Graduate School of Management

Lodhi Road, New Delhi-110003

PGDBM Batch: 2006-2008

Bridge Course in Economics

Professor Tarun Das

Textbooks:
Christopher R Thomas and S Charles Maurice- Managerial Economics, Tata McGraw
Hill Publishing Company Ltd., New Delhi, 2005.
Edward Shapiro- Macroeconomic Analysis, Galgotia Publications, New Delhi,
Economic Survey 2005-06, Ministry of Finance, Government of India, February 2006.

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 1. An Introduction to Microeconomics

Economics
Economics is a social science that studies allocation of limited resources for production of
goods and services to satisfy consumers’ unlimited wants and needs.

Macroeconomics and Microeconomics

Macroeconomics is the study of relations between broad economic aggregates at the national
level. It deals with theories of aggregate income, employment, consumption, savings,
investment, money and external trade. In contract, microeconomics is concerned with
theories on utility, output and prices of individual households, firms and market structures.

Utility
The intrinsic satisfaction of wants and needs obtained from the use or consumption of goods
and services.

Laws of diminishing marginal utility:

The law states that as a consumer consumes more and more of a good, its marginal utility
(i.e. additional utility per unit of consumption) declines.

Wealth
The net ownership of material possessions and productive resources. It is a stock concept and
equals the difference between physical and financial assets and liabilities.

Factors of production
Four basic factors of production include land, labor, capital and entrepreneurship. Income is
the sum total of factor incomes viz. rent, wages, interest and profits.

Demand
The willingness and ability to buy a range of quantities of goods and services at a range of
prices during a given period of tome, to satisfy their desires, wants and needs.

Supply
The willingness and ability to sell a range of quantities of goods and services at a range of
prices during a given period of tome to satisfy other’s demands and needs.

Price elasticity of demand

Price elasticity of demand (Ep) measures the proportionate change in demand due to a
proportionate change in prices, and income elasticity of demand (Ey) measures the
proportionate change in demand due to a proportionate change in income.

Ep = -d(logD) / d(logP) = - (dD/dP)/ (D/P)

Ey = -d(logD) / d(logY) = - (dD/dP)/ (D/Y)

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Different situations of price and income elasticities are indicated in the following table;
Type of good Income elasticity Type of good Price elasticity
Necessity 0 < Ey < 1 Inelastic 0 < Ep <1
Luxury Ey > 1 Elastic Ep > 1
Giffen good Ey < 0 Inferior Ep < 0
Unit elastic Ey = 1 Unit elastic Ep = 1
Perfectly inelastic Ey = 0 Perfectly inelastic Ep = 0
Perfectly elastic Ey = Infinity Perfectly elastic Ep = Infinity

Total Revenue
Total revenue (TR) is the sum total of revenue receipts from the sale of all units. Change of
total revenue due to change of output is called marginal revenue (MR) and the revenue per
unit of output sold is called the average revenue (AR).

TR = ∑ Ri where Ri = receipt from the sale of ith unit.

AR = TR / Q
TR = AR. Q
MR = d (TR) / d (Q) = d (AR . Q) / d (Q) = AR + Q . d (AR) / d (Q)
This implies that (i) If average revenue rises, marginal revenue is greater than average
revenue; (ii) If average revenue falls, marginal revenue is less than average revenue, and (iii)
If average revenue remains unchanged, marginal revenue equals average revenue.

The change of total revenue due to change of price is given by:

d (TR) / dP = Q + P. dQ/dP = Q (1 – Ep)

This implies that (i) if price elasticity of demand equals unity, total revenue remains invariant
with respect to change of price. (ii) If price elasticity of demand exceeds unity, total revenue
varies inversely with respect to change of price, and (iii) if price elasticity of demand is less
than unity; total revenue varies directly with price.

Market Structure
The following table summarizes the basic characteristics of major market types regarding
structures, strategy/ conduct, performance and equilibrium conditions.

Market type Market Structure/ Conditions on Conduct/ Strategy regarding

No. of Entry Product Price Product R&D and
firms strategy strategy advertising
(1) (2) (3) (4) (5) (6) (7)
Perfect Very large Free Standardized None Independent None
competition
Monopoly One Blocked Differentiated Independent Independent Light
Oligopoly Few Impeded Both Independent Independent Heavy
Monopolistic Large Easy Differentiated Independent Independent Heavy
competition Number

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 Table continued:

Market type Performance Equilibrium conditions

Profit Technical Progressive- Equity and
efficiency ness employment
(1) (8) (9) (10) (11) (12)
Perfect Normal Good Good Good MC=MR=P=AR
competition
Monopoly Excessive Poor Poor Poor MC=MR=P (1-1/Ep)
Oligopoly Excessive Poor Poor Poor MC=MR for all
Monopolistic Fair Good Fair Fair MC=MR=P (1-1/Ep)
competition

Enterprise Organizations:
Privatization: Transfer of ownership or management or both of an undertaking from the
public sector to private enterprise.

Management Leasing: Management contracting of an undertaking for a fixed period for a

specific fee to a non-owning entity.

Corporatisation: Conversion of departmental enterprises (like the Indian Railways) or

organizations constituted by charters (such as Air India) to the corporate form of
organization.

Marketisation or Commercialisation: Freezing the pubic sector enterprises from

administered prices for inputs and outputs and exposing these in the free market
forces.

BOT (Build Operate Transfer): A technique of privatization of specific projects especially

in infrastructure sectors for cost and risk sharing by the public and private sectors. This is a
method to distance operating facility from project designing and construction and to have
public-private partnership. Other forms include BOO (Build Operate Own), BOOT (Build
Operate Own Transfer) etc.

Golden Share: A share or a number of shares retained by the government in the privatisation
process to exercise control over or the voting rights in the subject enterprise.
Divesture/ Disinvestment: Sale of equity capital held by the government in a public sector
enterprise to private investors, banks, mutual funds or other financial institutions.
Globalisation: Worldwide intensive exchange of people, knowledge, technology, capital,
goods and services. Globalisation helps in integration of the world, and allows new ideas and
technological innovation to spread around the globe. Globalisation is much wider than an
economic process and involves all human relationships and civilizations.

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2. National Income and Accounting

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National Income Accounting (NIA) comprises of a set of rules and definitions for
measuring economic activity in the aggregate economy – that is, in the economy as a
whole. NIA is a way of measuring total or aggregate production.

Measuring Total Economic Output of Goods and Services:

Gross Domestic Product (GDP)
(GDP) is the total value of all final goods and services produced in
an economy (within geo-political boundary) in a one-year period. period. Gross National
Product (GNP)
(GNP) is the aggregate final output of citizens and businesses of an economy in
one year. India’s Gross National Product (GNP) refers to output produced by India or
Indian citizen/ businesses - owned factors regardless of location. GDP is geographically
focused - India’s GDP refers to output produced within India’s borders. Net foreign
factor income is added to GDP to calculate GNP. Net foreign factor income is the
income of domestic (Indian) factors of production earned abroad minus earnings of
foreign factors domestically (within India).

Calculating GDP:
GDP: Calculating GDP requires adding together million of goods and services.
All goods and services produced by an economy must be weighted by its price so that
we have value measure of output of each goods and services. Quantities produced can
not be added but value measures can be.

GDP is a flow concept distinguished from stock- A flow is a quantity measured over a
period such as income, savings, investment; while a stock is measured at a point of
time e.g. wealth, bank balance, debt, etc. The framework of NIA is a system of flows.
GDP is a flow concept. It is reported quarterly.

Wages, rents, interest, profits

Factor services

Goods

Households
Government Firms
(Consumption) Taxes Government
Government Spending (Production)
Savings
Financial
Financial markets
markets Investment

Personal consumption
Imports
Exports
Other
Other countries
countries

Figure-1: The Circular Flow

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GDP Measures Final GDP Measures Final Output: Final output – goods and services
purchased for final use. GDP does not measure total transactions in the economy. It
counts final output but not intermediate goods i.e. not goods and services those are
used as input for producing other (or value added) goods and services. Counting the
sale of both final goods and intermediate products would result in double and multiple
counting.

Two Ways of Eliminating Intermediate Goods: The first is to calculate only final output.
A second way is to follow the value added approach. Value added is the increase in
value that a firm contributes to a product or service.

Calculating GDP – Inclusions & Exclusions: Some Examples – In calculating GDP, we do

not include transactions like selling a stock or a bond, selling second hand goods, etc.
and transfers like social security payments, welfare payments, and veterans' benefits,
etc. These transfers or transactions do not lead to output or value addition. The services
of transaction facilitator (e.g. broker, bank, etc.) paid for would be included in GDP.
The work of unpaid house-spouses does not appear in GDP calculations – because not
paid for/ seen as service to the self.

Two Methods of Calculating GDP: There are two methods of calculating GDP: the
expenditure approach and the income approach. This is because of the national income
accounting identity.

The National Income Accounting Identity: The equality of output and income is an
accounting identity in the national income accounts. The identity can be seen in the
circular flow of income in an economy.

The Expenditure Approach

The expenditure approach is shown on the bottom half of the circular flow. Specifically,
GDP is equal to the sum of the four categories of expenditures.
GDP = C + I + G + (X - M)
Consumption (C): When individuals receive income, they can spend it on domestic goods,
save it, pay taxes, or buy foreign goods. Consumption is the largest and most important
of the flows. Personal consumption expenditures are the payments by households for
domestic goods and services.
Investment: The portion of their income that individuals save leaves the income stream and
goes into financial markets.
Gross domestic investment (I) is the business spending on equipment, structures, and
inventories.

Depreciation – the decrease in an asset's value due to its wearing out/ obsolescence (getting
outdated). Net investment is calculated by deducting depreciation from gross
investment.

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Government Expenditures (G): Taxes are either spent by government on goods and services
or are returned to individuals in the form of transfer payments. Government
expenditures are government payments for goods and services or investment in
equipment and structures.

Net Exports: Spending on imports (M) is subtracted from total expenditures. Exports (X) to
foreign nations are added to total expenditures. These flows are combined into net
exports (X-M).

GDP and NDP: Net domestic product (NDP) – the sum of consumption expenditures,
government expenditures, net foreign expenditures, and investment less depreciation
Net domestic product is GDP adjusted for depreciation.

GDP = C + I + G + (X - M)
and NDP = C + I + G + (X - M) - depreciation

GDP to GNP and NDP to NNP: From domestic (GDP and NDP) to national concept (GNP
and NNP) of output, one has to add NFIA (net factor income from abroad). This simply
means adding the income earned by our (nationals i.e. Indian) factors abroad minus the
income earned by foreign factors inside our domestic territory.
GNP = GDP + NFIA and NNP = NDP + NFIA

National Income at Constant and Current Prices: The NI measurement (value of final
output) can increase (vice versa decrease) due to increase in either prices of goods or volume
of output of goods and services or both. To eliminate the effects of changing prices, one must
compute Real GDP or GDP at constant prices, which values the output of various time
periods with a set of fixed prices. When value of output is measured on the respective
(current) year’s prices, we call it Nominal GDP. The year whose prices are chosen as fixed
prices for measuring real GDP, is called the base year.

National Income Deflator: The difference in nominal and real GDP can be attributed solely
to change in prices of goods and services because real GDP takes care of increase or decrease
due to increase or decrease in volume of output. The ratio of Nominal GDP and Real GDP,
therefore gives an indicator of inflation (i.e. rise in price level) from the base level and is
termed as implicit price deflator or GDP deflator.
GDP Deflator = Nominal GDP/ Real GDP x 100

Economic Growth and Development: The growth in NI i.e. GDP or NDP (domestic
concept) and GNP or NNP (national concept) - measured in real terms i.e. at fixed prices can
arguably be an indicator or a measure of economic growth. The others would argue that
growth in economic well being on average (therefore NI per head e.g. GDP per head) is a
better measure of economic growth. Still others would argue for inclusion of qualitative
improvement in living standards (access to and affordability of health, shelter, education,
leisure, etc.) of people as a better indicator of economic growth considerations. More
equitable distribution of income (individual’s in total income) - thus improving the overall
welfare of the citizens - is considered another aspect of economic development. Development
at the cost of depleting (extraction of irreplaceable) or degrading (polluting, spoiling) natural
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resources can not be sustainable in the long run – is another aspect of the economic
development.

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 3. Money and Banking

Broad money supply

Money acts as a medium of exchange, unit of account and store of value. Broad money
supply (M3) includes all time and term deposits of commercial and cooperative banks, post
office savings banks and cash balances with them.

Demand for Money

Keynesian demand for money has three components viz. transactions demand (to meet day-
to-day requirements), the speculative demand (in anticipation of a fall in the price of assets)
and precautionary demand (to meet unexpected future outlays).

Quantity Theory of money

It states that the money demand depends on the value of transactions and the price level,
whereas money supply depends on money created by the central bank and the velocity of
money. The equation of exchange stands as MV=PT where M=Nominal money supply,
V=average velocity of money, P is the average price level and T=volume of transactions.

Money multiplier
High powered money (H) = C+R = c. D + s. D = D (c+s) where c=cash reserve ratio,
s=statutory liquidity ratio; R=reserves, C=currency, D=Deposits. So, D = H/ (c+s)
M=C+D= c. D + D = (1+c) D = (1+c) (c+s) H, where (1+c) (c+s)= money multiplier.

Scheduled Banks
Scheduled banks are those, which are included in the Second schedule of Banking Regulation
Act, 1965. To be included in the Second Schedule, a bank 1) must have paid-up capital and
reserves of not less than Rs. 5 lakhs 2) must also satisfy the RBI that its affairs are not
conducted in a manner detrimental to the interests of its depositors.

Private Banks
Private Bank is a bank registered as public limited company under the Companies Act, 1956.
The RBI may on merit grant a license under the Banking Regulation Act, 1949 for such a
bank. HDFC Bank, ICICI Bank is the new generation private sector banks.

Nidhi
A Mutual Benefit Finance company will be notified as a Nidhi company under Section 620A
of the Companies Act, 1956 by the Government of India based on the performance of the
company. To become a Nidhi, benefit funds need to have 2000 members and a paid-up
capital of Rs.25 lakhs. Once the benefit funds comply with these, Department of Company
Affairs declares such companies as Nidhi.

Non Banking Finance Company (NBFC)

There are different categories of Nifco’s such as Loan and Investment Companies;
Equipment Leasing and Hire Purchase Companies; Miscellaneous Non-Banking Finance
Companies and Residuary Non-banking Finance companies.

Bank Rate
The minimum rate at which the Reserve Bank of India will make short-term advances
(usually for overnight) to the banks.

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Prime Lending Rate (PLR)
The rate of interest at which the commercial banks lend money to the clients.

London Interbank Offered Rate (LIBOR)

LIBOR is the benchmark or the reference rate. This is calculated everyday, at a specific time,
as the average of the lending rates of a group of 15 reference banks in London on short-term
funds lent to first class banks. Rates charged to non-bank customers on loans are stated as
LIBOR plus a margin or spread.

Mumbai Interbank Offered Rate (MIBOR)

MIBOR is the benchmark or the indicative rate prevailing in Mumbai money markets. This is
calculated everyday, at a specific time, as the average of the lending rates of a group of 18
reference banks in Mumbai on funds lent to first class borrowers.

Basis Point
One basis Point is 1/100th of 1 % point i.e. 100 basis point will make 1% point. It is used to
measure changes in yields of a bond. For example, if a bond yielding 6.09% changes in price
to yield 6.20%, it is said to have increased 11 basis points. Basis points (bps) are commonly
referred to as "beeps".

Accrued interest
This is the interest that has been earned by an investor but not become due for payment to the
investor. Bond buyers pay bond sellers accrued interest whenever a bond is purchased.

Annuity
An equal amount paid every year in lieu of a lump sum payment for a certain fixed period or
for life. Some investment schemes offered by banks, Life Insurance Corporation, Unit Trust
offer annuity payments.

Banking Credit
Banks provide short term credit for financing working capital needs, and term loans for new
projects or expansion. The various types of advances provided by banks are cash credits,
overdrafts, demand loans, purchase and discount of commercial bills and installment or hire
purchase credit.

Bridge Loan
Bridge Loans are given at the time when the entities come out (or want to come out) with a
public offer in the capital market, but need financing for covering the cost of issues and for
using the loan proceeds as a bridge for the funds that are obtained only after the public issue
gets completed.

Net Demand and Time Liabilities (NDTL)

For calculating its NDTL, a bank has to first sum up its total gross liabilities, which include
all demand and term deposits (DTD), and then deduct its interbank assets (IBA) from this
DTD. Usually NDTL is calculated with reference to alternate Fridays called "Reporting
Fridays". The banks are required to maintain CRR and SLR with reference to the NDTL.

Cash Reserve Ratio (CRR)

CRR is the statutory reserve that has to be maintained by banks either in cash or as balance
with the Reserve Bank of India. CRR is intended to be a reserve by which the RBI assures
11
itself that the bank is safe and has the liquidity for servicing its depositors. As per Section 42
of the RBI Act, RBI is allowed to announce any level of CRR depending on the market
conditions within a certain band, the minimum being 3% and the maximum 15% of NDTL.

Statutory Liquidity Ratio (SLR)

SLR is the statutory reserve that is set aside by banks for investment in cash, gold or
unencumbered approved securities valued at a price not exceeding the current market price.
SLR should not be less than 25% and not exceeding 40% of NDTL as per Section 24 of the
Banking Companies Regulation Act.

Credit Deposit Ratio (CDR)

It represents the ratio of Total Credit disbursed to Total Deposits garnered by a bank. Total
Credit includes Loans, Overdrafts, Cash Credits and Bills purchased and discounted. Total
Deposits include the Time and Demand deposits.

Nostro Account
An account opened by an Indian bank with a foreign bank in their currency for the purpose of
remittances and withdrawals is known as a nostro account.

Vostro Account
A rupee account opened by a foreign bank with an Indian bank for the purpose of remittances
and withdrawals is known as a vostro account.

Promissory Note
According to the Negotiable Instruments Act, a Promissory Note is an instrument in writing
(not being a bank note or a currency note) containing an unconditional promise, signed by the
maker, to pay a certain sum of money only to, or to the order of, a certain person, or to the
bearer of the instrument. Maker is the person who makes the promissory note and promises
to pay, and the person to whom the payment is made is the payee.

Term Loan
Term Loans are defined as loans sanctioned for a period exceeding one year with specific
schedule of repayment.

Value at risk
Simply speaking, value at risk is the forecasted amount that may be lost, on the investments
and other exposures that the bank may have, if an adverse market move were to happen.

Zero Coupon Bond

A bond that pays no periodic interest and sold at a deep discount from the face value. Buyer's
rate of return comes from the gradual appreciation of the bond.

Monetary Policy
Implemented by the Reserve Bank of India, it is policy using money supply and control of
credit in the Indian economy to control the general direction of interest rates and maintain the
integrity of the Indian Rupee. Tightening monetary policy is indicative of rising rates usually
near the end of a phase of economic expansion. Conversely, loosening monetary policy is
accompanied by decreasing rates that usually precedes economic expansion.

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 4. International Trade

Why do nations trade?

There are two possible answers yet: comparative advantage and division of labor. The first
concept is originated by David Ricardo. It roughly says that trade is due to autarkic (no trade)
price differences. Because of differences in the underlying parameters, some countries can
produce some goods relatively more efficiently, so that when trade is allowed they will
specialize in those goods. The second concept is even older, and goes back to Adam Smith.
His idea was that nations trade in order to exploit economies of scale that arise from
specialization. Smith’s argument of absolute advantage, in contrast to comparative
advantage, works even if the trading countries are identical in all respects.

Gains from trade:

International trade is essentially to achieve the gains that international specialization makes
possible. Trade allows each country to concentrate on producing those goods and services
that it produces relatively efficiency i.e. at a lower unit cost, while trading to obtain those
goods and services that it would produce less efficiently than others. Gains from trade arise
from differing opportunity costs in the countries.

Concept of production possibility curve and opportunity cost:

A production possibility curve (PPC) shows the combination of two goods a country can
make in a given time period with resource fully employed. A PPC is drawn assuming a
country has a fixed amount of resources and a constant state of technology.
LM is a production possibility curve
- Points under the PPC ( e.g. A) imply resource under utilization.
- Points along the PPC (e.g. B) indicate a full employment of resources.
- Points outside the PPC (e.g. C) are beyond the current productive capacity of the economy.
- The opportunity cost of producing OE amount of good X is LF of good Y.
- The opportunity cost of reallocating resources from B to D is FH of good Y.
- A concave (bowed outwards) production possibility curve indicates increasing opportunity
cost. As more of good X is produced increasing amounts of good Y have to be foregone to
produce an extra unit of good Y.

Terms of trade (TOT):

This measure the quantity of imported goods that can be obtained per unit of goods exported.
A rise in the price if imported goods with the price of exports unchanged indicates a fall in

13
terms of trade. Similarly a rise in the price of exported goods with price of imports
unchanged indicates a rise in terms of trade. Since actual international trade involves many
countries and many products, a country’s terms of trade are computed as index number.
TOT = Index of export prices x 100
Index of import prices

Concept of Balance of Payments (BOP) and Exchange Rates:

Balance of payment accounts measure the net transactions between domestic residents and
the rest of the world over a specific period. Each transaction such as a shipment of exports or
the arrival of

imported goods is classified according to the payments or receipts that would typically arise
from it. There are two main components of a BOP account.
1. Current account
2. Capital account

The current account records transactions arising from trade in goods and services, from
income accruing to residents of one country from another and from transfers by residents of
one country to another. The capital account records transactions related to international
movement of ownership of financial assets such as company shares, bank loans or
government securities. The current and capital account balances are necessarily of equal and
opposite size. When added together, they equal zero.

Trade between nations typically requires the exchange of one nation’s currency for that of
another. The exchange of one currency for another is a foreign exchange transaction. When
there is no official intervention by the monetary authorities or the government, the exchange
rate is determined by the equality between demand for and supply of the foreign currency
arising from capital and current accounts. This is called the flexible or floating exchange
rate regime. When official intervention is used to maintain the exchange rate at a particular
value, it is called a fixed or pegged exchange rate regime.

--------------------------

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 5. Public Finance and Fiscal Policy

Public Finance deals with concepts, policies and international best practices on
Government Receipts and Expenditures. Fiscal policies imply taxation and tariff policies
announced by the government.
Budget is the financial account of the government and has two basic heads- Receipts and
Expenditures.
Receipts and Revenues- All revenues are receipts, but all receipts are not revenues.
Revenues consist of those receipts which do not have obligations for repayments.
Expenditures and payments- Similarly, all expenditures are payments, but all payments are
not expenditure. Repayments of loans are not expenditure.
Requited and unrequited transactions- Requited transactions are those in which money is
paid or received in exchange of goods or services. But, transfers and grants are unrequited
expenditure as nothing is received in return of money.
Revenue and Capital Account
In Indian budget accounting system, both these heads have two accounts- revenue account
and capital account. In general, revenue account is the current account which is finalized and
closed during the year and has no spillover for future, whereas capital account has long term
implications and continues for a number of years until all the assets and liabilities are
finalized or closed.
Government expenditure is classified into two types – Revenue Expenditure and Capital
Expenditure. Revenue Expenditure is any expenditure for the normal running of the
Government, which does not lead to the creation of assets or value addition e.g. salaries of
Government employees and military staff, perks for ministers, office furniture, grants to State
Governments, subsidies, interest to be paid on loans taken, and pensions for ex-defense staff
are all accounted for here and referred to as revenue spending. This spending must be
financed from revenue receipts, i.e. revenue that the Government earns. The Government
earns revenue in the form of taxes (corporate, income), duties (excise, custom), receipts, fees,
interest and dividends (if the Government makes investments).
Capital spending (capital expenditure) refers to the money spent on creating assets (roads,
highways, and dams), buying land or building, purchasing machinery and equipments. Loans
from the center to various State Governments or Government-run companies, any
investments made by the Government in shares or other such instruments are also included.
This spending is financed from capital receipts, the money that the Government gets from
loans. The loans can be from the public (market loans), from the Reserve Bank of India (the
country's central bank), from foreign Governments or international organizations like the
World Bank. Loans paid back to the Government by states or Union Territories, sale of
Treasury bills and proceeds from the dilution of the Government’s stake in Public Sector
Undertakings, all form a part of capital receipt.
Plan and Non-plan expenditure: Any expenditure which is approved by the Planning
Commission as a part of National Five-Year or Annual Plan is called plan expenditure; all
other expenditures are called non-plan expenditure. The 1st 5-Year Plan was launched in 1951
and currently, the 10th 5-year plan (2002-2007) is on.
Non-debt creating receipts include revenue receipts, recovery of loans and disinvestment of
government equity for which government has no obligations to anybody.
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Tax: Tax is the major source of government revenue (about 70% of central govt receipts in
India). A tax is a sum of money that a local, state or national authority imposes on incomes
(income tax), properties (property tax), sales (sales tax), profits (profit tax) or the creation of
waste and/or pollution (waste/pollution tax). Taxes can be specified as a rate (e.g. x % of
taxable income, profit or sales) or as a fixed amount for a certain quantity (e.g. pollution tax
as x Rs. per ton of waste or pollutants emitted in the air, water). The taxes collected directly
from the person/ business is called direct taxes e.g. income tax, property tax, profit tax, etc.
Indirect tax is collected and deposited by intermediary e.g. sales and service tax (by sellers/
service providers), excise duty (by producers), etc. and are passed on to the end-users.
Principles of Taxation: A good tax system must satisfy several general principles of
taxation. The main principles include productivity, equity, and elasticity.
Productivity - The chief goal of a tax system is to generate the revenue a government needs
to pay its expenses – avoid deficit of revenue over expenses.
Equity - A tax system should be equitable (fair) to the taxpayers. Two kinds of equity – 1)
Horizontal equity – People with the same amount of income should be taxed at the same rate,
and 2) vertical equity - wealthier people should pay proportionately more taxes than poorer
people (also called the principle of ability to pay). Progressive tax (higher tax rate for higher
taxable amount) is generally used to achieve equity.
Elasticity - A tax system should be elastic (flexible) so that it can satisfy the changing
financial needs of a government - should help stabilize the economy.
Other principles of taxation: Taxes should – (i) be convenient to pay for people and
inexpensive for governments to collect, (ii) also satisfy the principle of neutrality - should
not affect taxpayers' economic decisions, such as how to spend, save, or invest their money.
Others believe a tax system must defy the principle of neutrality to achieve tax equity or to
stabilize economic growth. Tax system should play an active role in redistributing wealth.
Different Concepts of Deficit:
 Revenue deficit = Revenue expenditure less revenue receipts
 Capital deficit = Capital expenditure less capital receipts
 Budget deficit = Total expenditure less total receipts
= Revenue deficit +Capital deficit
 Gross Fiscal Deficit= Total expenditure less Non-Debt receipts= Total Exp less
(Revenue receipts + recovery of loans + disinvestment of government equity)
 Gross Primary deficit= Gross Fiscal Deficit less interest payments
 Net Fiscal Deficit=Gross Fiscal Deficit less Net Lending
 Net Primary Deficit= Net Primary Deficit less Net Interest Payments
 Net RBI Credit to the central Govt = RBI’s holdings of Treasury Bills, Govt of
India dated securities, rupee coins, and loans and advances taken from RBI
adjusted for center's cash balances.

Monetization: The Government can ask central bank (RBI) to print more notes. Resulting
increase in money supply often leads to inflation- rise in the prices of goods. In response, the
bank will also increase its nominal interest rate to stabilize the 'real' interest rate (=nominal
interest rate – inflation).
Deficit Financing: Government can borrow from central bank, financial institutions and
from the both internal and external markets. Incidentally, the Government is the largest
borrower in India. Since the Government is such a large borrower, its demand for money

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competes with private investor and could put an upward pressure on interest rates. So
borrowing tends to increase interest rates and this may crowd out private investment.

Budget 2005-06 at a glance

Items Rs. Billion Items Rs. Billion

1. Revenue receipts (a+b) 3512 5.Capital expenditure 678

(a) Tax revenues 274 6. Total expenditure (4+5) 5143
(b) Non-tax revenues 78 7. Revenue deficit (4-1) 953
2.Capital receipts, of which 1631 8.Capital deficit (5-2) -953
(a) Recovery of loans 120 9. Budget deficit= (7+8)=(6-3) 0
(b) Borrowings & other liability 1511 10. Gross fiscal deficit=(6-1-a)=2b 1511
3.Total receipts (1+2) 5143 11. Primary deficit= (10-4a) 172
4.Revenue expenditure 4465 12. Net fiscal deficit 1398
(a) Interest payments 1339 13. Net primary deficit 213

Fiscal policy is a government policy of using taxation and spending to affect

macroeconomic goals. Macroeconomic goals are- Stability (control unemployment and
inflation), Equity (reduce inequality and bring fairness), Sustainability (sustainable/ balanced
use of resources – conservation of irreplaceable and preservation of degradable resources),
Growth (boost per capita GDP and raise living standard), Flexibility (ability to change and
adapt) and meet other needs of the society.
Managing Economy through Fiscal Policy: Demand management through fiscal policy can
be done to stabilize the economy. Deficient demand situation (i.e. when aggregate demand <
aggregate supply) as seen during the recession can be tackled by either or both of the fiscal
measures – (i) increasing the level of government expenditure, and (ii) cutting the taxes
(direct/ indirect). Both are reflationary - the first increases aggregate demand directly while
the second encourages and leads consumers to spend more. Another difference is that the
first increases public sector’s share in total output and the second the private sector’s share in
total output. If there is an excess of demand (aggregate demand > aggregate supply), such as
in a boom, then the government will need to deflate the economy – i.e. deliberately reduce
the level of economic activity so as to stop/ decrease the demand-pull inflation.
Deflationary fiscal policies are just the opposite of reflationary measures. Other than the
growth and stability, the fiscal policy should also focus on which sector should government
spend on – ‘how much’ and ‘what kind’ depends on opportunity costs and benefits: public
health, education, and infrastructure, etc. Who to spend on - specific segment of each sector –
producers or consumers is another aspect of fiscal planning. Redistribution of resources and
output for equitable/ balanced growth can be other objectives through these fiscal policy
decisions. Transfer payments (subsidies, welfare stipend, etc.) can be seen as reduction in tax
at aggregate level and also as a way of redistribution of income/output.
Government can also stabilize the economy by reflationary (cutting interest rate and/or
money supply) or deflationary monetary policies. What mix of fiscal and monetary measures
government will take depends on the assessment of overall economic situation and the other
objectives – social benefits, long and short-term economic goals, etc.

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