensure that
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137international transactions and that the weights given to the
currencies r eflect their relative importance in the world’s trading and
financial systems. The allocation of SDRs to member countries is
done in proportion to their quotas in the IMF and the quota of each
member nation is determined by its share of national income in the
world. Every member of the IMF is required to subscribe to the
fund an amount equivalent to its quota. Each member is assigned
a quota in terms of SDRs. Quotas are used to determine the voting
power of members, their contribution to the Fund’s reso urces and
their share in the allocation of SDRs. A member’s quota reflects its
economic size in relation to the total membership of the Fund.
Each member pays a subscription to the IMF equal to its quota and
the IMF decides on the amount of SDRs to be pa id. A member
nation is required to pay about 25 per cent of its quota in SDRs or
in currencies of other members selected by the IMF and the
remaining contribution can be paid in the home currency of the
member. The IMF holds huge resources in members’ cu rrencies
and SDRs which are available to meet member countries’
temporary balance of payments requirements. The SDR holding of
India as on 20thApril 2018 was 1538 million USD. As on 19thApril
2019, SDR holdings went down to USD 1456 million.
Table 16 .1–Foreign Exchange Reserves of India (in USD
millions)
S.No. ItemAs on
20 Apr
2018As on
19 Apr
2019
1. Foreign Currency Assets 398,486 386,034
2. Gold 21,484 23,303
3. Special Drawing Rights (in
millions)1059 1,049
Special Drawing Rights (in
USD Millions)1538 1,456
4. Reserve Tranche Position
in IMF2075 3,355
Total 423,583 414,147
Source: table 32, RBI Bulletin –May 2019
FOREIGN CURRENCY ASSETS.
In 1990 -91, the foreign currency reserves were at the
decadal low of USD 2.236 billion. By 19 93-94, the foreign currency
assets reached ten times the figure of 1990 -91. The rise was due
to drawings from the IMF. Net foreign investment in India thereafter
contributed to the increasing trend in foreign currency assets. On
20thApril 2018, the for eign currency assets were USD 398,486
millions. The same declined to USD 386,034 millions on 19thApril
2019. India has come a long way from the foreign currency crisis of
1991 i.e. from a mere 2.23 billion reserves to 386 billion USD.munotes.in

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138RESERVE TRANCHE PO SITION IN IM F
The reserve tranche is an emergency account that IMF
members can access without agreeing to conditions or paying a
service fee. It is a fraction of the required quota of currency that
each member country of the IMF must provide to the IMF. T he
member country can utilize the reserve tranche for her purpose.
The reserve tranche fraction of the quota can be accessed by the
member nation at any time. A member country can borrow more
than her quota but must pay back principal with interest over a
three -year period. If the amount being sought by the member nation
exceeds its reserve tranche position, it becomes a credit tranche. In
the beginning, a member nation’s reserve tranche is 25% of her
quota, but her reserve tranche position will change acco rding to any
lending that the IMF does with its holdings of the member’s
currency.
The RTP position of India as on 20thApril 2018 was USD
2075 million whereas on 19thApril 2019, the RTP position improved
to USD 3355 million.
8.9 SOURCES OF DATA
1.www.rbi.org.in (RBI bulletins and Reports).
2.Indian Economic Survey various years
http://indiabudget.nic.in
3.http://finmin.nic.in
8.10QUESTIONS
1.Explain the meaning of Foreign Exchange Market.
2.Explain how free market Exchange Rate is determined?
3.Explain the Merits & Demerits of Flexible Exchange Rate
System.
4.Explain market intervention by the Central Bank under Fixed
Exchange Rate System.
5.Explain the Merits & Demerits of Fixed Exchange Rate System.
6.Explain the concept of Managed Exchange Rate.
7.Explain the significance of Foreign Exchange Reserves
8.Explain the concept of Foreign Exchange reserves and its
components.
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99
Modified Pattern of Question Paper for Semester End
Assessment implemented from 2020 -2021 For
Economics courses at F.Y.B.A.
Duration 3 hours Total Marks = 100 (per semester)
All 5 questions carry 20 marks and are compulsory.
There will be internal choice in each Question.
Q1.Attempt any two questions (Module 1) 20marks
A.
B.
C.
Q2.Attempt any two questions (Module 2) 20marks
A.
B.
C.
Q3.Attempt any two questions (Module 3) 20marks
A.
B.
C.
Q4.Attempt any two questions (Module 4) 20marks
A.
B.
C.
Q5.Attempt any two questions (Module 1,2,3,4. One question from
each module) 20 marks
A.
B.
C.
D.
munotes.in