Economics For Finance

Intermediate Course
Study Material
(Modules 1 to 3)
Paper 8B
Economics
for Finance
BOARD OF STUDIES
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA
© The Institute of Chartered Accountants of India

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This Study Material has been prepared by the faculty of the Board of Studies. The
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may write to the Director of Studies.
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for the students. However, the Study Material has not been specifically discussed by the
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Edition : July, 2017
Website : www.icai.org
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Committee/ : Board of Studies

Department
ISBN No. : 978-81-8441-890-3
Price : 150/- (For All Modules)
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July/2017/P2117 (New)

BEFORE WE BEGIN….
Evolving Role of a CA - Shift Towards Strategic Decision Making
The traditional role of a chartered accountant restricted to accounting and

auditing, has now changed substantially and there has been a marked shift
towards strategic decision making and entrepreneurial roles that add value
beyond traditional financial reporting. The primary factors responsible for the
change are the increasing business complexities on account of a plethora of
laws, borderless economies consequent to giant leap in e-commerce,
emergence of new financial instruments, emphasis on corporate social
responsibility, significant developments in information technology, to name a
few. These factors necessitate an increase in the competence of chartered
accountants to take up the role of not merely an accountant or auditor, but a
global solution provider. Towards this end, the scheme of education and
training is being continuously reviewed so that it is in sync with the requisites
of the dynamic global business environment; the competence requirements
are being continuously reviewed to enable aspiring chartered accountants to
acquire the requisite professional competence to take on new roles.
Skill Requirements at Intermediate Level
At the Intermediate Level, you are expected to not only acquire professional
knowledge but also the ability to apply such knowledge in problem solving.
Learning outcomes which you need to demonstrate after learning each topic
have been detailed in the first page of each chapter/unit. Demonstration of
these learning outcomes would help you to achieve the desired level of
technical competence. The process of learning should also help you inculcate
the requisite professional skills, i.e., the intellectual skills and communication
skills, necessary for achieving the desired professional competence.
Economics for Finance : Dynamic & Interesting
The dynamic nature of the economic variables that influence decision making
at various levels necessitates a comprehensive understanding of the
behavioural patterns of economic entities. Therefore, of late, the tools of
Economics have gained wide application in nearly all areas of business and
finance. It has thus become increasingly important that our accounting and
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finance professionals be equipped with practical knowledge of the
institutional framework and analytical tools of Economics to enable them to
make sense of the multitude of arguments and information that emerge
almost daily.
Framework of Chapters – Uniform Structure Comprising of Specific Component
The content of the course of study ‘Economics for Finance’ is devised by

incorporating the currently relevant subject matter of Macro Economics,
Public Finance, Monetary Theory and International Economics. Since this
course is framed to meet the functional requirements of accounting
professionals, the concepts and principles in this material are explained in a
lucid and non-technical manner with appropriate illustrations from the latest
available sources relating to the current economic and financial environment.
The blend of theory and its contextualization with stress on clarity of
exposition intend to facilitate learners to move beyond a mere understanding
of the subject toward a level of analyzing and evaluating current and future
developments in the economy. From a managerial perspective, this would
provide coherent foresight and logical judgment and contribute towards
strategic policy formulation.
The study material is organized in four chapters. Chapter 1 explains in two
units the concept of National Income and its measurement and the
conventional Keynesian theory of determination of national income. Chapter 2
examines the fiscal role of governments, the nature of market failures, the
rationale of government interventions to correct market failures and the
application of fiscal policy to ensure economic stability. Chapter 3 deals with
the role of money in the financial system, its demand and supply and
governments’ use of monetary policy to achieve and maintain economic
stability. With the objective of enlightening the students on the international
economic phenomena emanating from global integration and
interdependence, chapter 4 is entirely devoted to International Economics.
The chapter begins with a discussion on popular theories of international
trade and then explores the use and welfare effects of various instruments of
trade policy. Separate units discuss trade negotiations and aspects related to
multilateral trade agreements and the exchange rate policies chosen by
national governments and their economic effects. An entire unit is devoted to
expound patterns of international capital movements and the outcomes of
foreign investments.
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The learning outcomes put across at the beginning of each unit help orient
the learners to focus on key concepts. The end of the chapter summaries are
intended to integrate the discussions in the units. The sample questions
appended with each chapter, though not exhaustive in coverage, are expected
to provide crucial guidelines for preparation for examinations. The glossary at
the end of the book intends to provide a quick review of the major concepts
to the learners.
The learners are requested to keep themselves updated on the wide-ranging
changes that occur in the economic arena in view of the lack of feasibility of
instantly incorporating them in the study material. Your valuable suggestions
to improve the contents and /or use of pedagogical devices would be
appreciated.
Happy Reading and Best Wishes!

SYLLABUS
PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS
FOR FINANCE
(One paper – Three hours – 100 Marks)
SECTION B : ECONOMICS FOR FINANCE (MARKS: 40)

Objective:
To develop an understanding of the concepts and theories of Economics in the
context of Finance and acquire the ability to address application oriented issues.
1. Determination of National Income
(i) Macro Economic Aggregates and Measurement of National Income
(ii) The Keynesian Theory of Determination of National Income
2. The Money Market
(i) The Concept of Money Demand: Important Theories of Demand for
Money
(ii) The Concept of Money Supply
(iii) Monetary Policy
3. Public Finance
(i) Fiscal functions: An Overview.
(ii) Market Failure
(iii) Government Interventions to Correct Market Failure
(iv) Fiscal Policy
4. International Trade
(i) Theories of International Trade
(ii) Trade Policy – The Instruments of Trade Policy
(iii) Trade Negotiations
(iv) Exchange Rates and its economic effects
(v) International Capital Movements: Foreign Direct Investment
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CONTENTS
CHAPTER 1 – DETERMINATION OF NATIONAL INCOME
UNIT I - National Income Accounting ............................................................................... 1.1

1.1 Introduction....................................................................................................................... 1.1
1.2 Usefulness and Significance of National Income Estimates ...........................1.2
1.3 Different Concepts of National Income .................................................................. 1.4
1.4 Measurement of National Income in India ........................................................ 1.11
1.5 The System of Regional Accounts in India ......................................................... 1.18
1.6 Limitations and Challenges of National Income Computation .................. 1.18
Summary ......................................................................................................................... 1.20
UNIT II - The Keynesian Theory of Determination of National Income……1.35

2.1 Introduction.................................................................................................................... 1.36
2.2. Circular Flow in a Simple Two-Sector Model..................................................... 1.36
2.3 The Aggregate Demand Function: Two-sector Model .................................. 1.38
2.4 The Two-Sector Model of National Income Determination ........................ 1.43
2.5 The Investment Multiplier ......................................................................................... 1.48
2.6 Determination of Equilibrium Income: Three Sector Model ........................ 1.51
2.7 Determination of Equilibrium Income: Four Sector Model .......................... 1.55
2.8 Conclusion ...................................................................................................................... 1.59
Summary ......................................................................................................................... 1.60
CHAPTER 2 – PUBLIC FINANCE
UNIT I - Fiscal Functions: An Overview .................................................................. 2.2

1.1 Introduction....................................................................................................................... 2.2
1.2 The Role of Government in an Economic System...............................................2.3
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1.3 The Allocation Function ................................................................................................ 2.4
1.4 Redistribution Function ................................................................................................ 2.7
1.5 Stabilization Function ........................................................................................................ 2.8
1.6 Conclusion ...................................................................................................................... 2.10

Summary ......................................................................................................................... 2.11
UNIT II - Market Failure............................................................................................. 2.18

2.1 Introduction ........................................................................................................ 2.19
2.2 The Concept of Market Failure ....................................................................... 2.20
2.3 Why Do Markets Fail ........................................................................................ 2.20
2.4 Public Goods ..................................................................................................... 2.26
2.5 Incomplete Information.................................................................................... 2.35
2.6 Conclusion ........................................................................................................... 2.37
Summary.............................................................................................................. 2.37
UNIT III - Government Interventions to Correct Market Failure ...................... 2.48

3.1 Government Intervention to Minimize Market Power ................................... 2.49
3.2. Government Intervention to Correct Externalities ........................................... 2.50
3.3 Government Intervention in the Case of Merit Goods .................................. 2.55
3.4 Government Intervention in the Case of Demerit Goods ............................. 2.58
3.5 Government Intervention in the Case of Public Goods ................................. 2.61
3.6 Price Intervention: Non-Market Pricing.............................................................. 2.61
3.7 Government Intervention for Correcting Information Failure..................... 2.63
3.8 Government Intervention for Equitable Distribution...................................... 2.64
Summary ......................................................................................................................... 2.65
UNIT IV - Fiscal Policy ............................................................................................................ 2.74

4.1 Introduction.................................................................................................................... 2.74
4.2. Objectives of Fiscal Policy ......................................................................................... 2.76
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4.3 Automatic Stabilizers Versus Discretionary Fiscal Policy............................... 2.76
4.4 Instruments of Fiscal Policy ...................................................................................... 2.78
4.5 Types of Fiscal Policy .................................................................................................. 2.82
4.6 Fiscal Policy For Long-Run Economic Growth ................................................. 2.87
4.7 Fiscal Policy for Reduction in Inequalities of Income and
Wealth .............................................................................................................................. 2.88
4.8 Limitations of Fiscal Policy ........................................................................................ 2.89
4.9 Conclusion ...................................................................................................................... 2.92
Summary ......................................................................................................................... 2.92
CHAPTER 3 – MONEY MARKET .................................................................................. 3.1
UNIT I - The Concept of Money Demand : Important Theories...........................3.1

1.1 Introduction ........................................................................................................... 3.2
1.2 Functions of Money.............................................................................................. 3.3
1.3 The Demand for Money ..................................................................................... 3.5
1.4 Theories of Demand for Money......................................................................... 3.6
1.5 Post-Keynesian Developments in the Theory of Demand for
Money .................................................................................................................. 3.13
1.6 Conclusion ........................................................................................................... 3.16
Summary ............................................................................................................. 3.17
UNIT II - The Concept of Money Supply ....................................................................... 3.26

2.1. Introduction.................................................................................................................... 3.27
2.2 Rationale of Measuring Money Supply ............................................................... 3.28
2.3 The Sources of Money Supply ................................................................................ 3.28
2.4 Measurement of Money Supply ............................................................................. 3.29
2.5 Determinants of Money Supply.............................................................................. 3.32
2.6 The Concept of Money Multiplier .......................................................................... 3.32
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2.7 The Money Multiplier Approach to Supply of Money ................................... 3.33
2.8 Effect of Government Expenditure on Money Supply ................................... 3.36
Summary ......................................................................................................................... 3.38
UNIT III - Monetary Policy ................................................................................................... 3.50

3.1. Introduction.................................................................................................................... 3.51
3.2 Monetary Policy Defined ........................................................................................... 3.51
3.3 The Monetary Policy Framework ............................................................................ 3.51
3.4 The Organisational Structure for Monetary Policy Decisions...................... 3.62
3.5 Conclusion ...................................................................................................................... 3.64
Summary ......................................................................................................................... 3.64
CHAPTER 4 – INTERNATIONAL TRADE
UNIT I - Theories of International Trade ............................................................... 4.1

1.1 Introduction ........................................................................................................... 4.2
1.2 Important Theories of International Trade ...................................................... 4.5
Summary ............................................................................................................. 4.16
UNIT II - The Instruments of Trade Policy ................................................................... 4.26

2.1 Introduction.................................................................................................................... 4.27
2.2. Tariffs ................................................................................................................................ 4.28
2.3 Non -Tariff Measures (NTMs) .................................................................................. 4.33
2.4 Export-Related Measures .......................................................................................... 4.39
Summary ......................................................................................................................... 4.40
UNIT III - Trade Negotiations ............................................................................................. 4.50

3.1 Introduction.................................................................................................................... 4.51
3.2. Taxonomy of Regional Trade Agreements (RTAs) ........................................... 4.51
3.3 The General Agreement on Tariffs and Trade (GATT) .................................... 4.52
3.4 The Uruguay Round and the Establishment of WTO ..................................... 4.54
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3.5 The World Trade Organization (WTO) ................................................................. 4.54
3.6 The Doha Round .......................................................................................................... 4.61
3.7 The WTO: A Few Concerns ...................................................................................... 4.62
Summary ......................................................................................................................... 4.64
UNIT IV - Exchange Rate and Its Economic Effects ................................................. 4.73

4.1 Introduction.................................................................................................................... 4.73
4.2 The Exchange Rate ...................................................................................................... 4.74
4.3 The Exchange Rate Regimes .................................................................................... 4.75
4.4 Nominal Versus Real Exchange Rates .................................................................. 4.79
4.5 The Foreign Exchange Market................................................................................. 4.80
4.6 Determination of Nominal Exchange Rate ......................................................... 4.82
4.7 Changes in Exchange Rates...................................................................................... 4.83
4.8 Devaluation (Revaluation) Vs Depreciation (Appreciation) ......................... 4.86
4.9 Impacts of Exchange Rate Fluctuations on Domestic Economy ................ 4.86
Summary ......................................................................................................................... 4.92
UNIT V - International Capital Movements ............................................................... 4.103

5.1 Introduction ..................................................................................................... 4.103
5.2 Types of Foreign Capital ............................................................................. 4.104
5.3 Foreign Direct Investment (FDI) ............................................................... 4.105
5.4 Foreign Portfolio Investment (FPI) .......................................................... 4.106
5.5 Reasons for Foreign Direct Investment ................................................. 4.108
5.6 Modes of Foreign Direct Investment (FDI) ........................................... 4.111
5.7 Benefits of Foreign Direct Investment ................................................... 4.112
5.8 Potential Problems Associated with Foreign Direct Investment ... 4.114
5.9 Foreign Direct Investment in India (FDI) .............................................. 4.117
5.10 Overseas Direct Investment by Indian Companies ............................ 4.119
Summary ........................................................................................................... 4.120
GLOSSARY ........................................................................................ I.1 - I.21
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CHAPTER 1
DETERMINATION OF
NATIONAL INCOME
UNIT I: NATIONAL INCOME ACCOUNTING
LEARNING OUTCOMES
At the end of this unit, you will be able to:
 Define national income
 Explain the usefulness and significance of national income

estimates
 Differentiate among the various concepts of national income
 Describe the different methods of calculation of national income
 Outline measurement of national income in India
 Describe the system of regional accounts in India
 Identify the challenges involved in national income computation

1.2 ECONOMICS FOR FINANCE
Determination of
National Income
National Income
Accounting
Limitations and
Different concepts of Measurement of
Challenges of National
National Income National Income in India
Income Computation
1.1 INTRODUCTION
When we undertake the study of national economies, we are interested in
macroeconomic aggregates such as, aggregate income, output, employment,
prices, consumption, savings, investment etc. Just as there are accounting
conventions which measure the performance of business, there are conventions for
measuring and analyzing the economic performance of a nation. National Income
Accounting, pioneered by the Nobel prize-winning economists Simon Kuznets and
Richard Stone, is one such measure.
National Income is defined as the net value of all economic goods and services
produced within the domestic territory of a country in an accounting year plus the
net factor income from abroad. According to the Central Statistical Organisation
(CSO) ‘National income is the sum total of factor incomes generated by the normal
residents of a country in the form of wages, rent , interest and profit in an
accounting year’.
1.2 USEFULNESS AND SIGNIFICANCE OF NATIONAL INCOME

ESTIMATES
National income accounts are fundamental aggregate statistics in macroeconomic
analysis and are extremely useful, especially for the emerging and transition
economies.
1. National income accounts provide a comprehensive, conceptual and
accounting framework for analyzing and evaluating the short-run performance
of an economy. The level of national income indicates the level of economic

NATIONAL INCOME ACCOUNTING 1.3
activity and economic development as well as aggregate demand for goods

and services of a country.
2. The distribution pattern of national income determines the pattern of demand
for goods and services and enables businesses to forecast the future demand
for their products.
3. Economic welfare depends to a considerable degree on the magnitude and
distribution of national income, size of per capita income and the growth of
these over time.
4. The estimates of national income show the composition and structure of
national income in terms of different sectors of the economy, the periodical
variations in them and the broad sectoral shifts in an economy over time. It is
also possible to make temporal and spatial comparisons of the trend and speed
of economic progress and development. Using these information, the
governments can fix various sector-specific development targets for different
sectors of the economy and formulate suitable development plans and policies
to increase growth rates.
5. National income statistics also provide a quantitative basis for macroeconomic
modeling and analysis, for assessing and choosing economic policies and for
objective statement as well as evaluation of governments’ economic policies.
These figures often influence popular and political judgments about the
relative success of economic programmes.
6. National income estimates throw light on income distribution and the possible
inequality in the distribution among different categories of income earners. It
is also possible make comparisons of structural statistics, such as ratios of
investment, taxes, or government expenditures to GDP.
7. International comparisons in respect of incomes and living standards assist in
determining eligibility for loans, and or other funds or conditions on which
such loans, and/ or funds are made available. The national income data are
also useful to determine the share of nation’s contributions to various
international bodies.
8. Combined with financial and monetary data, national income data provide a
guide to make policies for growth and inflation.
9. National income or a relevant component of it is an indispensable variable
considered in economic forecasting and to make projections about the future
development trends of the economy.

1.3 DIFFERENT CONCEPTS OF NATIONAL INCOME

The basic concepts and definitions of the terms used in national accounts largely
follow those given in the UN System of National Accounts (SNA) developed by
United Nations to provide a comprehensive conceptual and accounting framework
for compiling and reporting macroeconomic statistics for analysing and evaluating
the performance of an economy. Each of these concepts has a specific meaning,
use and method of measurement.
National income accounts have three sides: a product side, an expenditure side
and an income side. The product side measures production based on concept of
value added. The expenditure side looks at the final sales of goods and services.
Whereas the income side measures the distribution of the proceeds from sales to
different factors of production. Accordingly, national income is a measure of the
total flow of ‘earnings of the factor-owners’ which they receive through the
production of goods and services. Thus, national income is the sum total of all the
incomes accruing over a specified period to the residents of a country and consists
of wages, salaries, profits, rent and interest.
On the product side there are two widely reported measures of overall production
namely, Gross Domestic Product (GDP) and Gross National Product (GNP).
1.3.1 Gross Domestic Product (GDP MP)
Gross domestic product (GDP) is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory
of a country during a given time period. It is the sum total of ‘value added’ by all
producing units in the domestic territory and includes value added by current
production by foreign residents or foreign-owned firms. The term ‘gross’ implies
that GDP is measured ‘gross’ of depreciation. ‘Domestic’ means domestic territory
or resident production units. However, GDP excludes transfer payments, financial
transactions and non- reported output generated through illegal transactions such
as narcotics and gambling (these are also known as ‘bads’ as opposed to goods
which GDP accounts for).
Gross Domestic Product (GDP) is in fact Gross Domestic Product at market prices
(GDP MP) because the value of goods and services is determined by the common
measuring unit of money or it is evaluated at market prices. Money enables us to
measure and find the aggregate of different types of products expressed in
different units of measurement by converting them in terms of Rupees, say tonnes

of wheat may, thus, be added with millions of apples and with value of services
such as airplane journeys.
GDPMP = Value of Output in the Domestic Territory – Value of

Intermediate Consumption
GDP MP = ∑ Value Added
While learning about national income, there are a few important points which one
needs to bear in mind:
(i) The value of only final goods and services or only the value added by the
production process would be included in GDP. By ‘value added’ we mean the
difference between value of output and purchase of intermediate goods. Value
added represents the contribution of labour and capital to the production
process.
(ii) Intermediate consumption consists of the value of the goods and services
consumed as inputs by a process of production, excluding fixed assets whose
consumption is recorded as consumption of fixed capital. Intermediate goods
used to produce other goods rather than being sold to final purchasers are not
counted as it would involve double counting. The intermediate goods or
services may be either transformed or used up by the production process. For
example, the value of flour used in making bread would not be counted as it
will be included while bread is counted. This is because flour is an intermediate
good in bread making process. Similarly, if we include the value of an
automobile in GDP, we should not be including the value of the tyres
separately.
(iii) Gross Domestic Product (GDP) is a measure of production activity. GDP covers
all production activities recognized by SNA called the ‘production boundary’.
The production boundary covers production of almost all goods and services
classified in the National Industrial Classification (NIC). Production of
agriculture, forestry and fishing which are used for own consumption of
producers is also included in the production boundary. Thus, Gross Domestic
Product (GDP) of any nation represents the sum total of gross value added
(GVA) (i.e, without discounting for capital consumption or depreciation) in all
the sectors of that economy during the said year.
(iv) Economic activities, as distinguished from non-economic activities, include all
human activities which create goods and services that are exchanged in a

market and valued at market price. Non-economic activities are those which
produce goods and services, but since these are not exchanged in a market
transaction they do not command any market value; for e.g. hobbies,
housekeeping and child rearing services of home makers and services of family
members that are done out of love and affection.
(v) National income is a ‘flow’ measure of output per time period—for example,
per year—and includes only those goods and services produced in the current
period i.e. produced during the time interval under consideration. The value
of market transactions such as exchange of goods which already exist or are
previously produced, do not enter into the calculation of national income.
Therefore, the value of assets such as stocks and bonds which are exchanged
during the pertinent period are not included in national income as these do
not directly involve current production of goods and services. However, the
value of services that accompany the sale and purchase (e.g. fees paid to real
estate agents and lawyers) represent current production and, therefore, is
included in national income.
(vi) An important point to remember is that two types of goods used in the
production process are counted in GDP namely, capital goods (business plant
and equipment purchases) and inventory investment—the net change in
inventories of final goods awaiting sale or of materials used in the production
which may be positive or negative. Additions to inventory stocks of final goods
and materials belong to GDP because they are currently produced output.
The national income in real terms when available by industry of origin, give a
measure of the structural changes in the pattern of production in the country which
is vital for economic analysis.
1.3.2 Nominal GDP vs Real GDP: GDP at Current and Constant prices
Since we measure the value of output in terms of market prices, GDP, which is
essentially a quantity measure, is sensitive to changes in the average price level.
The same physical output will correspond to a different GDP level if the average
level of market prices changes. That is, if prices rise, GDP measured at market prices
will also rise without any real increase in physical output. This is misleading because
it does not reflect the changes in the actual volume of output. To correct this i.e. to
eliminate the effect of prices, in addition to computing GDP in terms of current
market prices, termed ‘nominal GDP’ or ‘GDP at current prices’, the national income
accountants also calculate ‘real GDP ’or ‘GDP at constant prices’ which is the value
of domestic product in terms of constant prices of a chosen base year. Real GDP

changes only when production changes. As a rule, when prices are changing
drastically, nominal GDP and real GDP diverge substantially. The converse is true
when prices are more or less constant. For example, the GDP of 2015-16 may be
expressed either at prices of that year or at prices that prevailed in 2011-12. In the
former case, GDP will be affected by price changes, but in the latter case GDP will
change only when there has been a change in physical output.
1.3.3 Gross National Product (GNP)
Gross National Product (GNP) is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory
of a country by normal residents during an accounting year including net factor
incomes from abroad. Gross National Product (GNP) is evaluated at market prices
and therefore it is in fact Gross National Product at market prices (GNP MP).
GNP MP = GDP MP + Net Factor Income from Abroad
GDP MP = GNP MP – Net Factor Income from Abroad

NFIA is the difference between the aggregate amount that a country's citizens and
companies earn abroad, and the aggregate amount that foreign citizens and
overseas companies earn in that country.
If Net Factor Income from Abroad is positive, then GNP MP would be greater than
GDP MP.
You might have noticed that the distinction between ‘national’ and ‘domestic’ is
net factor income from abroad.
National = Domestic + Net Factor Income from Abroad

The two concepts GDP and GNP differ in their treatment of international
transactions. The term ‘national’ refers to normal residents of a country who may
be within or outside the domestic territory of a country and is a broader concept
compared to the term ‘domestic’. For example, GNP includes earnings of Indian
corporations overseas and Indian residents working overseas; but GDP does not
include these. In other words, GDP excludes net factor income from abroad.
Conversely, GDP includes earnings from current production in India that accrue to
foreign residents or foreign-owned firms; GNP excludes those items. For instance,
profits earned in India by X Company, a foreign-owned firm, would be included in

GDP but not in GNP. Similarly, profits earned by Company Y, an Indian company in
UK would be excluded from GDP, but included in GNP.
1.3.4 Net Domestic Product at market prices (NDP MP)
Net domestic product at market prices (NDP MP) is a measure of the market value
of all final economic goods and services, produced within the domestic territory of
a country by its normal residents and non residents during an accounting year less
depreciation. The portion of the capital stock used up in the process of production
or depreciation must be subtracted from final sales because depreciation
represents capital consumption and therefore a cost of production.
NDP MP = GDP MP – Depreciation

NDP MP = NNP MP – Net Factor Income from Abroad
As you are aware, the basis of distinction between ‘gross’ and ‘net’ is depreciation
or consumption of fixed capital.
Gross = Net + Depreciation or Net = Gross – Depreciation
1.3.5 Net National Product at Market Prices (NNP MP)

Net National Product at Market Prices (NNP MP) is a measure of the market value of
all final economic goods and services, produced by normal residents within the
domestic territory of a country including Net Factor Income from Abroad during an
accounting year excluding depreciation.
NNP MP = GNP MP – Depreciation

NNP MP = NDP MP + Net Factor Income from Abroad
NNP MP = GDP MP + Net Factor Income from Abroad – Depreciation
1.3.6 Gross Domestic Product at Factor Cost (GDPFC)

The production and income approach (which we will discuss later in this unit)
measure the domestic product as the cost paid to the factors of production.
Therefore, it is known as ‘domestic product at factor cost’. GDP at factor cost is
called so because it represents the total cost of factors viz. labor, capital and
entrepreneurship.

At this stage, we need to clearly understand the difference between the concepts:
‘market price’ and ‘factor cost.’ In addition to factor cost, the market value of the
goods and services will include indirect taxes which are:
• product taxes like excise duties, customs, sales tax, service tax etc., levied by
the government on goods and services, and
• taxes on production, such as, factory license fee, taxes to be paid to the local
authorities, pollution tax etc. which are unrelated to the quantum of
production.
You might have noticed that the government gives subsidy to many goods and
services. The market price will be lower by the amount of subsidies on products
and production which the government pays to the producer. Hence, the market
value of final expenditure would exceed the total obtained at factor cost by the
amount of product and production taxes reduced by the value of similar kinds of
subsidies. Direct taxes do not have the same effect since they do not impinge
directly on transactions but are levied directly on the incomes. For example if the
factor cost of a unit of good X is ` 50/, indirect taxes amount to ` 15/per unit and
the government gives a subsidy of ` 10/per unit, then market price will be ` 55/-
Thus, we find that the basis of distinction between market price and factor cost is
net indirect taxes (i.e., Indirect taxes - Subsidies).
Market Price = Factor Cost + Net Indirect Taxes

= Factor Cost + Indirect Taxes – Subsidies
Factor Cost = Market Price - Net Indirect Taxes

= Market Price - Indirect Taxes + Subsidies
Gross Domestic Product at Factor Cost (GDPFC)
= GDP MP – Indirect Taxes + Subsidies

= Compensation of employees
+ Operating Surplus (rent + interest+ profit)

+ Mixed Income of Self- employed

+ Depreciation
1.3.7 Net Domestic Product at Factor Cost (NDPFC)

Net Domestic Product at Factor Cost (NDPFC) is defined as the total factor incomes
earned by the factors of production. In other words, it is sum of domestic factor
incomes or domestic income net of depreciation.
As mentioned above, market price includes indirect taxes imposed by
government. We have to deduct indirect taxes and add the subsidies in order to
calculate that part of domestic product which actually accrues to the factors of
production. The measure that we obtain so is called Net Domestic Product at factor
cost.
NDPFC = NDP MP – Net Indirect Taxes

= Compensation of employees
1.3.8 Net National Product at Factor Cost (NNPFC) or National Income

National Income is defined as the factor income accruing to the normal residents
of the country during a year. It is the sum of domestic factor income and net factor
income from abroad. In other words, national income is the value of factor income
generated within the country plus factor income from abroad in an accounting year.
NNPFC = National Income = FID (factor income earned in domestic territory) + NFIA.
If NFIA is positive, then national income will be greater than domestic factor
incomes.
1.3.9 Per Capita Income
The GDP per capita is a measure of a country's economic output per person. It is
obtained by dividing the country’s gross domestic product, adjusted by inflation,
by the total population. It serves as an indicator of the standard of living of a
country.

1.3.10 Personal Income

While national income is income earned by factors of production, Personal Income
is the income received by the household sector including Non-Profit Institutions
Serving Households. Thus, national income is a measure of income earned and
personal income is a measure of actual current income receipts of persons from all
sources which may or may not be earned from productive activities during a given
period of time. In other words, it is the income ‘actually paid out’ to the household
sector, but not necessarily earned. Examples of this include transfer payments such
as social security benefits, unemployment compensation, welfare payments etc.
Individuals also contribute income which they do not actually receive; for example,
undistributed corporate profits and the contribution of employers to social security.
Personal income forms the basis for consumption expenditures and is derived from
national income as follows:
PI = NI + income received but not earned – income earned but not

received.
An important point to remember is that national income is not the sum of personal
incomes because personal income includes transfer payments ( eg. pension) which
are excluded from national income. Also, not all national income accrues to
individuals as their personal income.
1.3.11 Disposable Personal Income (DI)
Disposable personal income is a measure of amount of the money in the hands of
the individuals that is available for their consumption or savings. Disposable
personal income is derived from personal income by subtracting the direct taxes
paid by individuals and other compulsory payments made to the government.
DI = PI - Personal Income Taxes
1.4 MEASUREMENT OF NATIONAL INCOME IN INDIA

National Accounts Statistics (NAS) in India are compiled by National Accounts
Division in the Central Statistics Office, Ministry of Statistics and Programme
Implementation. Annual as well as quarterly estimates are published. This
publication is the key source-material for all macroeconomic data of the country.
As per the mandate of the Fiscal Responsibility and Budget Management Act 2003,
the Ministry of Finance uses the GDP numbers (at current prices) to determine the
fiscal targets.

The Ministry of Statistics and Programme Implementation has released the new
series of national accounts, revising the base year from 2004-05 to 2011-12. In the
revision of National Accounts statistics done by Central Statistical Organization
(CSO) in January 2015, it was decided that sector-wise estimates of Gross Value
Added (GVA) will now be given at basic prices instead of at factor cost. In simple terms,
for any commodity the ‘basic price’ is the amount receivable by the producer from
the purchaser for a unit of a product minus any tax on the product plus any subsidy on
the product.
1.4.1 The Circular Flow of Income
Circular flow of income refers to the continuous circulation of production, income
generation and expenditure involving different sectors of the economy. There are
three different interlinked phases in a circular flow of income, namely: production,
distribution and disposition as can be seen from the following figure.
Figure 1.1.1
Circular Flow of Income
Production of
goods and
services
Disposition Distribution as
Consumption factor incomes
/Investment (Rent , Wages,
Interest ,Profit
(i) In the production phase, firms produce goods and services with the help of
factor services.
(ii) In the income or distribution phase, the flow of factor incomes in the form of
rent, wages, interest and profits from firms to the households occurs

(iii) In the expenditure or disposition phase, the income received by different

factors of production is spent on consumption goods and services and
investment goods. This expenditure leads to further production of goods and
services and sustains the circular flow.
These processes of production, distribution and disposition keep going on
simultaneously and enable us to look at national income from three different angles
namely: as a flow of production or value added, as a flow of income and as a flow
of expenditure. Each of these different ways of looking at national income suggests
a different method of calculation and requires a different set of data. The details in
respect of what is measured and what data are required for all three methods
mentioned above are given in the following table.
Table 1.1.1
Data requirements and Outcomes of Different Methods of National Income
Calculation
Method Data required What is measured
Phase of Output: Value The sum of net values added Contribution of production
added method (Product by all the producing units

Method) enterprises of the country
Phase of income : Income Total factor incomes Relative contribution of
Method generated in the production factor owners

of goods and services
Phase of disposition: Sum of expenditures of the Flow of consumption and

Expenditure method three spending units in the investment expenditures
economy, namely,
government, consumer
households, and producing
enterprises
Corresponding to the three phases, there are three methods of measuring national
income. They are: Value Added Method (alternatively known as Product Method);
Income Method; and Expenditure Method.

1.4.2 Value Added Method or Product Method

Product Method or Value Added Method is also called Industrial Origin Method or
Net Output Method. National income by value added method is the sum total of
net value added at factor cost across all producing units of the economy. The value
added method measures the contribution of each producing enterprise in the
domestic territory of the country in an accounting year and entails consolidation of
production of each industry less intermediate purchases from all other industries.
This method of measurement shows the unduplicated contribution by each
industry to the total output. This method involves the following steps:
Step 1. Identifying the producing enterprises and classifying them into different
sectors according to the nature of their activities
All the producing enterprises are broadly classified into three main sectors namely:
(i) Primary sector,
(ii) Secondary sector, and
(iii) Tertiary sector or service sector
These sectors are further divided into sub-sectors and each sub-sector is further
divided into commodity group or service-group.
Step 2. Estimating the gross value added (GVA MP) by each producing enterprise
Gross value added (GVA MP) = Value of output – Intermediate

consumption
= (Sales + change in stock) –Intermediate
consumption
Step 3. Estimation of National income
For each individual unit, Net value added is found out.
∑ (GVA MP) – Depreciation = Net value added (NVA MP)
Adding the net value-added by all the units in one sub-sector, we get the net value-
added by the sub-sector. By adding net value-added or net products of all the sub-
sectors of a sector, we get the value-added or net product of that sector. For the
economy as a whole, we add the net products contributed by each sector to get
Net Domestic Product. We subtract net indirect taxes and add net factor income
from abroad to get national income.

Net value added (NVA MP) – Net Indirect taxes = Net Domestic
Product (NVA FC)
Net Domestic Product (NVA FC ) + (NFIA) = National Income (NNP FC )
The values of the following items are also included:

(i) Own account production of fixed assets by government, enterprises and
households.
(ii) Production for self- consumption, and
(iii) Imputed rent of owner occupied houses.
1.4.3 Income Method
Production is carried out by the combined effort of all factors of production. The
factors are paid factor incomes for the services rendered. In other words, whatever
is produced by a producing unit is distributed among the factors of production for
their services.
Under Factor Income Method, also called Factor Payment Method or Distributed
Share Method, national income is calculated by summation of factor incomes paid
out by all production units within the domestic territory of a country as wages and
salaries, rent, interest, and profit. By definition, it includes factor payments to both
residents and non- residents.
Thus,
NDP FC = Sum of factor incomes paid out by all production units within the
domestic territory of a country
NNP FC or National Income = Compensation of employees

+ Net Factor Income from Abroad
Only incomes earned by owners of primary factors of production are included in
national income. Transfer incomes are excluded from national income. Thus, while
wages of labourers will be included, pensions of retired workers will be excluded
from national income. Labour income includes, apart from wages and salaries,

bonus, commission, employers’ contribution to provident fund and compensations

in kind. Non-labour income includes dividends, undistributed profits of
corporations before taxes, interest, rent, royalties and profits of unincorporated
enterprises and of government enterprises.
However, normally, it is difficult to separate labour income from capital income
because in many instances people provide both labour and capital services. Such is
the case with self-employed people like lawyers, engineers, traders, proprietors etc.
In economies where subsistence production and small commodity production is
dominant, most of the incomes of people would be of mixed type. In sectors such
as agriculture, trade, transport etc. in underdeveloped countries (including India),
it is difficult to differentiate between the labour element and the capital element of
incomes of the people. In order to overcome this difficulty a new category of
incomes, called ‘mixed income’ is introduced which includes all those incomes
which are difficult to separate.
1.4.4 Expenditure Method
In the expenditure approach, also called Income Disposal Approach, national
income is the aggregate final expenditure in an economy during an accounting
year. In the expenditure approach to measuring GDP, we add up the value of the
goods and services purchased by each type of final user mentioned below.
1. Final Consumption Expenditure
(a) Private Final Consumption Expenditure (PFCE)
To measure this, the volume of final sales of goods and services to
consumer households and nonprofit institutions serving households
acquired for consumption (not for use in production) are multiplied by
market prices and then summation is done. It also includes the value of
primary products which are produced for own consumption by the
households, payments for domestic services which one household renders
to another, the net expenditure on foreign financial assets or net foreign
investment. Land and residential buildings purchased or constructed by
households are not part of PFCE. They are included in gross capital
formation. Thus, only expenditure on final goods and services produced in
the period for which national income is to be measured and net foreign
investment are included in the expenditure method of calculating national
income.
(b) Government Final Consumption Expenditure

Since the collective services provided by the governments such as defence,

education, healthcare etc are not sold in the market, the only way they can be
valued in money terms is by adding up the money spent by the government in the
production of these services. This total expenditure is treated as consumption
expenditure of the government. Government expenditure on pensions,
scholarships, unemployment allowance etc. should be excluded because these are
transfer payments.
2. Gross Domestic Capital formation
Gross domestic fixed capital formation includes final expenditure on machinery and
equipment and own account production of machinery and equipments,
expenditure on construction, expenditure on changes in inventories, and
expenditure on the acquisition of valuables such as, jewelry and works of art.
3. Net Exports
Net exports are the difference between exports and imports of a country during
the accounting year. It can be positive or negative.
How do we arrive at national income or NNP FC using expenditure method ? We
first find the sum of final consumption expenditure, gross domestic capital
formation and net exports. The resulting figure is gross domestic product at market
price ( GDP MP ). To this, we add the net factor income from abroad and obtain
Gross National Product at market price (GNP MP). Subtracting indirect taxes from
GNP MP, we get Gross National Product at factor cost (GNP FC). National income or
NNP FC is obtained by subtracting depreciation from Gross national product at
factor cost (GNP FC).
Ideally, all the three methods of national income computation should arrive at the
same figure. When national income of a country is measured separately using these
methods, we get a three dimensional view of the economy. Each method of
measuring GDP is subject to measurement errors and each method provides a
check on the accuracy of the other methods. By calculating total output in several
different ways and then trying to resolve the differences, we will be able to arrive
at a more accurate measure than would be possible with one method alone.
Moreover, different ways of measuring total output give us different insights into
the structure of our economy.
Income method may be most suitable for developed economies where people
properly file their income tax returns. With the growing facility in the use of the
commodity flow method of estimating expenditures, an increasing proportion of

the national income is being estimated by expenditure method. As a matter of fact,

countries like India are unable to estimate their national income wholly by one
method. Thus, in agricultural sector, net value added is estimated by the production
method, in small scale sector net value added is estimated by the income method
and in the construction sector net value added is estimated by the expenditure
method.
1.5 THE SYSTEM OF REGIONAL ACCOUNTS IN INDIA

Regional accounts provide an integrated database on the innumerable transactions
taking place in the regional economy and help decision making at the regional
level. At present, practically all the states and union territories of India compute
state income estimates and district level estimates. State Income or Net State
Domestic Product (NSDP) is a measure in monetary terms of the volume of all
goods and services produced in the state within a given period of time (generally
a year) accounted without duplication. Per Capita State Income is obtained by
dividing the NSDP (State Income) by the midyear projected population of the state.
The state level estimates are prepared by the State Income Units of the respective
State Directorates of Economics and Statistics (DESs). The Central Statistical
Organisation assists the States in the preparation of these estimates by rendering
advice on conceptual and methodological problems. In the preparation of state
income estimates, certain activities such as are railways, communications, banking
and insurance and central government administration, that cut across state
boundaries, and thus their economic contribution cannot be assigned to any one
state directly are known as the ‘Supra-regional sectors’ of the economy. The
estimates for these supra regional activities are compiled for the economy as a
whole and allocated to the states on the basis of relevant indicators.
1.6 LIMITATIONS AND CHALLENGES OF NATIONAL INCOME

COMPUTATION
There are innumerable limitations and challenges in the computation of national
income. The task is more complex in underdeveloped and developing countries.
Following are the general dilemmas in measurement of national income. GDP
measures ignore the following:
(a) Income distributions and, therefore, GDP per capita is a completely inadequate
measure of welfare. Countries may have significantly different income

distributions and, consequently, different levels of overall well-being for the

same level of per capita income.
(b) Quality improvements in systems and processes due to technological as well
as managerial innovations which reflect true growth in output from year to
year.
(c) Productions hidden from government authorities, either because those
engaged in it are evading taxes or because it is illegal (drugs, gambling etc).
(d) Non-market production (with a few exceptions) and Non-economic
contributors to well-being for example: health of a country’s citizens, education
levels, political participation, or other social and political factors that may
significantly affect well-being levels.
(e) The dis-utility of loss of leisure time. We know that, other things remaining
the same, a country’s GDP rises if the total hours of work increase.
(f) Economic ’bads’ for example: crime, pollution, traffic congestion etc which
make us worse off.
(g) The volunteer work and services rendered without remuneration undertaken in
the economy, even though such work can contribute to social well-being as
much as paid work.
(h) Many things that contribute to our economic welfare such as, leisure time,
fairness, gender equality, security of community feeling etc.,
(i) The distinction between production that makes us better off and production
that only prevents us from becoming worse off, for e.g. defence expenditures
such as on police protection. Increased expenditure on police due to increase
in crimes may increase GDP but these expenses only prevent us from becoming
worse off. However, no reflection is made in national income of the negative
impacts of higher crime rates. As another example, automobile accidents result
in production of repairs, output of medical services, insurance, and legal
services all of which are production included in GDP just as any other
production.
There are many conceptual difficulties related to measurement which are difficult
to resolve, such as:
(a) lack of an agreed definition of national income,
(b) accurate distinction between final goods and intermediate goods,

(c) issue of transfer payments,

(d) services of durable goods,
(e) difficulty of incorporating distribution of income
(f) valuation of a new good at constant prices, and
(g) valuation of government services
Other challenges relate to:
(a) Inadequacy of data and lack of reliability of available data,
(b) presence of non-monetised sector,
(c) production for self-consumption,
(d) absence of recording of incomes due to illiteracy and ignorance,
(e) lack of proper occupational classification, and
(f) accurate estimation of consumption of fixed capital
SUMMARY
• National income accounts are extremely useful for analyzing and evaluating
the performance of an economy, knowing the composition and structure of the
national income, income distribution, economic forecasting and for choosing
economic policies and evaluating them..
• Gross domestic product (GDP MP) is a measure of the market value of all final
economic goods and services, gross of depreciation, produced within the
domestic territory of a country during a given time period gross of
depreciation.
• Capital goods (business plant and equipment purchases) and inventory
investment—the net change in inventories of final goods awaiting sale or of
materials used in the production are counted in GDP
• To eliminate the effect of prices, in addition computing GDP in terms of current
market prices, termed ‘nominal GDP’ or GDP at current prices, the national
income accountants also calculate ‘real GDP ’or GDP at constant prices which
is the value of domestic product in terms of constant prices of a chosen base
year.
• GNP MP = GDP MP + Net Factor Income from Abroad

• NDP MP = GDP MP - Depreciation

• NDP MP = NNP MP - Net Factor Income from Abroad
• NNP MP = GNP MP - Depreciation
• Market Price = Factor Cost + Net Indirect Taxes= Factor Cost + Indirect Taxes
– Subsidies
• Gross Domestic Product at Factor Cost (GDPFC) = GDP MP – Indirect Taxes +
Subsidies
• Net Domestic Product at Factor Cost (NDPFC) is defined as the total factor
incomes earned by the factors of production.
• Net National Product at Factor Cost (NNPFC) or National Income
• NNPFC = National Income = FID (factor income earned in domestic territory) +
NFIA.
• Personal income is a measure of the actual current income receipt of persons
from all sources. Disposable Personal Income (DI) that is available for their
consumption or savings DI = PI - Personal Income Taxes
• Circular flow of income refers to the continuous interlinked phases in
circulation of production, income generation and expenditure involving
different sectors of the economy.
• Product Method or Value Added Method is also called Industrial Origin
Method or Net Output Method and entails the consolidation of the production
of each industry less intermediate purchases from all other industries.
• Under income method, national income is calculated by summation of factor
incomes paid out by all production units within the domestic territory of a
country as wages and salaries, rent, interest, and profit. Transfer incomes are
excluded.
• Under the expenditure approach, also called Income Disposal Approach,
national income is the aggregate final expenditure in an economy during an
accounting year composed of final consumption expenditure, gross domestic
capital formation and net exports.

TEST YOUR KNOWLEDGE

I Multiple Choice Type Questions
1. The concept of ‘resident unit’ involved in the definition of GDP denotes
(a) A business enterprise which belongs to a citizen of India with production
units solely situated in India
(b) the unit having predominant economic interest in the economic territory
of the country for one year or more irrespective of the nationality or legal
status
(c) A citizen household which had been living in India during the accounting
year and one whose economic interests are solely in India
(d) Households and business enterprises composed of citizens of India alone
living in India during the accounting year
2. Read the following statements and answer the following question.
I. Intermediate consumption consists of the value of the goods and services
consumed as inputs by a process of production,
II. Intermediate consumption excludes fixed assets whose consumption is
recorded as consumption of fixed capital.
(a) Only I is true
(b) Both I and II are true
(c) Only II is true
(d) Neither I nor II is true
3. Gross Domestic Product (GDP) of any nation
(a) excludes capital consumption and intermediate consumption
(b) is inclusive of capital consumption or depreciation
(c) is inclusive of indirect taxes but excludes subsidies
(d) None of the above
4. While computing Gross Domestic Product (GDP), intermediate goods
(a) are counted as part of final consumption expenditure
(b) are counted on a value added basis but excluded from gross output

(c) are not counted as it would involve double counting

(d) are treated as stock in trade and therefore included in computation
5. Read the following statements
I ‘Value added’ refer to the difference between value of output and
purchase of intermediate goods.
II. Value added’ represent the contribution of labour and capital to the
production process.
(a) Statements I and II are incorrect
(b) Statements I and II are correct
(c) Statement I is correct and II is incorrect
(d) Statement II is correct and I is incorrect
6. Non-economic activities are
(a) those activities whose value is excluded from national income calculation
as it will involve double counting
(b) those which produce goods and services, but since these are not
exchanged in a market transaction they do not command any market value
(c) those which do not involve production of goods and services as they are
meant to provide hobbies and leisure time activities
(d) those which result in production for self consumption and therefore not
included in national income calculation
7 Which of the following does not enter into the calculation of national income?
(a) exchange of previously produced goods
(b) exchange of second hand goods
(c) exchange of stocks and bonds
(d) all the above
8. Which of the following enters into the calculation of national income?
(a) the value of the services that accompany the sale
(b) Additions to inventory stocks of final goods and materials

(c) Stocks and bonds sold during eth current year

(d) (a) and (b) above
9. Nominal GDP is
(a) GDP at current prices
(b) GDP at constant prices
(c) Real GDP
(d) (a) and (c) above
10 Gross National Product at market prices GNP MP is
(a) GDP MP + Net Factor Income from Abroad
(b) GDP MP - Net Factor Income from Abroad
(c) GDP MP - Depreciation
(d) GDP MP + Net Indirect Taxes
11. Choose the correct statement
(a) GNP includes earnings of Indian corporations overseas and Indian
residents working overseas; but GDP does not include these
(b) NNPFC = National Income = FID (factor income earned in domestic
territory) -NFIA.
(c) capital goods and inventory investment are excluded from computation of
GDP
(d) NDP MP = GDP MP + Depreciation
12. The basis of distinction between market price and factor cost is
(a) net factor income from abroad
(b) net indirect taxes (i.e., Indirect taxes - Subsidies)
(c) net indirect taxes (i.e., Indirect taxes + Subsidies)
(d) depreciation ( consumption of fixed capital)
13. If net factor income from abroad is positive, then
(a) national income will be greater than domestic factor incomes.
(b) national income will be less than domestic factor incomes.

(c) net exports will be negative

(d) domestic factor incomes will be greater than national income
14. The GDP per capita is
(a) a measure of a country's economic output per person
(b) actual current income receipts of persons
(c) national income divided by population
15. The new series of national accounts in India, is published revising the base year
from
(a) 2004-05 to 2011-12
(b) 2004-05 to 2010-11.
(c) 2004-05 to 2014-15.
16. Which of the following is an example of transfer payment?
(a) Old age pensions and family pensions
(b) Scholarships given to deserving diligent students.
(c) Compensation given for loss of property due to floods
(d) All the above
17. Mixed income of the self -employed means
(a) net profits received by self -employed people
(b) outside wages received by self- employed people
(c) combined factor payments which are not distinguishable,
(d) wages due to non- economic activities
18. Demand for final consumption arises in
(a) household sector only
(b) government sector only

(c) both household and government sectors

(d) neither household nor government sector
19. GDP per capita is a completely inadequate measure of welfare because
(a) It reflects only incomes accrued not earned
(b) It does not reflect distribution of income among people
(c) It is usually low in underdeveloped countries
(d) Net factor income from abroad is not included in it
20. Which of the following is added to national income while calculating personal
income?
(a) Transfer payments to individuals
(b) Undistributed profits of corporate
(c) Transfer payments made to foreigners
(d) Mixed income of self employed
II Short Answer Type Questions
1. Define national income
2. What function does the System of National accounts (SNA) serve?
3. Define GDP MP
4. What do you understand by ‘final goods’?

5. Distinguish between Intermediate goods and final goods
6. Distinguish between non-economic activities and economic activities
7. Distinguish between nominal GDP and real GDP
8. Draw the basis if distinction between GDP current and constant prices
9. What is the difference between ‘national’ and ‘domestic’?
10. What do you understand by ‘factor cost’
11. Differentiate between ‘taxes on production’ and ‘product taxes’
12. Define ‘mixed income of self- employed’
13. Define Per Capita Income

14. How does Personal Income differ from Disposable Personal Income?
15. Define ‘Private income’ as used in India
16. Illustrate the circular flow of income
17. How do you arrive at ‘gross value added’
18. What is meant by intermediate consumption?
19. How is production for self consumption treated in national income accounts?
20. Define ‘Net Factor Income from Abroad’
21. What is meant by the term ‘net exports’
III Long Answer Type Questions
1. Define national income and explain the usefulness of national income
estimates
2. Describe the generally used concepts of national income
3. What are the different methods of calculation of national income
4. Explain the term Gross Domestic Product (GDP). How is it estimated?
5. Distinguish between GDP current and constant prices. What purpose does real
GDP serve?
6. What is the difference between the concepts ‘market price’ and ‘factor cost in
national income accounting?
7. Illustrate the circular flow of income and describe its relevance for
measurement of national income
8. Explain Value Added Method as applied in national income? accounting
9. How is national income calculated under ‘Income Method’?
10. Explain ‘Expenditure Method’ for calculation of national income?
11. Write notes on the system of regional accounts in India
12. Explain with illustrations the limitations of national income computation?

IV Application Oriented Questions

1. Compute National income
Consumption 750
Investment 250
Government Purchases 100
Exports 100
Imports 200
2. Calculate Gross Domestic Product at market Prices (GDPMP) and derive national
income from the following data (in Crores of Rupees)
Inventory Investment 100
Exports 200
Indirect taxes 100
Net factor income from abroad - 50
Personal consumption expenditure 3500
Gross residential construction investment 300
Depreciation 50
Imports 100
Government purchases of goods and services 1000
Gross public investment 200
Gross business fixed investment 300
3. Find GDPMP and GNP MP from the following data (in Crores of Rs) using income
method. Show that it is the same as that obtained by expenditure method.

Personal Consumption 7,314
Depreciation 800
Wages 6,508
Indirect Business Taxes 1,000
Interest 1,060
Domestic Investment 1,482
Government Expenditures 2,196
Rental Income 34
Corporate Profits 682
Exports 1,346
Net Factor Income from Abroad 40
Mixed Income 806
Imports 1,408
4. From, the following data calculate the Gross National Product at Market Price
using Value Added method
(` in Crores)
Value of output in primary sector 500
Net factor income from abroad -20
Value of output in tertiary sector 700
Intermediate consumption in secondary sector 400
Value of output in secondary sector 900
Government Transfer Payments 600

700
Intermediate consumption in tertiary sector 300
Intermediate consumption in primary sector 250
Value of output in secondary sector 900
Intermediate consumption in secondary sector 300
ANSWERS/HINTS
1 b 6 b 11 a 16 d
2 b 7 d 12 b 17 c
3 b 8 d 13 a 18 c
4 c 9 a 14 d 19 b
5 b 10 a 15 a 20 a
II Hints to Short Type Questions
1. The net value of all economic goods and services produced within the domestic
territory of a country in an accounting year plus the net factor income from
abroad/ the sum total of factor incomes generated by the normal residents of
a country in the form of wages, rent , interest and profit in an accounting year’
2. SNA, developed by United Nations, provide a comprehensive conceptual and
accounting framework for compiling and reporting macroeconomic statistics
for analysing and evaluating the performance of an economy.
3. GDP MP is the market value of all final economic goods and services, gross of
depreciation, produced within the domestic territory of a country during a
given time period.
4. ‘Value added’ we mean the difference between value of output and purchase
of intermediate goods.
5. Intermediate goods used to produce other goods rather than being sold to
final purchasers are not counted as it would involve double counting whereas
final goods are those that meant for final consumption

6. Economic activities as distinguished from non-economic activities include all

human activities which create goods and services that can be valued at market
price .Non-economic activities are those which produce goods and service, but
are not exchanged in a market transaction so that do not command any market
value.
7. GDP in terms of current market prices, termed ‘nominal GDP’ or GDP at current
prices, the national income accountants also calculate ‘real GDP ’or GDP at
constant prices which is the value of domestic product in terms of constant
prices of a chosen base year.
8. Refer Hint 7 above.
9. The term ‘national’ refers to normal residents of a country who may be within
or outside the domestic territory of a country and is a broader concept
compared to the term ‘domestic’ which refers to the domestic territory of the
country.
10. Factor Cost = Market Price - Net Indirect Taxes = Market Price - Indirect
Taxes + Subsidies
11. Product taxes are related to the quantum of production are levied by the
government on goods and services and other taxes on production, factory,
license fee, pollution tax which is. These taxes are known as indirect taxes.
12. Mixed income includes all those incomes which are difficult to separate eg.
labour income from capital income because people provide both labour and
capital services.
13. The GDP per capita is a measure of a country's economic output per person. It
is obtained by dividing the country’s gross domestic product, adjusted by
inflation, by the total population.
14. Personal income is a measure of the actual current income receipt of persons
from all sources. Disposable personal income is what is available for their
consumption or savings and is derived from personal income by subtracting
the direct taxes paid by individuals and other compulsory payments made to
the government.
15. National income plus the sum of government transfer payments and interest
on national debt and subtracting the property income of government
departments and profits of government enterprises.

16. Circular flow of income refers to the continuous circulation of production,

income generation and expenditure involving different sectors of the economy.
Illustrate
17. Used in the process of production , not counted to avoid double counting
18. Intermediate consumption consists of the value of the goods and services
consumed as inputs by a process of production, excluding fixed assets whose
consumption is recorded as consumption of fixed capital; the goods or services
may be either transformed or used up by the production process.
19. Production for self consumption added under Value Added Method
20. The difference between the aggregate amount that a country's citizens and
companies earn abroad, and the aggregate amount that foreign citizens and
overseas companies earn in that country.
21. Net exports are the difference between exports and imports of a country
during the accounting year. It can be positive or negative.
III Hints to Long Type Questions/ Application Oriented Questions
I. The length of the answer should relate to the marks allotted.
II. The answer should be structured in three parts in the following style.
(a) Explain the economic fundamentals underlying the action/issue by
integrating the course material in innovative ways; not necessarily
confined to one unit. This part provides an opportunity for students to
explain their understanding of the underlying theory. The examiner may
easily discern the level of cognition of the student. This should be a
compulsory component with a reasonably high proportion of marks
earmarked.
(b) Analyse the issue at hand (given the framework and tools) and explain the
policy position by applying the fundamentals as explained in (a) above.
Substantiate with illustrations from current economic scenario
IV Application Oriented Question
1. Expenditure Method: National income equals domestic spending
Y = C + I + G + (X – M)
(C + I + G = 1100) plus exports (X = 100) less imports (M = 200). Y = 1000

2. Expenditure Method
GDPMP = Personal consumption expenditure + Gross Investment (Gross
business fixed investment + inventory investment) + Gross residential
construction investment + Gross public investment + Government purchases
of goods and services + Net Exports (Exports-imports)
GNPMP = GDPMP +Net factor income from abroad
GNPMP - Indirect Taxes = GNP FC
GNP FC – Depreciation = NNP FC (National Income)

GDP Mp = `
Personal consumption expenditure = 3500
+ Gross Investment = 900
which include (Gross Business fixed investment = 300
Gross residential construction investment = 300
Gross public investment = 200
Inventory investment = 100)
+ Government purchases of goods arid services = 1000
+ Net exports which include: = 100
(Exports = 200
Imports = 100)
GDP Mp = = 5500 Crores
+Net Factor Income From Abroad = -50
GNP MP = = 5450 Crores -
-Indirect Taxes = 100
GNP FC = 5350 Crores
- Depreciation = 50
NNP FC (National Income) = 5300 Crores

3. Income Method
GDPMP = Employee compensation (wages and salaries + employers'
contribution towards social security schemes) + profits + rent + interest +
mixed income + depreciation + net indirect taxes (Indirect taxes - subsidies)
GDPMP = 6,508+ 34 + 1060 + 806+ 682 + 1,000 + 800 = 10,890
GNP MP = GDPMP + NFIA =10,890+ 40 =10,930
Expenditure Method
Y = C + I + G + (X – M)
Y = 7314 + 1482 + 2196+ (1346 –1408)
Y = (7314 + 1482 + 2196) – 62
Y = 10930
GNP MP = GDPMP + NFIA =10,890+ 40 =10,930
4. GDPMP = (Value of output in primary sector - intermediate consumption of
primary sector) + (value of output in secondary sector - intermediate
consumption of secondary sector) + (value of output in tertiary sector -
intermediate consumption of tertiary sector)
Value of output in primary sector = 500
- Intermediate consumption of primary sector = 250
+ Value of output in secondary sector = 900
- Intermediate consumption in secondary sector = 300
+ Value of output in tertiary sector = 700
- Intermediate consumption of tertiary sector = 300
GDP MP = ` 1250 Crores

UNIT II: THE KEYNESIAN THEORY OF
DETERMINATION OF NATIONAL INCOME
LEARNING OUTCOMES
 Define Keynes’ concept of equilibrium aggregate income
 Describe the components of aggregate expenditure in two,
three and four sector economy models

 Explain national income determination in two, three and four
sector economy models

 Illustrate the functioning of multiplier, and
 Outline the changes in equilibrium aggregate income on

account of changes in its determinants
Determination of National
Income
The Keynesian Theory of

Determination of National
Income
The Determination of Determination of

The Two-Sector Model
Investment Equilibrium Income : Equilibrium
for National Income
Multiplier Three Sector Model Income : Four
Determination
Sector Model

2.1 INTRODUCTION
In the last unit on measurement of national income, we have developed theoretical
insights into the different concepts of national income and methods of
measurement. In this unit, we shall focus on two issues namely, the factors that
determine the level of national income and the determination of equilibrium
aggregate income and output in an economy. A comprehensive theory to explain
these phenomena was first put forward by the British economist John Maynard
Keynes in his masterpiece ‘The General Theory of Employment Interest and Money’
published in 1936. The Keynesian theory of income determination is presented in
three models:
(i) The two-sector model consisting of the household and the business sectors,
(ii) The three-sector model consisting of household, business and government
sectors, and
(iii) The four-sector model consisting of household, business, government and
foreign sectors
Before we attempt to explain the determination of income in each of the above
models, it is pertinent that we understand the concept of circular flow in an
economy which explains the functioning of an economy.
2.2 CIRCULAR FLOW IN A SIMPLE TWO-SECTOR MODEL

Initially we consider a hypothetical simple two-sector economy. Even though an
economy of this kind does not exist in reality, it provides a simple and convenient
basis for understanding the Keynesian theory of income determination. The simple
two sector economy model assumes that there are only two sectors in the economy
viz., households and firms, with only consumption and investment outlays.
Households own all factors of production and they sell their factor services to earn
factor incomes which are entirely spent to consume all final goods and services
produced by business firms. The business firms are assumed to hire factors of
production from the households; they produce and sell goods and services to the
households and they do not save. There are no corporations, corporate savings or
retained earnings. The total income produced, Y, accrues to the households and
equals their disposable personal income Yd i.e., Y = Y d.
All prices (including factor prices), supply of capital and technology remain
constant. The government sector does not exist and therefore, there are no taxes,
government expenditure or transfer payments. The economy is a closed economy,

THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 1.37
i.e., foreign trade does not exist; there are no exports and imports and external
inflows and outflows. All investment outlay is autonomous (not determined either
by the level of income or the rate of interest); all investment is net and, therefore,
national income equals the net national product.
In the figure 1.2.1, the circular flow of income and expenditure which presents the
working of the two- sector economy is illustrated in a simple manner.
Figure 1.2.1
Circular Flow in a Two Sector Economy
The circular broken lines with arrows show factor and product flows and present
‘real flows’ and the continuous line with arrows show ‘money flows’ which are
generated by real flows. These two circular flows-real flows and money flows-are
in opposite directions and the value of real flows equal the money flows because
the factor payments are equal to household incomes. There are no injections into
or leakages from the system. Since the whole of household income is spent on
goods and services produced by firms, household expenditures equal the total
receipts of firms which equal value of output.
Factor Payments = Household Income= Household Expenditure =

Total Receipts of Firms = Value of Output.

Before we go into the discussion on the equilibrium aggregate income and changes
in it, we shall first try to understand the meaning of the term ‘equilibrium’ (defined
as a state in which there is no tendency to change; or a position of rest). Equilibrium
output occur when the desired amount of output demanded by all the agents in
the economy exactly equals the amount produced in a given time period. Logically,
an economy can be said to be in equilibrium when the production plans of the firms
and the expenditure plans of the households match.
Having understood the working of the two sector model and the meaning of
equilibrium output, we shall now have the formal presentation of the theory of
income determination in a two-sector model which is the simplest representation
of the key principles of Keynesian economics. To see the factors that determine the
level of income, first we consider the factors that affect the components of
aggregate demand namely, consumption and investment.
2.3 THE AGGREGATE DEMAND FUNCTION: TWO-SECTOR

MODEL
In a simple two-sector economy aggregate demand (AD) or aggregate expenditure
consists of only two components:
(i) aggregate demand for consumer goods (C), and
(ii) aggregate demand for investment goods (I)
AD = C + I (2. 1)
Of the two components, consumption expenditure accounts for the highest
proportion of the GDP. In a simple economy, the variable I is assumed to be
determined exogenously and constant in the short run. Therefore, the short-run
aggregate demand function can be written as:
AD = C + I̅ (2.2)
Where = constant investment.
From the equation (2.2), we can infer that, in the short run, AD depends largely on
the aggregate consumption expenditure. We shall now go over to the discussion
on consumption function.

2.3.1 The Consumption Function

The positive relationship between consumption spending and disposable income
is described by the consumption function. Consumption function expresses the
functional relationship between aggregate consumption expenditure and
aggregate disposable income, expressed as:
C = f (Y) (2.3)
The private demand for goods and services accounts for the largest proportion of
the aggregate demand in an economy and plays a crucial role in the determination
of national income. According to Keynes, the total volume of private expenditure
in an economy depends on the total current disposable income of the people and
the proportion of income which they decide to spend on consumer goods and
services. The specific form of consumption–income relationship termed the
consumption function, proposed by Keynes is as follows:
C = a + bY (2.4)
where C = aggregate consumption expenditure; Y = total disposable income; a is
a constant term which denotes the (positive) value of consumption at zero level of
disposable income; and the parameter b, the slope of the function, (∆C /∆Y) is the
marginal propensity to consume (MPC) i.e the increase in consumption per unit
increase in disposable income.
Figure 1.2.2
The Keynesian Consumption Function

The consumption function shows the level of consumption (C) corresponding to

each level of disposable income (Y) and is expressed through a linear consumption
function, as shown by the line marked C = f(Y) in figure 1.2.2. When income is low,
consumption expenditures of households will exceed their disposable income and
households dissave i.e. they either borrow money or draw from their past savings
to purchase consumption goods. The intercept for the consumption function, a,
can be thought of as a measure of the effect on consumption of variables other
than income, variables not explicitly included in this simple model.
The Keynesian assumption is that consumption increases with an increase in
disposable income, but that the increase in consumption will be less than the
increase in disposable income (b < 1). i.e. 0 < b < 1. This fundamental relationship
between income and consumption plays a crucial role in the Keynesian theory of
income determination.
2.3.2 Marginal Propensity to Consume (MPC)
The consumption function is based on the assumption that there is a constant
relationship between consumption and income, as denoted by constant b which is
marginal propensity to consume. The concept of MPC describes the relationship
between change in consumption (∆C) and the change in income (∆Y). The value of
the increment to consumer expenditure per unit of increment to income is termed
the Marginal Propensity to Consume (MPC).
∆𝐂𝐂
MPC = =b (2.5)
∆ 𝒀𝒀
Although the MPC is not necessarily constant for all changes in income (in fact, the
MPC tends to decline at higher income levels), most analysis of consumption
generally works with a constant MPC.
2.3.3 Average Propensity to Consume (APC)
Just as marginal propensity to consume, the average propensity to consume is a
ratio of consumption defining income consumption relationship. The ratio of total
consumption to total income is known as the average propensity to consume (APC).
Total Consumption 𝐂𝐂
APC = Total Income
= (2.6)
𝐘𝐘
The table below shows the relationship between income consumption and saving.

Table 2.1
Relationship between Income and Consumption
Income Consumption APC ( C/Y) MPC(∆C /∆Y) MPS(∆S

(Y) (C ) /∆Y)
(1-MPC)
0 500 500/0 = ∞ - -
1000 1250 1250/1000 = 1.25 750/1000 = 0.75 0.25
2000 2000 2000/2000 = 1.00 750/1000 = 0.75 0.25
3000 2750 2750/3000 = 0.92 750/1000 = 0.75 0.25
6000 5000 5000/6000 = 0.83 1500/2000 = 0.75 0.25
10,000 8000 8000/10,000 = 0.80 3000/4000 = 0.75 0.25
APC is calculated at various income levels. It is obvious that the proportion of

income spent on consumption decreases as income increases. What happens to the
rest of the income that is not spent on consumption? If it is not spent, it must be
saved because income is either spent or saved; there are no other used to which it
can be put. Thus, just as consumption, saving is a function of income. S=f(Y).
2.3.4 The Saving Function
In figure 1.2.3, the consumption and saving functions are graphed. The saving
function shows the level of saving (S) at each level of disposable income (Y). The
intercept for the saving function, (—a) is the (negative) level of saving at zero level
of disposable income at consumption equal to ‘a’ . By definition, national income Y
= C + S which shows that disposable income is, by definition, consumption plus
saving. Therefore, S = Y – C. Thus, when we represent the theory of the
consumption-income relationship, it also implicitly establishes the saving-income
relationship.

2.3.5 The Marginal Propensity to Save (MPS)

The slope of the saving function is the marginal propensity to save. If a one-unit
increase in disposable income leads to an increase of b units in consumption, the
remainder (1 - b) is the increase in saving. This increment to saving per unit increase
in disposable income (1 - b) is called the marginal propensity to save (MPS). In
other words, the marginal propensity to save is the increase in saving per unit
increase in disposable income.
∆𝐒𝐒
MPS = = 1- b (2.7)
∆𝐘𝐘
Marginal Propensity to Consume (MPC) is always less than unity, but greater than
zero, i.e., 0 < b < 1 Also, MPC + MPS = 1; we have MPS 0 < b < 1. Thus, saving is
an increasing function of the level of income because the marginal propensity to
save (MPS) = 1- b is positive, i.e. saving increase as income increases.
2.3.6 Average Propensity to Save (APS)
The ratio of total saving to total income is called average propensity to save (APS).
Alternatively, it is that part of total income which is saved.
Total Saving 𝐒𝐒
APS = Total Income = (2.8)
𝐘𝐘
In figure 2.3 showing the consumption and saving functions, the 45° line is drawn
to split the positive quadrant of the graph and shows the income-consumption
relation with Y = C (AD = Y) at all levels of income. All points on the 45° line indicate
that aggregate expenditure equal aggregate output; i.e. the value of the variables
measured on the vertical axis (C+I) is equal to the value of the variable measured
on the horizontal axis ( i.e. Y). Because aggregate expenditures equal total output
for all points along the 45-degree line, the line maps out all possible equilibrium
income levels. As long as the economy is operating at less than its full-employment
capacity, producers will produce any output along the 45-degree line that they
believe purchasers will buy.

Figure 1.2.3.
The Consumption and Saving Function
2.4 THE TWO-SECTOR MODEL OF NATIONAL INCOME

DETERMINATION
In this section, we shall describe the two-sector model of determination of
equilibrium levels of output and income in its formal form using the aggregate
demand function and the aggregate supply function. According to Keynesian
theory of income determination, the equilibrium level of national income is a

situation in which aggregate demand (C+ I) is equal to aggregate supply (C + S)

i.e.
C+I=C+S
or
I=S (2.9)
In a two sector economy, the aggregate demand (C+ I) refers to the total spending
in the economy i.e. it is the sum of demand for the consumer goods (C) and
investment goods (I) by households and firms respectively. In figure 1.2.4, the
aggregate demand curve is linear and positively sloped indicating that as the level
of national income rises, the aggregate demand (or aggregate spending) in the
economy also rises. The aggregate expenditure line is flatter than the 45-degree
line because, as income rises, consumption also increases, but by less than the
increase in income.
Figure 1.2.4
Determination of Equilibrium Income: Two Sector Model

You may bear in mind the basic point that according to Keynes, aggregate demand
will not always be equal to aggregate supply. Aggregate demand depends on
households plan to consume and to save. Aggregate supply depends on the
producers’ plan to produce goods and services. For the aggregate demand and
the aggregate supply to be equal so that equilibrium is established, the households’
plan must coincide with producers’ plan. The expectations of businessmen are
realized only when aggregate expenditure equals aggregate income. In other
words, aggregate supply represents aggregate value expected by business firms
and aggregate demand represents their realized value. At equilibrium, expected
value equals realized value. However, Keynes held the view that that there is no
reason to believe that:
(i) consumers’ consumption plan always coincides with producers’ production
plan, and
(ii) that producers’ plan to invest matches always with households plan to save
Putting it differently, there is no reason for C + I and C + S to be always equal.
The figure 1.2.4 depicts the determination of equilibrium income. Income is
measured along the horizontal axis and the components of aggregate demand, C
and I, are measured along the vertical axis. The consumption function (I) is shown
in panel B of the figure, the (C+ I) or aggregate expenditure schedule which is
obtained by adding the autonomous expenditure component namely investment
to consumption spending at each level of income. Since the autonomous
expenditure component (I) does not depend directly on income, the (C+I) schedule
lies above the consumption function by a constant amount. Equilibrium level of
income is such that aggregate demand equals output (which in turn equals
income). Only at point E and at the corresponding equilibrium levels of income and
output (Y0), does aggregate demand exactly equal output. At that level of output
and income, planned spending precisely matches production. Once national
income is determined, it will remain stable in the short run.
Our understanding of the equilibrium level of income would be better if we find
out why the other points on the graph are not points of equilibrium. For example,
consider a level of income below Y0, for example Y1, generates consumption as
shown along the consumption function. When this level of consumption is added
to the autonomous investment expenditure (I), the aggregate demand exceeds
income; i.e the (C +1) schedule is above the 45° line. Equivalently, at all those
levels I is greater than S, as can be seen in panel (B) of the figure 1.2.4. The
aggregate expenditures exceed aggregate output. Excess demand makes

businesses to sell more than what they currently produce. The unexpected sales
would draw down inventories and result in less inventory investment than business
firms planned. They will react by hiring more workers and expanding production.
This will increase the nation’s aggregate income. It also follows that with demand
outstripping production, desired investment will exceed actual investment.
Conversely, at levels of income above Y0, for example at Y2, output exceed demand
(the 45° line is above the C +I schedule). The planned expenditures on goods and
services are less than what business firms thought they would be; business firms
would be unable to sell as much of their current output as they had expected. In
fact, they have unintentionally made larger inventory investments than they
planned and their actual inventories would increase. Therefore, there will be a
tendency for output to fall. This process continues till output reaches Y0, at which
current production exactly matches planned aggregate spending and unintended
inventory shortfall or accumulation are therefore equal to zero. At this point,
consumers’ plan matches with producers’ plan and savers’ plan matches with
investors’ plan. Consequently, there is no tendency for output to change.
Since C + S = Y, the national income equilibrium can be written as
Y=C+I (2.10)
The saving schedule S slopes upward because saving varies positively with income.
In equilibrium, planned investment equals saving. Therefore, corresponding to this
income, the saving schedule (S) intersects the horizontal investment schedule (I).
This intersection is shown in panel (B) of figure 1.2.4.
This condition applies only to an economy in which there is no government and no
foreign trade. To understand this relationship, refer to panel (B) of figure 1.2.4
Without government and foreign trade, the vertical distance between the
aggregate demand (C+I) and consumption line (C) in the figure is equal to planned
investment spending, I. You may also find that the vertical distance between the
consumption schedule and the 45° line also measures saving (S = Y- C) at each
level of income. At the equilibrium level of income (at point E in panel B), and only
at that level, the two vertical distances are equal. Thus, at the equilibrium level of
income, saving equals (planned) investment. By contrast, above the equilibrium
level of income, Y0 , saving (the distance between 45° line and the consumption
schedule) exceeds planned investment, while below Y0 level of income, planned
investment exceeds saving.

The equality between saving and investment can be seen directly from the identities
in national income accounting. Since income is either spent or saved, Y = C + S.
Without government and foreign trade, aggregate demand equals consumption plus
investment, Y = C + I. Putting the two together, we have C + S = C + I, or S = I.
An important point to remember is that Keynesian equilibrium with equality of
planned aggregate expenditures and output need not take place at full
employment. It is possible that the rate of unemployment is high. In the Keynesian
model, neither wages nor interest rates will decline in the face of abnormally high
unemployment and excess capacity. Therefore, output will remain at less than the
full employment rate as long as there is insufficient spending in the economy.
Keynes argued that this was precisely what was happening during the Great
Depression.
Numerical Example:
Given the empirical consumption function C= 100+0.75 Y and I = 1000, calculate
equilibrium level of national income. What would be the consumption expenditure
at equilibrium level national income?
C= 100+0.75 Y and I = 1000,
𝐈𝐈
Y= 100+0.75 Y + 1000 = 𝐘𝐘 = (100+1000)
𝟏𝟏−𝟎𝟎.𝟐𝟐𝟐𝟐
𝐈𝐈
(1100) = 4400.
𝟏𝟏−𝟎𝟎.𝟐𝟐𝟐𝟐
Y=C + I; C= 4400 – 1000 = 3400

Given the intercept a, a steeper aggregate demand function—as would be implied
by a higher marginal propensity to consume—implies a higher level of equilibrium
income. Similarly, for a given marginal propensity to consume, a higher level of
autonomous spending implies a higher equilibrium level of income. Therefore, it
may be inferred that a change in aggregate spending will shift the equilibrium from
one point to another and a shift in the equilibrium will change the level of national
income. An increase in aggregate spending makes the aggregate demand schedule
shift upward. As a result, the equilibrium point would shift upward along the AS
schedule causing an increase in the national income. Likewise, a fall in the
aggregate spending causes a fall in the national income. This relationship between
the aggregate spending and the national income is simple and straight forward.
The proposition put forth above tells us only the direction of change in the national
income resulting from the change in the aggregate demand. It does not quantify
the relationship between the two variables, i.e.; it does not tell us the magnitude of

change in national income due to a given change in aggregate spending. The

theory of investment multiplier provides answer to the above problem.
We will first graphically illustrate the change in the aggregate spending and the
shift in the equilibrium. It will be followed by a simple model of the multiplier. We
will finally discuss the limitations of the multiplier.
2.5 THE INVESTMENT MULTIPLIER

In our two-sector model, a change in aggregate demand may be caused by change
in consumption expenditure or in business investment or in both. Since
Consumption expenditure is a stable function of income, changes in income are
primarily from changes in the autonomous components of aggregate demand,
especially from changes in the unstable investment component. We shall now
examine the effect of an increase in investment (upward shift in the investment
schedule) causing an upward shift in the aggregate demand function.
Figure 1.2.5
Effect of Changes in Autonomous Investment

In the figure 1.2.5, an increase in autonomous investment by ∆ I shifts the aggregate

demand schedule from C+I to C+I+ ∆I. Correspondingly, the equilibrium shifts from
E to E1 and the equilibrium income increases more than proportionately from Yo
to Y1. Why and how does this happen? This occurs due to the operation of the
investment multiplier.
The multiplier refers to the phenomenon whereby a change in an injection of
expenditure will lead to a proportionately larger change (or multiple change) in the
level of national income. Multiplier explains how many times the aggregate income
increases as a result of an increase in investment. When the level of investment
increases by an amount say ∆I, the equilibrium level of income will increase by some
multiple amounts, ∆ Y. The ratio of ∆Y to ∆I is called the investment multiplier, k.
∆Y
k= (2.11)
∆I
The size of the multiplier effect is given by ∆ Y = k ∆I.
For example, if a change in investment of ` 2000 million causes a change in national
income of ` 6000 million, then the multiplier is 6000/2000 =3. Thus multiplier
indicates the change in national income for each rupee change in the desired
investment. The value 3 in the above example tells us that for every ` 1 increase in
desired investment expenditure, there will be ` 3 increase in equilibrium national
income. Multiplier, therefore, expresses the relationship between an initial
increment in investment and the resulting increase in aggregate income. Since the
increase in national income (∆Y) is the result of increase in investment (∆I), the
multiplier is called ‘investment multiplier.’
The process behind the multiplier can be compared to the ‘ripple effect’ of water.
Let us assume that the initial disturbance comes from a change in autonomous
investment (∆I) of 500 units. The economy being in equilibrium, an upward shift in
aggregate demand leads to an increase in national income which in a two sector
economy will be, by definition, distributed as factor incomes. There will be an equal
increase in disposable income. Firms experience increased demand and as a
response, their output increases. Assuming that MPC is 0.80, consumption
expenditure increases by 400, resulting in increase in production. The process does
not stop here; it will generate a second-round of increase in income. The process
further continues as an autonomous rise in investment leads to induced increases
in consumer demand as income increases.

We find at the end that the increase in income per rupee increase in investment is:
∆𝒀𝒀 𝟏𝟏 𝟏𝟏
∆𝑰𝑰
=
𝟏𝟏−𝑴𝑴𝑴𝑴𝑴𝑴
= 𝑴𝑴𝑴𝑴𝑴𝑴
(2.12)
From the above, we find that the marginal propensity to consume (MPC) is the
determinant of the value of the multiplier and that there exists a direct relationship
between MPC and the value of multiplier. Higher the MPC, more will be the value
of the multiplier, and vice-versa. On the contrary, higher the MPS, lower will be the
value of multiplier and vice-versa. The maximum value of multiplier is infinity when
the value of MPC is 1 i.e the economy decides to consume the whole of its
additional income. We conclude that the value of the multiplier is the reciprocal of
MPS.
For example, if the value of MPC is 0.75, then the value of the multiplier is multiplier
as per (2. 11) is:
1
=4
0.25
The multiplier concept is central to Keynes's theory because it explains how shifts
in investment caused by changes in business expectations set off a process that
causes not only investment but also consumption to vary. The multiplier shows how
shocks to one sector are transmitted throughout the economy.
Increase in income due to increase in initial investment, does not go on endlessly.
The process of income propagation slows down and ultimately comes to a halt.
Causes responsible for the decline in income are called leakages. Income that is not
spent on currently produced consumption goods and services may be regarded as
having leaked out of income stream. If the increased income goes out of the cycle
of consumption expenditure, there is a leakage from income stream which reduces
the effect of multiplier. The more powerful these leakages are the smaller will be
the value of multiplier. The leakages are caused due to:
1. progressive rates of taxation which result in no appreciable increase in
consumption despite increase in income
2. high liquidity preference and idle saving or holding of cash balances and an
equivalent fall in marginal propensity to consume
3. increased demand for consumer goods being met out of the existing stocks or
through imports

4. additional income spent on purchasing existing wealth or purchase of

government securities and shares from shareholders or bond holders
5. undistributed profits of corporations
6. part of increment in income used for payment of debts
7. case of full employment additional investment will only lead to inflation, and
8. scarcity of goods and services despite having high MPC
The MPC on which the multiplier effect of increase in income depends, is high in
under developed countries; ironically the value of multiplier is low. Due to structural
inadequacies, increase in consumption expenditure is not generally accompanied
by increase in production. E.g. increased demand for industrial goods consequent
on increased income does not lead to increase in their real output; rather prices
tend to rise.
An important element of Keynesian models is that they relate to short-period
equilibrium and contain no dynamic elements. There is nothing like Keynesian
macro-economic dynamics. When a shock occurs, for example when there is a
change in autonomous investment due to change in some variable, one equilibrium
position can be compared with another as a matter of comparative statics. There is
no link between one period and the next and no provision is made for an analysis
of processes through time.
2.6 DETERMINATION OF EQUILIBRIUM INCOME: THREE

SECTOR MODEL
Aggregate demand in the three sector model of closed economy (neglecting
foreign trade) consists of three components namely, household consumption(C),
desired business investment demand(I) and the government sector’s demand for
goods and services(G). Thus in equilibrium, we have
Y = C+I+G (2.13)
Since there is no foreign sector, GDP and national income are equal. As prices are
assumed to be fixed, all variables are real variables and all changes are in real terms.
To help interpret these conditions, we turn to the flowchart below. Each of the
variables in the model is a flow variable.

Figure 2.6
Circular Flow in a Three Sector Economy
The functioning of the two sectors namely household and the business sector has
been discussed by us in the two sector model. The three-sector, three-market
circular flow model which accounts for government intervention highlights the role

played by the government sector. From the above flow chart, we can find that the
government sector adds the following key flows to the model:
i) Taxes on households and business sector to fund government purchases
ii) Transfer payments to household sector and subsidy payments to the business
sector
iii) Government purchases goods and services from business sector and factors of
production from household sector, and
iv) Government borrowing in financial markets to finance the deficits occurring
when taxes fall short of government purchases
However, unlike in the two sector model, the whole of national income does not
return directly to the firms as demand for output. There are two flows out of the
household sector in addition to consumption expenditure namely, saving flow and
the flow of tax payments to the government. These are actually leakages. The
saving leakage flows into financial markets, which means that the part of that is
saved is held in the form of some financial asset (currency, bank deposits, bonds,
equities, etc.). The tax flow goes to to the government sector. The leakages which
occur in household sector do not necessarily mean that the total demand must fall
short of output. There are additional demands for output on the part of the
business sector itself for investment and from the government sector. In terms of
the circular flow, these are injections. The investment injection is shown as a flow
from financial markets to the business sector. The purchasers of the investment
goods, typically financed by borrowing, are actually the firms in the business sector
themselves. Thus, the amount of investment in terms of money represents an
equivalent flow of funds lent to the business sector.
The three-sector Keynesian model is commonly constructed assuming that
government purchases are autonomous. This is not a realistic assumption, but it
will simplify our analysis. Determination of income can be explained with the help
of figure 1.2.7

Figure 1.2.7
Determination of Equilibrium Income: Three Sector Model
The variables measured on the vertical axis are C, I and G. The autonomous
expenditure components namely, investment and government spending do not
directly depend on income and are exogenous variables determined by factors
outside the model. You may observe that in panel B of the figure 1.2.7, the lines
that plot these autonomous expenditure components are horizontal as their level
does not depend on Y. Therefore, C + I + G schedule lies above the consumption
function by a constant amount.

The line S + T in the graph plots the value of savings plus taxes. This schedule
slopes upwards because saving varies positively with income. Just as government
spending, level of tax receipts (T) is decided by policy makers.
The equilibrium level of income is shown at the point E 1 where the (C + l + G)
schedule crosses the 45° line, and aggregate demand is therefore equal to income
(Y). In equilibrium, it is also true that the (S + T) schedule intersects the (I + G)
horizontal schedule.
We shall now see why other points on the graph are not points of equilibrium.
Consider a level of income below Y. We find that it generates consumption as
shown along the consumption function. When this level of consumption is added
to the autonomous expenditures (I + G), aggregate demand exceeds income; the
(C + I + G) schedule is above the 45° line. Equivalently at this point I + G is greater
than S + T, as can be seen in panel B of the figure 1.2.7. With demand outstripping
production, desired investments will exceed actual investment and there will be an
unintended inventory shortfall and therefore a tendency for output to rise.
Conversely, at levels of income above Y1, output will exceed demand; people are
not willing to buy all that is produced. Excess inventories will accumulate, leading
businesses to reduce their future production. Employment will subsequently
decline. Output will fall back to the equilibrium level. It is only at Y that output is
equal to aggregate demand; there is no unintended inventory shortfall or
accumulation and, consequently, no tendency for output to change. An important
thing to note is that the change in total spending, followed by changes in output
and employment, is what will restore equilibrium in the Keynesian model, not
changes in prices.
2.7 DETERMINATION OF EQUILIBRIUM INCOME: FOUR

SECTOR MODEL
The four sector model includes all four macroeconomic sectors, the household
sector, the business sector, the government sector, and the foreign sector. The
foreign sector includes households, businesses, and governments that reside in
other countries. The following flowchart shows the circular flow in a four sector
economy.

Figure 1.2.8
Circular Flow in a Four Sector Economy
In the four sector model, there are three additional flows namely: exports, imports
and net capital inflow which is the difference between capital outflow and capital
inflow. The C+I+G+(X-M) line indicates the total planned expenditures of

consumers, investors, governments, and foreigners (net exports) at each

income level. In equilibrium, we have
Y = C + I + G + (X-M) (2.14)
The domestic economy trades goods with the foreign sector through exports and
imports. Exports are the injections in the national income, while imports act as
leakages or outflows of national income. Exports represent foreign demand for
domestic output and therefore, are part of aggregate demand. Since imports are
not demands for domestic goods, we must subtract them from aggregate demand.
The demand for imports has an autonomous component and is assumed to depend
on income. Imports depend upon marginal propensity to import which is the
increase in import demand per unit increase in GDP. The demand for exports
depends on foreign income and is therefore exogenously determined. Imports are
subtracted from exports to derive net exports, which is the foreign sector's
contribution to aggregate expenditures. With the help of figure 1.2.9, we shall
explain income determination in the four sector model.
Figure 1.2.9
Determination of Equilibrium Income: Four Sector Model

Equilibrium is identified as the intersection between the C + I + G + (X - M) line

and the 45-degree line. The equilibrium income is Y. From panel B, we find that the
leakages(S+T+M) are equal to injections (I+G+X) only at equilibrium level of
income.
We have seen above that only net exports(X-M) are incorporated into the four
sector model of income determination. We know that injections increase the level
of income and leakages decrease it. Therefore, if net exports are positive (X > M),
there is net injection and national income increases. Conversely, if X<M, there is
net withdrawal and national income decreases. The figure 1.2.10 depicts a case of
X<M.
We find that when the foreign sector is included in the model (assuming M > X),
the aggregate demand schedule C+I+G shifts downward with equilibrium point
shifting from F to E. The inclusion of foreign sector (with M > X) causes a reduction
in national income from Y0 to Y1. Nevertheless, when X > M, the aggregate demand
schedule C+I+G shifts upward causing an increase in national income. Learners may
infer diagrammatic expressions for possible changes in equilibrium income for X>M
and X = M.
Figure 1.2.10
Effects on Income When Imports are Greater than Exports

We have seen in section 2.5 above that equilibrium income is expressed as a

product of two terms: ∆ Y = k ∆I; i.e the level of autonomous investment expenditure
and the investment multiplier. The autonomous expenditure multiplier in a four
1
sector model includes the effects of foreign transactions and is stated as
(1−𝑏𝑏+𝑣𝑣)
where v is the propensity to import which is greater than zero. You may recall that
1
the multiplier in a closed economy is
(1−𝑏𝑏)
The greater the value of v, the lower will be the autonomous expenditure multiplier.
The more open an economy is to foreign trade, (the higher v is) the smaller will be
the response of income to aggregate demand shocks, such as changes in
government spending or autonomous changes in investment demand. A change in
autonomous expenditures— for example, a change in investment spending,—will
have a direct effect on income and an induced effect on consumption with a further
effect on income. The higher the value of v, larger the proportion of this induced
effect on demand for foreign, not domestic, consumer goods. Consequently, the
induced effect on demand for domestic goods and, hence on domestic income will
be smaller. The increase in imports per unit of income constitutes an additional
leakage from the circular flow of (domestic) income at each round of the multiplier
process and reduces the value of the autonomous expenditure multiplier.
An increase in demand for exports of a country is an increase in aggregate demand
for domestically produced output and will increase equilibrium income just as an
increase in government spending or an autonomous increase in investment. In
summary, an increase in the demand for a country’s exports has an expansionary
effect on equilibrium income, whereas an autonomous increase in imports has a
contractionary effect on equilibrium income. However, this should not be
interpreted to mean that exports are good and imports harmful in their economic
effects. Countries import goods that can be more efficiently produced abroad, and
trade increases the overall efficiency of the worldwide allocation of resources. This
forms the rationale for attempts to stimulate the domestic economy by promoting
exports and restricting imports.
2.8 CONCLUSION
According to the Keynesian theory of income and employment, national income
depends upon the aggregate effective demand. If the aggregate effective demand
falls short of that output at which all those who are both able and willing to work
are employed, it will result in unemployment in the economy. Consequently, there
will be a gap between the economy's actual and optimum potential output. On the

contrary, if the aggregate effective demand exceeds the economy's full

employment output (production capacity), it will result in inflation. Nominal output
will increase, but it simply reflects higher prices, rather than additional real output.
It is not necessary that the equilibrium aggregate output will also be the full
employment aggregate output. It is undesirable and a cause of great concern for
the society and government if large number of people remains unemployed. In the
absence of government policies to stabilize the economy, incomes will be unstable
because of the instability of investment. By making appropriate changes in
government spending (G) and taxes, the government can counteract the effects of
shifts in investment. Appropriate changes in fiscal policy by adjusting in
government expenditure and taxes could keep the autonomous expenditure
constant even in the face of undesirable changes in the investment.
SUMMARY
• John Maynard Keynes in his masterpiece ‘The General Theory of Employment
Interest and Money’ published in 1936 put forth a comprehensive theory to
explain the determination of equilibrium aggregate income and output in an
economy.
• The equilibrium analysis is best understood with a hypothetical simple a two-
sector economy which has only households and firms with all prices (including
factor prices), supply of capital and technology constant; the total income
produced Y, accrues to the households and equals their disposable personal
income.
• The equilibrium output occur when the desired amount of output demanded
by all the agents in the economy exactly equals the amount produced in a
given time period.
• In the two-sector economy aggregate demand (AD) or aggregate expenditure
consists of only two components: aggregate demand for consumer goods and
aggregate demand for investment goods, I being determined exogenously and
constant in the short run.
• Consumption function expresses the functional relationship between
aggregate consumption expenditure and aggregate disposable income,
expressed as C = f (Y). The specific form consumption function, proposed by
Keynes C = a + bY
• The value of the increment to consumer expenditure per unit of increment to
income (b) is termed the Marginal Propensity to Consume (MPC).

• The Keynesian assumption is that consumption increases with an increase in

disposable income (b > 0), but that the increase in consumption will be less
than the increase in disposable income (b < 1).
• The propensity to consume refers to the proportion of the total and the
marginal incomes which people spend on consumer goods and services.
• The proportion or fraction of the total income consumed is called ‘average
propensity to consume’ (APC)= Total Consumption /Total Income
• Since Y = C + S, consumption and saving functions are counterparts of each
other. The condition for national income equilibrium can thus be expressed as
C+I=C+S
• Changes in income are primarily from changes in the autonomous components
of aggregate demand, especially from changes in the unstable investment
component.
• The investment multiplier k is defined as the ratio of change in national income
(∆Y) due to change in investment (∆I)
• The marginal propensity to consume (MPC) is the determinant of the value of
the multiplier. The higher the marginal propensity to consume (MPC) the
greater is the value of the multiplier.
• The more powerful the leakages are, the smaller will be the value of multiplier.
• Aggregate demand in the three sector model of closed economy (neglecting
foreign trade) consists of three components namely, household
consumption(C), desired business investment demand(I) and the government
sector’s demand for goods and services(G).
• The government sector imposes taxes on households and business sector,
effects transfer payments to household sector and subsidy payments to the
business sector, purchases goods and services and borrows from financial
markets.
• In equilibrium, it is also true that the (S + T) schedule intersects the (I + G)
horizontal schedule.
• The four sector model includes all four macroeconomic sectors, the household
sector, the business sector, the government sector, and the foreign sector and
in equilibrium, we have Y = C + I + G + (X-M)

• The domestic economy trades goods with the foreign sector through exports
and imports.
• Imports are subtracted from exports to derive net exports, which is the foreign
sector's contribution to aggregate expenditures. If net exports are positive (X
> M), there is net injection and national income increases. Conversely, if X<M,
there is net withdrawal and national income decreases.
• The autonomous expenditure multiplier in a four sector model includes the
1 1
effects of foreign transactions and is stated as (1−𝑏𝑏+𝑣𝑣) against (1−𝑏𝑏) in a closed
economy.
• The greater the value of v, the lower will be the autonomous expenditure
multiplier.
• An increase in the demand for exports of a country is an increase in aggregate
demand for domestically produced output and will increase equilibrium
income just as would an increase in government spending or an autonomous
increase in investment.
TEST YOUR KNOWLEDGE

I Multiple Choice Questions
1. In the Keynesian model, equilibrium aggregate output is determined by
(a) aggregate demand
(b) consumption function
(c) the national demand for labor
(d) the price level
2. Keynes believed that an economy may attain equilibrium level of output
(a) only at the full-employment level of output
(b) below the full-employment level of output
(c) only if prices were inflexible
(d) a) and c) above
3. According to Keynes, consumption expenditure is determined by
(a) the level of interest rates

(b) extent of government taxes and subsidies

(c) disposable income
(d) autonomous investment expenditure
4. The marginal propensity to consume (MPC) can be defined as
(a) a change in spending due to a change in income
(b) a change in income that is saved after consumption
(c) part of income that is spent on consumption.
(d) part of income that is not saved.
5. If the consumption function is expressed as C = a + bY then b represents
(a) autonomous consumer expenditure when income is zero
(b) the marginal propensity to consume.
(c) the expenditure multiplier when consumption is increased
(d) part of disposable income
6. If the consumption function is expressed as C = a + bY then a represents

(a) autonomous consumer expenditure.
(b) the marginal propensity to consume.
(c) the consumption income relationship
(d) Non- linear consumption function
7. If the consumption function is C = 20 + 0.5YD, then an increase in disposable
income by ` 100 will result in an increase in consumer expenditure by `-------
----
(a) 25
(b) 70
(c) 50.
(d) 100
8. If the autonomous consumption equals ` 2,000 and the marginal propensity to
consume equals 0.8. If disposable income equals ` 10,000, then total
consumption will be ` ---------

(a) 8,000
(b) 6,000
(c) 10,000
9. In the Keynesian cross diagram, the point at which the aggregate demand
function crosses the 45 degree line indicates the
(a) level of full employment income.
(b) less than full employment level of income.
(c) equilibrium level of income which may or may not be full employment level
of income
(d) autonomous level of income which may not be full employment level of
income
10. In a closed economy, aggregate demand is the sum of
(a) consumer expenditure, demand for exports , and government spending.
(b) consumer expenditure, planned investment spending, and government
spending.
(c) consumer expenditure, actual investment spending, government
spending, and net exports.
(d) consumer expenditure, planned investment spending, government
spending, and net exports.
11. In an open economy, aggregate demand is the sum of
(a) C+I+G
(b) C+I
(c) C+I+G+(X-M)
12. Aggregate output and autonomous consumer expenditure are ________ related
(a) negatively
(b) positively
(c) proportionately

(d) collectively
13. The slope of the consumption function is called
(a) autonomous consumption when income is zero
(b) average propensity to consume.
(c) marginal propensity to consume.
14. The saving function shows
(a) the incremental saving caused by incremental disposable income
(b) the level of saving at each level of disposable income
(c) position where saving is equal to investment
(d) change in saving due to autonomous investment
15. Which of the following statement is true
(a) saving is an increasing function of the level of income and MPS is positive
(b) Since the Marginal Propensity to Consume (MPC) is always less than unity,
but greater than zero, i.e., 0 < b < 1
(c ) MPC + MPS = 1 and MPS 0 < b < 1.
(d) All the above
1. Define equilibrium output?
2. What are the components of aggregate expenditure in two sector economy?
3. Define consumption function?
4. Explain the concept of marginal propensity to consume?
5. Define average propensity to consume?
6. Distinguish between saving function and marginal propensity to save
7. What is meant by autonomous expenditure?
8. What would happen if aggregate expenditures were to exceed the economy’s
production capacity?

9. Outline the relationship between marginal propensity to consume and

multiplier?
10. What is the effect of income leakages on multiplier?
11. List out the components of aggregate demand in a three sector economy?
12. What role does government play in a three sector economy?
13. Define net exports?
14. How do imports affect investment multiplier?
1. Explain Keynesian concept of equilibrium aggregate income? Illustrate your
answer with appropriate diagrams.
2. Describe the circular flow in a simple two-sector model?
3. Explain the concept of investment multiplier? Give suitable examples?
4. Describe the components of aggregate expenditure in two, three and four
sector economy models
5. Explain national income determination in a two, sector economy?
6. Distinguish between national income determination in three and four sector
economy models?
7. Define multiplier. Explain the functioning of multiplier?
8. Outline the changes in equilibrium aggregate income on account of changes
in its determinants?
9. Elucidate the relationship between consumption function and saving function?
10. Describe the rationale behind multiplier? Point out the factors that weaken the
multiplier?
11. How do imports and exports with the rest of the world affect the level of
income and output?
1. In a two sector economy, the business sector produces 7000 units at an average
price of ` 5.
(a) What is the money value of output?

(b) What is the money income of households?

(c) If households spend 80 percent of their income, what is the total consumer
expenditure?
(d) What is the total money revenues received by the business sector?
(e) What should happen to the level of output?
2. Assume that an economy’s consumption function is specified by the equation
C = 500 + 0.80Y.
(a) What will be the consumption when disposable income (Y) is ` 4,000,
` 5,000, and ` 6,000?
(b) Find saving when disposable income is ` 4,000, ` 5,000, and ` 6,000.
(c) What amount of consumption for consumption function C is autonomous?
(d) What amount is induced when disposable income is ` 4,000? ` 5,000?
` 6,000?
3. Find the value of the multiplier when
(a) MPC is 0.2
(b) MPC is 0.5
(c) MPC is 0.8
4. For the linear consumption function is C = 700 + 0.8Y; I is ` 1200 and Net
exports X-M = 100. Find equilibrium output?
ANSWERS/ HINTS
1 a 6 a 11 c
2 b 7 c 12 b
3 c 8 c 13 c
4 a 9 c 14 b
5 b 10 b 15 d

II Hints to Short Answer Type Questions

1. Equilibrium output occur when the desired amount of output demanded by all
the agents in the economy exactly equals the amount produced in a given time
period.
2. Only two components namely: aggregate demand for consumer goods ( C),
and aggregate demand for investment goods (I)
3. Functional relationship between aggregate consumption expenditure and
aggregate disposable income, expressed as C = f (Y) ;shows the level of
consumption (C) corresponding to each level of disposable income (Y)
4. The value of the increment to consumer expenditure per unit of increment to
income; termed b such that 0 < b < 1.
C
5. The ratio of total consumption to total income i.e
Y
6. The saving function shows the level of saving (S) at each level of disposable
income (Y). The increment to saving per unit increase in disposable income (1
- b) is called the marginal propensity to save.
7. Expenditures that do not vary with the level of income. They are determined
by factors other than income such as business expectations and economic
policy
8. Aggregate expenditures in excess of output lead to a higher price level once
the economy reaches full employment. Nominal output will increase, but it
merely reflects higher prices, rather than additional real output.
9. The marginal propensity to consume is the determinant of the value of the
multiplier. The higher the (MPC) the greater is the value of the multiplier.
10. The more powerful the leakages are, the smaller will be the value of multiplier.
11. Three components namely, household consumption(C), desired business
investment demand (I) and the government sector’s demand for goods and
services (G).
12. Imposes taxes on households and business sector, effects transfer payments to
household sector and subsidy payments to the business sector, purchases
goods and services and borrows from financial markets
13. The foreign sector's contribution to aggregate expenditures; derived by
subtracting imports from exports

14. The greater the value of propensity to import v, the lower will be the
autonomous expenditure multiplier.
1. (a) The money value of output equals total output times the average price per
unit. The money value of output is (7,000 x 5) = ` 35,000.
(b) In a two sector economy, households receive an amount equal to the
money value of output. Therefore, the money income of households is the
same as the money value of output i.e ` 35,000.
(c ) Total spending by households (` 35,000 x 0.8) ie. ` 28,000.
(d) The total money revenues received by the business sector is equal to
aggregate spending by households ie. ` 28, 000.
(e) The business sector makes payments of ` 35000 to produce output,
whereas the households purchase only output worth ` 28,000 of what is
produced. Therefore, the business sector has unsold inventories valued at
` 7000. They should be expected to decrease output.
2. (a) Consumption for each level of disposable income is found by substituting
the specified disposable income level into the consumption equation.
Thus, for Y = ` 4,000, C = ` 500 + 0.80(` 4,000) = ` 500 + ` 3,200 = ` 3,700.
Likewise C is ` 4,500 when Y = ` 5,000, and ` 5,300 when Y = ` 6,000.
(b) Saving is the difference between disposable income and consumption. It
is the difference between the consumption line and the 45 line at each
level of disposable income
Using the calculation from part a) above, we find that saving is ` 300 when
Y is ` 4,000; ` 500 when Y is ` 5,000 and ` 700 when Y is ` 6,000.
(c) Autonomous consumption is the amount consumed when disposable
income is zero; autonomous consumption is ` 500, i.e the consumption
expenditure when the consumption line C intersects the vertical axis and
disposable income is 0. Since autonomous consumption is unrelated to
income, autonomous consumption is ` 500 for all levels of income.
(d) Induced consumption is the amount of consumption that depends upon
the level of income. Consumption is ` 3,700 when disposable income is
` 4,000. Since ` 500 is autonomous (ie consumed regardless of the income
level), ` 3,200 out of the ` 3,700 level of consumption is induced by

disposable income. Similarly, Induced consumption is ` 4,000 when

disposable income is ` 5,000, and ` 4,800 when disposable income is
` 6,000.
3. The value of the multiplier (k) is found by relating the change in output (∆Y) to
the initial change in aggregate spending. The value of the multiplier is directly
related to the level of MPC, i.e., the greater the MPC, the larger the value of
the multiplier. The value of the multiplier is found from the equation k = 1/ (1
− MPC).
(a) Thus, when MPC is 0.2, the multiplier is 1.25
(b) When MPC is 0.5, the multiplier is 2
(c) When MPC = 0.80, the multiplier is 5
4. The equilibrium level of output can be found by equating output and
aggregate spending i.e by solving Y = C + I + X-M for Y
Y = C + I + X- M
Y = 700 + 0.8Y + 1200 + 100
Y − 0.8Y = 700 + 1200 + 100
0.2Y = 2000
Y =2000/.2 = 10,000

CHAPTER 2
PUBLIC FINANCE
UNIT I: FISCAL FUNCTIONS: AN OVERVIEW
LEARNING OUTCOMES

 Enumerate the rationale of government intervention in markets
 Explain the three branch taxonomy of the role of government in a market
economy
 Describe the various interventionist measures adopted by the
government
 Analyze the governmental economic actions and classify them
according to the economic functions of the government

Public Finance
Fiscal Functions: An
Overview
Allocation Redistribution Stablization

Function Function Function
1.1 INTRODUCTION
The following are a few headlines which appeared recently in the leading business
dailies:
1. Crop worry: Centre scraps import duty on wheat to ease supply and check
prices
2. Monetary Policy panel members voted unanimously for a rate cut
3. A fortified mid -day meal gets underway at Karnataka’s government schools
4. Government to spend ` 60,000 crores more on rural jobs
5. Government looking at subsidizing Smart phones to boost digital payments
6. No service tax on credit, debit card transactions up to ` 2,000
Each of the above statements represents a proactive response on the part of the
government to achieve certain objectives in the interest of the economy and the
society.
What exactly is the government planning to accomplish by the above measures?
On close examination, we can find that the first two steps are intended to control
potential rise in prices; the next two seek to bring in welfare to the underprivileged
sections of the society by ensuring equity and fairness and the remaining two are
meant to provide incentives to promote the production/ use of resources in a
socially desirable direction. The government does not expect the economic
variables underlying the above mentioned phenomena to function automatically;

FISCAL FUNCTIONS: AN OVERVIEW 2.3
rather it intervenes to direct them to function in particular directions. Such

intervention on the part of the government is based on the belief that the objective
of the economic system and the role of government is to improve the wellbeing of
individuals and households.
We have experienced in our day to day life that though governments at various
levels impose many rules and regulations in the economy, some matters still go
unregulated. Similarly, most of the goods and services that we consume are
provided to us by private producers, but certain goods and services are provided
exclusively by the government. For a variety of reasons, we believe that
governments should accomplish some activities and should not do others. The
purpose of this lesson is to examine the economic functions of the government and
to understand why the government should invariably perform them.
1.2 THE ROLE OF GOVERNMENT IN AN ECONOMIC SYSTEM

We shall first consider why an economic system should be in place. The basic
economic problem of scarcity arises from the fact that on account of qualitative as
well as quantitative constraints, the resources available to any society cannot
produce all economic goods and services that its members desire to have.
Therefore, an economic system should exist to answer the basic questions such as
what, how and for whom to produce and how much resources should be set apart
to ensure growth of productive capacity. The modern society, in general, offers
three alternate economic systems through which the decisions of resource
reallocation may be made namely, the market, the government and a mixed system
where both markets and governments simultaneously determine resource
allocation.
Adam Smith is often described as a bold advocate of free markets and minimal
governmental activity. However, Smith saw an important resource allocation role
for government when he underlined the role of government in national defence,
maintenance of justice and the rule of law, establishment and maintenance of
highly beneficial public institutions and public works which the market may fail to
produce on account of lack of sufficient profits. Since the 1930s, more specifically
as a consequence of the great depression, the state’s role in the economy has been
distinctly gaining in importance and therefore, the traditional functions of the state
as described above, have been supplemented with what is referred to as economic
functions (also called fiscal functions or public finance function).While there are
differences among different countries in respect to the nature and extent of
government intervention in economies, all governments are still expected to play

a major role. This comes out of the belief that government intervention will
invariably influence the performance of the economy in a positive way.
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959),
introduced the three branch taxonomy of the role of government in a market
economy. Musgrave believed that, for conceptual purposes, the functions of
government are to be separated into three, namely, resource allocation, (efficiency),
income redistribution (fairness) and macroeconomic stabilization. The allocation
and distribution functions are primarily microeconomic functions, while
stabilization is a macroeconomic function. The allocation function aims to correct
the sources of inefficiency in the economic system while the distribution role
ensures that the distribution of wealth and income is fair. Monetary and fiscal
policy, the problems of macroeconomic stability, maintenance of high levels of
employment and price stability etc fall under the stabilization function. We shall
now discuss in detail this conceptual three function framework of the
responsibilities of the government.
1.3 THE ALLOCATION FUNCTION

Resource allocation refers to the way in which the available factors of production
are allocated among the various uses to which they might be put. It determines
how much of the various kinds of goods and services will actually be produced in
an economy. One of the most important functions of an economic system is the
optimal or efficient allocation of scarce resources so that the available resources
are put to their best use and no wastages are there.
As we know, the private sector resource allocation is characterized by market supply
and demand and price mechanism as determined by consumer sovereignty and
producer profit motives. The state’s allocation, on the other hand, is accomplished
through the revenue and expenditure activities of governmental budgeting. In the
real world, resource allocation is both market determined and government
determined.
A market economy is subject to serious malfunctioning in several basic respects.
There is also the problem of nonexistence of markets in a variety of situations.
While private goods will be sufficiently provided by the market, public goods will
not be produced in sufficient quantities by the market. Why do markets fail to give
right answers to the question as to what goods should be produced and in what
quantities? In other words, why do markets generate misallocation of resources?

Efficient allocation of resources is assumed to take place only in perfectly

competitive markets. In reality, markets are never perfectly competitive. Market
failures which hold back the efficient allocation of resources occur mainly due to
the following reasons:
• Imperfect competition and presence of monopoly power in different degrees
leading to under-production and higher prices than would exist under
conditions of competition. These distort the choices available to consumers
and reduce their welfare.
• Markets typically fail to provide collective goods which are, by their very nature,
consumed in common by all the people.
• Externalities which arise when the production and consumption of a good or
service affects people and they cannot influence through markets the decision
about how much of the good or service should be produced e.g. pollution.
• Factor immobility which causes unemployment and inefficiency
• Imperfect information, and
• Inequalities in the distribution of income and wealth.
According to Musgrave, the state is the instrument by which the needs and
concerns of the citizens are fulfilled and therefore, public finance is connected with
economic mechanisms that should ideally lead to the effective and optimal
allocation of limited resources. This logic, in effect, makes it necessary for the
government to intervene in the market to bring about improvement in social
welfare. In the absence of appropriate government intervention, market failures
may occur and the resources are likely to be misallocated by too much production
of certain goods or too little production of certain other goods. The allocation
responsibility of the governments involves suitable corrective action when private
markets fail to provide the right and desirable combination of goods and services.
Briefly put, market failures provide the rationale for government’s allocative
function.
You might have noticed that in many cases, the government can provide us with
goods and services that we cannot produce on our own or buy at a price from the
market. For example, the government establishes property rights and makes the
necessary arrangements for enforcing contracts through provision of law
enforcement and courts. Goods which involve externalities that are not met by the
market require intervention by the government for corrective measures. Merit
goods which are greatly beneficial to the society also fall under the purview of

provision by the government. These interventions do not imply that markets are
replaced by government action. In its allocation role, the government acts as a
complement rather than as a substitute to the market system in an economy.
The resource allocation role of government’s fiscal policy focuses on the potential
for the government to improve economic performance through its expenditure and
tax policies. The allocative function in budgeting determines who and what will be
taxed as well as how and on what the government revenue will be spent. It is
concerned with the provision of public goods and the process by which the total
resources of the economy are divided among various uses and an optimum mix of
various social goods (both public goods and merit goods). The allocation function
also involves the reallocation of society’s resources from private use to public use.
A variety of allocation instruments are available by which governments can
influence resource allocation in the economy. For example,
• government may directly produce the economic good(for example, electricity
and public transportation services)
• government may influence private allocation through incentives and
disincentives (for example, tax concessions and subsidies may be given for the
production of goods that promote social welfare and higher taxes may be
imposed on goods such as cigarettes and alcohol)
• government may influence allocation through its competition policies, merger
policies etc which will affect the structure of industry and commerce ( for
example, the Competition Act in India promotes competition and prevents
anti-competitive activities)
• governments’ regulatory activities such as licensing, controls, minimum wages,
and directives on location of industry influence resource allocation
• government sets legal and administrative frameworks, and
• any of a mixture of intermediate techniques may be adopted by governments
Maximizing social welfare is one of the primary and most commonly manifest
reasons for government intervention in the market. However, it is also possible
that instead of eliminating market distortions, sometimes governments may
contribute to generate them. The possible sources of this type of government
failures are inadequate information, conflicting objectives and administrative costs
involved in government intervention.

1.4 REDISTRIBUTION FUNCTION

You might have noticed that over the past decades there has been tremendous
expansion in economic activities which has generated enormous increase in
aggregate output and wealth. However, the outcomes of this growth have not
spread evenly across the households. A major function of present-day governments
therefore involves changing the pattern of distribution of income from what the
market would offer to a more egalitarian one. The distribution responsibility of the
government arises from the fact that, left to the market, the distribution of income
and wealth among individuals in the society is likely to be skewed and therefore
the government has to intervene to ensure a more desirable and just distribution.
The distributive function of budget is related to the basic question of for whom
should an economy produce goods and services. As such, it is concerned with the
adjustment of the distribution of income and wealth so as to ensure distributive
justice namely, equity and fairness. The distribution function also relates to the
manner in which the effective demand over the economic goods is divided among
the various individual and family spending units of the society. Effective demand is
determined by the level of income of the households and this in turn determines
the distribution of real output among the population.
The distribution function of the government aims at:
• redistribution of income to achieve an equitable distribution of societal output
among households
• advancing the well-being of those members of the society who suffer from
deprivations of different types
• providing equality in income, wealth and opportunities
• providing security for people who have hardships, and
• ensuring that everyone enjoys a minimal standard of living
A few examples of the redistribution function (or market intervention for socio-
economic reasons) performed by governments are:
• taxation policies of the government whereby progressive taxation of the rich is
combined with provision of subsidy to the poor households
• proceeds from progressive taxes used for financing public services, especially
those that benefit low-income households (example, supply of essential food
grains at highly subsidized prices to BPL households)

• employment reservations and preferences to protect certain segments of the

population,
• regulation of the manufacture and sale of certain products to ensure the health
and well-being of consumers, and
• special schemes for backward regions and for the vulnerable sections of the
population
In modern times, most of the egalitarian welfare states provide free or subsidized
education and health-care system, unemployment benefits, pensions and such
other social security measures. There is, nevertheless, an argument that in
exercising the redistributive function, there exists a conflict between efficiency and
equity. In other words, governments’ redistribution policies which interfere with
producer choices or consumer choices are likely to have efficiency costs or
deadweight losses. For example, greater equity can be achieved through high rates
of taxes on the rich; but high rates of taxes could also act as a disincentive to work,
and discourage people from savings and investments and risk taking. This in turn
will have negative consequences for productivity and growth of the economy.
Consequently, the potential tax revenue may be reduced and the scope for
government’s welfare activities would get seriously limited. As such, an optimal
budgetary policy towards any distributional change should reconcile the conflicting
goals of efficiency and equity by exercising an appropriate trade off between them.
In other words, redistribution measures should be accomplished with minimal
efficiency costs by carefully balancing equity and efficiency objectives.
1.5 STABILIZATION FUNCTION

The theoretical rationale for the stabilization function of the government is derived
from the Keynesian proposition that a market economy does not automatically
generate full employment and price stability and therefore the governments
should pursue deliberate stabilization policies. Business cycles are natural
phenomena in any economy and they tend to occur periodically. The market
system has inherent tendencies to create business cycles. The market mechanism
is limited in its capacity to prevent or to resolve the disruptions caused by the
fluctuations in economic activity. In the absence of appropriate corrective
intervention by the government, the instabilities that occur in the economy in the
form of recessions, inflation etc. may be prolonged for longer periods causing
enormous hardships to people especially the poorer sections of society. It is also
possible that a situation of stagflation (a state of affairs in which inflation and
unemployment exist side by side) may set in and make the problem more intricate.

The stabilization issue also becomes more complex as the increased international
interdependence causes forces of instability to get easily transmitted from one
country to other countries This is also known as contagion effect”.
The stabilization function is one of the key functions of fiscal policy and aims at
eliminating macroeconomic fluctuations arising from suboptimal allocation. As you
might recall, the economic crisis that engulfed the world in 2008 and the more
recent euro area crisis have highlighted the importance of macroeconomic stability
and has, therefore, revived interest in countercyclical fiscal policy.
The stabilization function is concerned with the performance of the aggregate
economy in terms of:
• labour employment and capital utilization,
• overall output and income,
• general price levels,
• balance of international payments, and
• the rate of economic growth.
Government’s fiscal policy has two major components which are important in
stabilizing the economy:
1. an overall effect generated by the balance between the resources the
government puts into the economy through expenditures and the resources it
takes out through taxation, charges, borrowing etc.
2. a microeconomic effect generated by the specific policies it adopts.
Government’s stabilization intervention may be through monetary policy as well as
fiscal policy. Monetary policy has a singular objective of controlling the size of
money supply and interest rate in the economy which in turn would affect
consumption, investment and prices. Fiscal policy for stabilization purposes
attempts to direct the actions of individuals and organizations by means of its
expenditure and taxation decisions. On the expenditure side, Government can
choose to spend in such a way that it stimulates other economic activities. For
example, government expenditure on building infrastructure may initiate a series
of productive activities. Production decisions, investments, savings etc can be
influenced by its tax policies.
We know that government expenditure injects more money into the economy and
stimulates demand. On the other hand, taxes reduce the income of people and

therefore, reduce effective demand. During recession, the government increases its
expenditure or cuts down taxes or adopts a combination of both so that aggregate
demand is boosted up with more money put into the hands of the people. On the
other hand, to control high inflation the government cuts down its expenditure or
raises taxes. In other words, expansionary fiscal policy is adopted to alleviate
recession and contractionary fiscal policy is resorted to for controlling high
inflation. The nature of the budget (surplus or deficit) also has important
implications on a country’s economic activity. While deficit budgets are expected
to stimulate economic activity, surplus budgets are thought to slow down economic
activity. Generally government’s fiscal policy has a strong influence on the
performance of the macro economy in terms of employment, price stability,
economic growth and external balance.
There is often a conflict between the different goals and functions of budgetary
policy. Effective policy design to meet the diverse goals of government is very
difficult to conceive and to implement. The challenge before any government is
how to design its budgetary policy so that the pursuit of one goal does not
jeopardize the other.
1.6 CONCLUSION
We have discussed the need for and rationale of government intervention to
improve social welfare by enhancing stability, efficiency and fairness. However, we
should also understand that when we say that the market-generated allocation of
resources is imperfect, it does not necessarily imply that the government is always
infallible and at all times capable of correcting the failures of the market.
Governments are likely to commit serious errors in its attempt to correct market
failure. For example, in certain cases the costs incurred by government to deal with
some market failure could be greater than the cost of the market failure itself.
Moreover, just as individuals, governments too have only imperfect information,
and hence can commit mistakes. It is also possible that individuals may use
government as a mechanism for maximizing their self-interest. Moreover,
governments may not always be unbiased and benevolent.

SUMMARY
• Government intervention to direct the functioning of the economy is based on
the belief that the objective of the economic system and the role of
government is to improve the wellbeing of individuals and households.
• An economic system should exist to answer the basic questions such as what, how
and for whom to produce and how much resources should be to set apart to
ensure growth of productive capacity
• Since the 1930s, the traditional functions of the state have been supplemented
with the economic functions (also called the fiscal functions or the public finance
function)
• Richard Musgrave (1959) introduced the three branch taxonomy of the role of
government in a market economy namely, resource allocation, income
redistribution and macroeconomic stabilization
• The allocation and distribution functions are primarily microeconomic functions,
while stabilization is a macroeconomic function.
• One of the most important functions of an economic system is the optimal or
efficient allocation of scare resources so that the available resources are put to
their best use and no wastages are there.
• Market failures, which hold back the efficient allocation of resources, occur
mainly due to imperfect competition, presence of monopoly power, collectively
consumed public goods, externalities, factor immobility, imperfect information,
and inequalities in the distribution of income and wealth.
• The allocation responsibility of the governments involves appropriate corrective
action when private markets fail to provide the right and desirable combination
of goods and services
• A variety of allocation instruments are available by which governments can
influence resource allocation in the economy such as, direct production,
provision of incentives and disincentives, regulatory and discretionary policies
etc.,
• The distributive function of budget is related to the basic question of for whom
should an economy produce goods and services
• The distribution function aims at redistribution of income so as to ensure
equity and fairness to promote the wellbeing of all sections of people and is

achieved through taxation, public expenditure, regulation and preferential

treatment of target populations.
• Redistribution policies are likely to have efficiency costs or deadweight losses and
therefore redistribution measures should be accomplished with minimal efficiency
cost by carefully balancing equity and efficiency objectives
• A market economy does not automatically generate full employment and price
stability and therefore the governments should pursue deliberate stabilization
policies.
• Stabilization function is one of the key functions of fiscal policy and aims at
eliminating macroeconomic fluctuations arising from suboptimal allocation
• The stabilization function is concerned with the performance of the aggregate
economy in terms of labour employment and capital utilization, overall output
and income, general price levels, economic growth and balance of international
payments
• Government’s stabilization intervention may be through monetary policy as well
as fiscal policy. Monetary policy has a singular objective of controlling the size of
money supply and interest rate in the economy, while fiscal policy aims at
changing aggregate demand by suitable changes in government spending and
taxes.
• There is often conflict between the different goals and functions of budgetary
policy. The challenge before any government is how to design its budgetary policy
so that the pursuit of one goal does not jeopardize the other.
• Government intervention does not necessarily imply that the government is
always capable of correcting the market failures. Government failures occur due
to the imperfect information, high administrative costs and tendency of
bureaucracy and the politicians to promote vested self- interest using government
mechanisms

TEST YOUR KNOWLEDGE

1. Macroeconomic stabilization may be achieved through
(a) Free market economy
(b) Fiscal policy
(c) Monetary policy
(d) (b) and (c) above
2. Which of the following policies of the government fulfills the redistribution
function
(a) Parking the army on the northern borders of the country
(b) Supply of medicines at subsidized prices to the poor people
(c ) Controlling the supply of money through monetary policy
(a) Fiscal policy involves the use of changes in taxation and government
spending; while monetary policy involves the use of price and profit
controls.
(b) Fiscal policy involves the use of price and profit controls; while monetary
policy involves the use of taxation and government spending.
(c ) Fiscal policy involves the use of changes in taxation and government
spending; while monetary policy involves the use of changes in the supply
of money and interest rates.
(d) Fiscal policy involves the use of changes in the supply of money and
interest rates; while monetary policy involves the use of changes in
taxation and government spending.
4. The justification for government intervention is best described by
(a) The need to prevent recession and inflation in the economy
(b) The need to modify the outcomes of private market actions
(c ) The need to bring in justice in distribution of income and wealth

(d) All the above

5. When the government decides to produce fertilizers and supply them to the
agriculturists, it aims
(a) to achieve equity and fairness to the agriculturists
(b) to influence the way resources are allocated in the economy
(c ) to ensure higher profits to agriculturists
(d) to make greater profits for the public sector
6. Read the following statements:
1. The market-generated allocation of resources is usually imperfect and
leads to inefficient allocation of resources in the economy
2. Market failures can at all times be corrected through government
intervention
3. Public goods will not be produced in sufficient quantities in a market
economy
Of the three statements above:
(a) 1 ,2 and 3 are correct
(b) 1 and 3 are correct
(c ) 2 and 3 are correct
(d) 3 alone is correct
7. The allocation and distribution functions are primarily :
(a) Micro-economic functions
(b) Macro-economic functions
(c) both micro as well as macro-economic functions
(d) aimed at bringing in price stability and economic growth
II. Short Answer Type Questions
1. Describe why governments should perform the allocation function in an
economy?
2. How does monopoly power affect efficiency of markets?
3. Explain how government can get domestic producers produce more pulses?

4. Enumerate the circumstances which necessitate redistribution by government.

5. Illustrate with an example the redistribution effect of a tax and transfer policy
6. What is the objective of government subsidy?
7. Why do private producers hesitate to produce public parks, bridges and
highways?
8. What reason would you assign for employment reservations to socially
backward communities?
9. What would be the objective of a government when it declares special schemes
for backward regions?
10. What should be the public revenue and expenditure policy of the government
during recession?
11. Describe the rationale for the stabilization function of government policy.
III. Long Answer Type Questions
1. Explain the role of government in a market economy.
2. Illustrate four cases which provide justification for government intervention in
markets.
3. Describe the various interventional measures adopted by the government.
4. What are the different instruments available to the government to improve
allocation efficiency in an economy?
5. Explain how economic stability can be achieved through fiscal policy.
IV. Application Oriented Questions
1. Elucidate the nature of economic function performed by the government in the
following cases:-
(a) The government initiates a massive programme for eradication of
mosquito-borne diseases in coastal areas.
(b) The government fixes the prices of 377 essential medicines listed in the
National List of Essential Medicine, 2015.
2. The government decides to levy up to ` 20, 500 per flight from private airlines
on major routes in order to fund an ambitious regional connectivity scheme
which seeks to connect small cities by air and to make flying more affordable

for the masses. Critically examine the implications of this policy on the airlines
market.
ANSWERS/HINTS
1.(d) 2.(b) 3.(c) 4.(d) 5(b) 6.(b) 7(a)
IV Hints to Application Oriented Questions
1. (a) (i) Public good – Merit good- Positive externalities – Inefficient market
outcomes - Possible market failure –scope for market intervention to
improve social welfare - Adam Smith’s proposition of resource
allocation role of government i.e establishment and maintenance of
highly beneficial public institutions and public works which the market
may fail to produce on account of lack of sufficient profits. Define the
resource allocation role of government’s policy - the potential for the
government to improve economic performance through its
expenditure to provide an optimum mix of various social goods.
(ii) Nature and characteristics of the programme of government action –
Policy of Expenditure - Purpose- Welfare outcomes of programmes
for eradication of mosquito-borne diseases –Possibility of government
failure.
(iii) Substantiate with examples from recent policy propositions of
government.
(b) (i) The distributive function of budget related to the basic question of for
whom should an economy produce goods and services. Left to the
market, only private benefits and private costs would be reflected in
the price paid by consumers. This means, through the market
mechanism, people would consume inadequate quantities compared
to what is socially desirable. Outcome: social welfare will not be
maximized. Therefore - Government Intervention in the case of Merit
Goods eg Healthcare - government deems that its consumption
should be encouraged - Price intervention- setting price ceilings - to
influence the outcomes of a market on grounds of fairness and equity
- price floor for ensuring minimum price and price ceiling for making
a resource or commodity available to all at reasonable prices - May
illustrate with diagram.

(ii) Nature and characteristics of the programme of government action -

Purpose- Welfare outcomes of the policy – Negative outcomes - Possible
disincentives to producers- diversion of resources away from regulated
products- black marketing- etc.
(iii) Substantiate with examples
2. Theory of Government intervention for redistribution to ensure fairness and
equity (As discussed in the above two questions)
(i) Price intervention - a market-based policy - contributing airlines may
experience cost escalation – possible fare hikes – changes in equilibrium
quantities – disincentives to fly aircrafts in taxed routes - possible exit from
market by low profit margin airlines- Regional connectivity and other
welfare outcomes as subsidies to producers would lower their cost of
production increase output- substantial positive externalities.
(ii) Another possibility: government intervention in the economy to correct a
market failure creates inefficiency and leads to a misallocation of scarce
resources - social welfare will not be maximized – uncertainty as to the
need for merit goods – disincentives to existing players - cannot be sure
that the government interventions would be effective – possibility of
government failure.

UNIT II: MARKET FAILURE
LEARNING OUTCOMES

 Define the concept of market failure
 Describe the different sources of market failure
 Explain the role of externalities in welfare loss of markets
 Distinguish between different types of public goods and illustrate how they
cause market failure
 Describe the free rider problem associated with public goods
 Appraise the role of incomplete information in generating market failure
 Evaluate government interventions for correcting market failure
Public Finance
Maket Failure
Incomplete
Market Power Externalities Public Goods
Information

MARKET FAILURE 2.19
2.1 INTRODUCTION
Before we go into the subject matter of market failure which is the focus of this
unit, we shall examine two familiar events that are in some way connected with the
phenomenon of market failure.
Case I
Sarva Shiksha Abhiyan (SSA) is a centrally sponsored scheme implemented by the
Government of India in partnership with the state governments, for universalising
good quality elementary education for all children in the 6-14 age groups in a time-
bound manner. Through this programme, the government aims to provide
opportunity for children to learn about and master their natural environment in order
to develop their potential intellectually, spiritually as well as materially. The ultimate
objective is to bring in social, regional and gender quantity.
Nearly everyone believes that providing basic education to all citizens is an
important responsibility of the government. This is the reason why education is
almost entirely administered and extensively financed by government.
Questions
• Why do you think governments should intervene to provide education?
• What do you think the outcome will be if it is left to private entrepreneurs?
Case II
In November 2016, the Central Pollution Control Board (CPCB), the nation’s apex
pollution control body, has come up with the ‘Guidelines For Environmentally
Sound Management (ESM) of End- of - Life Vehicles (ELVs)’ with the
recommendation that the Union Environment Ministry draft the necessary
legislative framework for the sector considering the growing concern about the
health and environmental hazards posed by them. CPCB advocates disposing of
such vehicles in an environmentally friendly manner and recommends a system of
“shared responsibility” involving all stakeholders—the government, manufacturers,
recyclers, dealers, insurers and consumers.
The central board has called for periodic review of the registration of all vehicles
by transport offices so that the environment is not harmed by the continued use of
polluting vehicles as well as initiation of a massive awareness campaign aimed at
sensitizing stakeholders like consumers about the environmental hazards posed by
ELVs.

The above case is an example of how government departments and specifically

constituted bodies address different issues to sustain our environment.
Question
Since citizens should ideally know the need for clean environment, why should
governments interfere with the system?
2.2. THE CONCEPT OF MARKET FAILURE

The general belief is that markets are amazingly competent in organizing the
activities of an economy as they are generally efficient and capable of achieving
optimal allocation of resources. However, there are exceptions to this. Under certain
circumstances, ‘market failure’ occurs, i.e. the market fails to allocate resources
efficiently and therefore, market outcomes become inefficient.
Market failure is a situation in which the free market leads to misallocation of
society's scarce resources in the sense that there is either overproduction or
underproduction of particular goods and services leading to a less than optimal
outcome. The reason for market failure lies in the fact that though perfectly
competitive markets work efficiently, most often the prerequisites of competition
are unlikely to be present in an economy. Market failures are situations in which a
particular market, left to itself, is inefficient. We shall first try to understand why
markets fail and later, in the subsequent unit, proceed to identify the role of
government in dealing with market failure.
We need to appreciate the fact that there are two aspects of market failures namely,
demand-side market failures and supply side market failures. Demand-side market
failures are said to occur when the demand curves do not take into account the full
willingness of consumers to pay for a product. For example, none of us will be
willing to pay to view a wayside fountain because we can view it without paying.
Supply-side market failures happen when supply curves do not incorporate the full
cost of producing the product. For example, a thermal power plant that uses coal
may not have to include or pay completely for the costs to the society caused by
fumes it discharges into the atmosphere as part of the cost of producing electricity.
2.3. WHY DO MARKETS FAIL?

The pertinent question here is why do markets fail? There are four major reasons
for market failure. They are:
• Market power,

MARKET FAILURE 2.21
• Externalities,
• Public goods, and
• Incomplete information
We shall discuss each of the above in detail.
2.3.1 Market Power
Market power or monopoly power is the ability of a firm to profitably raise the
market price of a good or service over its marginal cost. Firms that have market
power are price makers and therefore, can charge a price that gives them positive
economic profits. Excessive market power causes the single producer or a small
number of producers to produce and sell less output than would be produced in a
competitive market. Market power can cause markets to be inefficient because it
keeps price higher and output lower than the outcome of equilibrium of supply
and demand. In the extreme case, there is the problem of non existence of markets
or missing markets resulting in failure to produce various goods and services,
despite the fact that such products and services are wanted by people. For example,
the markets for pure public goods do not exist.
2.3.2 Externalities
We begin by describing externalities and then, proceed to discuss how they create
market inefficiencies. As we are aware, anything that one individual does, may have,
at the margin, some effect on others. For example, if individuals decide to switch
from consumption of ordinary vegetables to consumption of organic vegetables,
they would, other things equal, increase the price of organic vegetables and
potentially reduce the welfare of existing consumers of organic vegetables.
However, we should note that all these operate through price mechanism i.e.
through changes in prices. The price system works efficiently because market prices
convey information to both producers and consumers.
However, sometimes, the actions of either consumers or producers result in costs
or benefits that do not reflect as part of the market price. Such costs or benefits
which are not accounted for by the market price are called externalities because
they are “external” to the market. In other words, there is an externality when a
consumption or production activity has an indirect effect on other’s consumption
or production activities and such effects are not reflected directly in market prices.
The unique feature of an externality is that it is initiated and experienced not
through the operation of the price system, but outside the market. Since it occurs

outside the price mechanism, it has not been compensated for, or in other words
it is uninternalized or the cost (benefit) of it is not borne (paid) by the parties.
Externalities are also referred to as 'spillover effects', 'neighbourhood effects'
'third-party effects' or 'side-effects', as the originator of the externality imposes
costs or benefits on others who are not responsible for initiating the effect.
Externalities may be unidirectional or reciprocal. Suppose a workshop creates
earsplitting noise and imposes an externality on a baker who produces smoke and
disturbs the workers in the workshop, then this is a case of reciprocal externality.
If an accountant who is disturbed by loud music but has not imposed any
externality on the singers, then the externality is unidirectional.
Externalities can be positive or negative. Negative externalities occur when the
action of one party imposes costs on another party. Positive externalities occur
when the action of one party confers benefits on another party. The four possible
types of externalities are:
• Negative production externalities
• Positive production externalities
• Negative consumption externalities ,and
• Positive consumption externalities
Negative Production Externalities
A negative externality initiated in production which imposes an external cost on
others may be received by another in consumption or in production. As an example,
a negative production externality occurs when a factory which produces aluminum
discharges untreated waste water into a nearby river and pollutes the water causing
health hazards for people who use the water for drinking and bathing. Pollution of
river also affects fish output as there will be less catch for fishermen due to loss of
fish resources. The former is a case where a negative production externality is
received in consumption and the latter presents a case of a negative production
externality received in production. The firm, however, has no incentive to account
for the external costs that it imposes on consumers of river water or fishermen
when making its production decision. Additionally, there is no market in which
these external costs can be reflected in the price of aluminum.

MARKET FAILURE 2.23
Positive production externalities

A positive production externality initiated in production that confers external
benefits on others may be received in production or in consumption. Compared to
negative production externalities, positive production externalities are less
common. As an example of positive production externality received in production,
we can cite the case of a firm which offers training to its employees for increasing
their skills. The firm generates positive benefits on other firms when they hire such
workers as they change their jobs. Another example is the case of a beekeeper who
locates beehives in an orange growing area enhancing the chances of greater
production of oranges through increased pollination. A positive production
externality is received in consumption when an individual raises an attractive
garden and the persons walking by enjoy the garden. These external effects were
not in fact taken into account when the production decisions were made.
Negative consumption externalities
Negative consumption externalities are extensively experienced by us in our day to
day life. Such negative consumption externalities initiated in consumption which
produce external costs on others may be received in consumption or in production.
Examples to cite where they affect consumption of others are smoking cigarettes
in public place causing passive smoking by others, creating litter and diminishing
the aesthetic value of the room and playing the radio loudly obstructing one from
enjoying a concert. The act of undisciplined students talking and creating
disturbance in a class preventing teachers from making effective instruction and
the case of excessive consumption of alcohol causing impairment in efficiency for
work and production are instances of negative consumption externalities affecting
production.
Positive consumption externalities
A positive consumption externality initiated in consumption that confers external
benefits on others may be received in consumption or in production. For example,
if people get immunized against contagious diseases, they would confer a social
benefit to others as well by preventing others from getting infected. Consumption
of the services of a health club by the employees of a firm would result in an
external benefit to the firm in the form of increased efficiency and productivity.
Having discussed the nature of externalities in production and consumption, we
shall now examine how externalities cause inefficiency and market failure. Before
we attempt this, we need to understand the difference between private costs and
social costs. Private cost is the cost faced by the producer or consumer directly

involved in a transaction. If we take the case of a producer, his private cost includes
direct cost of labour, materials, energy and other indirect overheads. As we have
mentioned above, firms do not have to pay for the damage resulting from the
pollution which they generate. As a result, each firm’s private cost would be the
direct cost of production only which does not incorporate externalities.
Social costs refer to the total costs to the society on account of a production or
consumption activity. Social costs are private costs borne by individuals directly
involved in a transaction together with the external costs borne by third parties not
directly involved in the transaction.
Social Cost = Private Cost + External Cost

The presence of externalities creates a divergence between private and social
costs of production. When negative production externalities exist, social costs
exceed private cost because the true social cost of production would be private
cost plus the cost of the damage from externalities. If producers do not take into
account the externalities, there will be over-production and market failure.
Applying the same logic, negative consumption externalities lead to a situation
where the social benefit of consumption is less than the private benefit.
Externalities cause market inefficiencies because they hinder the ability of market
prices to convey accurate information about how much to produce and how much
to consume. Given that externalities are more often negative, we shall focus on
them.
A market exchange assumes that the participants have total control over every
aspect of their product and that the prices (or fees) they charge represent the full
cost of production plus profit. As a matter of fact, the producers of products with
extensive negative externalities are not fully accountable for the full cost of their
production which includes private as well as social costs. Recall our earlier case of
the aluminum factory which causes pollution of river water. As a matter of fact, the
prices of aluminum tend to reflect only the private costs of the producer. Since
externalities are not reflected in market prices, they can be a source of economic
inefficiency. Production remains efficient only when all benefits and costs are paid
for. Negative externalities impose costs on society that extend beyond the cost of
production as originally intended by the producer. Without government
intervention, such a producer will have no reason to consider the social costs of
pollution. When firms do not have to worry about the negative externalities

MARKET FAILURE 2.25
associated with their production, the result is excess production and unnecessary
social costs. The problem, though serious, does not usually float up much because:
• The society does not know precisely who are the producers of harmful
externalities
• Even if the society knows it, the cause-effect linkages are so unclear that the
negative externality cannot be unquestionably traced to its producer.
The problem can be explained with the help of the figure below:
Figure 2.2.1
Negative Externalities and Loss of Social welfare
The equilibrium level of output that would be produced by a free market is Q1 at

which marginal private benefit (MPB) is equal to marginal private cost (MPC).
Marginal social cost (MSC) represents the full or true cost to the society of
producing another unit of a good. It includes marginal private cost (MPC) and
marginal social cost (MSC). Assuming that there are no externalities arising from
consumption, we can see that marginal social cost (Q1S) is higher than marginal
private cost (Q1E). Social efficiency occurs at Q2 level of output where MSC is equal
to MSB. Output Q1 is socially inefficient because at Q1, the MSC is greater than the

MSB and represents over production. The shaded triangle represents the area of
dead weight welfare loss. It indicates the area of overconsumption. Thus, we
conclude that when there is negative externality, a competitive market will produce
too much output relative to the social optimum. This is a clear case of market failure
where prices fail to provide the correct signals.
2.4 PUBLIC GOODS

Paul A. Samuelson who introduced the concept of ‘collective consumption good’
in his path-breaking 1954 paper ‘The Pure Theory of Public Expenditure’ is usually
recognized as the first economist to develop the theory of public goods. A public
good (also referred to as collective consumption good or social good) is defined
as one which all enjoy in common in the sense that each individual’s consumption
of such a good leads to no subtraction from any other individuals’ consumption of
that good.
Before we go on to discuss the distinguishing features of public goods and how
they differ from private goods, it is pertinent to first understand the characteristics
of private goods.
2.4.1 Characteristics of Private Goods
• Private goods refer to those goods that yield utility to people. Anyone who
wants to consume them must purchase them.
• Owners of private goods can exercise private property rights and can prevent
others from using the good or consuming their benefits.
• Consumption of private goods is ‘rivalrous’ that is the purchase and
consumption of a private good by one individual prevents another individual
from consuming it. In other words, simultaneous consumption of a rivalrous
good by more than one person is impossible.
• Private goods are ‘excludable’ i.e. it is possible to exclude or prevent consumers
who have not paid for them from consuming them or having access to them.
In other words, those who want to consume private goods must buy them at a
price from its sellers. Excludability necessitates that consumers of private
goods send the right signals in the market. A buyer of a private good is forced
in a transaction to reveal what he or she is willing to pay for a good or a service.
• Private goods do not have the free rider problem. This means that the private
godds will be available to only those persons who are willing to pay for it.

MARKET FAILURE 2.27
• Private goods can be parceled out among different individuals and therefore,
it is possible to refer to total consumption as the sum of each individual’s
consumption. Therefore, the market demand curve for a private good is
obtained by horizontal summation of individual demand curves
• All private goods and services can be rejected by the consumers if their needs,
preferences or budgets change.
• Additional resource costs are involved for producing and supplying additional
quantities of private goods
• Since buyers can be excluded from enjoying the good if they are not willing
and able to pay for it, consumers will get different amounts of goods and
services based on their desires and ability and willingness to pay. Therefore,
whenever there is inequality in income distribution in an economy, issues of
fairness and justice tend to arise with respect to private goods.
• Normally, the market will efficiently allocate resources for the production of
private goods.
Most of the goods produced and consumed in an economy are private goods. A
few examples are: food items, clothing, movie ticket, television, cars, houses etc.
You can make a list of ten such goods and check whether each of them satisfies all
the above mentioned characteristics.
Having understood the features of private goods, we shall now proceed to consider
the distinguishing characteristics of public goods.
2.4.2 Characteristics of Public Goods
• Public goods yield utility to people and are products (goods or services) whose
consumption is essentially collective in nature. No direct payment by the
consumer is involved in the case of pure public goods.
• Public good is non-rival in consumption. It means that consumption of a public
good by one individual does not reduce the quality or quantity available for all
other individuals. When consumed by one person, it can be consumed in equal
amounts by the rest of the persons in the society. That is, your consumption of
a public good in no way interferes with its consumption by other people. For
example, if, you eat your apple, another person too cannot eat it. But, if you
walk in street light, other persons too can walk without any reduced benefit
from the street light.

• Public goods are non-excludable. Consumers cannot (at least at less than
prohibitive cost) be excluded from consumption benefits. If the good is
provided, one individual cannot deny other individuals’ consumption. Provision
of a public good at all by government means provision for all. For example,
national defence once provided, it is impossible to exclude anyone within the
country from consuming and benefiting from it.
• Public goods are characterized by indivisibility. For example, you can buy
chocolates or ice cream as separate units, but a lighthouse, a highway, an
airport, defence, clean air etc cannot be consumed in separate units. In the
case of public goods, each individual may consume all of the good i.e. the total
amount consumed is the same for each individual.
• Public goods are generally more vulnerable to issues such as externalities,
inadequate property rights, and free rider problems.
Once a public good is provided, the additional resource cost of another person
consuming the goods is ‘zero’. A good example is a Lighthouse near a sea shore
to guide the ships. Once the beacon is lit, an additional ship can use it without any
additional cost of provision.
Public goods are generally divided into two categories namely, public consumption
goods and public factors of production. A few examples of public goods are:
national defence, highways, public education, scientific research which benefits
everyone, law enforcement, lighthouses, fire protection, disease prevention and
public sanitation.
A unique feature of public goods is that they do not conform to the settings of
market exchange. The property rights of public goods with extensive indivisibility
and nonexclusive properties cannot be determined with certainty. Therefore, the
owners of such products cannot exercise sufficient control over their assets. For
example, if you maintain a beautiful garden, you cannot exercise full control over
it so as to charge your neighbours for the enjoyment which they get from your
garden. As a consequence of their peculiar characteristics, public goods do not
provide incentives that will generate optimal market reaction. Producers are not
motivated to produce a socially-optimal amount of products if they cannot charge
a positive price for them or make profits from them. As such, though public goods
are extremely valuable for the well being of the society, left to the market, they will
not be produced at all or will be grossly under produced.
Now that we have understood the difference between private goods and public
goods, we shall examine the implications of these characteristics on the production,

MARKET FAILURE 2.29
supply and use of these goods. As mentioned above, ideally competitive markets
have sufficient incentives to produce and supply private goods. Because of the
peculiar characteristics of public goods such as indivisibility, non excludability and
nonrivalry, competitive private markets will fail to generate economically efficient
outputs of public goods. That is why public goods are often (though not always)
under-provided in a free market economy.
2.4.3 Classification of Public Goods
One approach to classify goods so as to establish taxonomy of different types of
goods is to concentrate on the non rival and non excludable characteristics of
public goods. The following table presenting the taxonomy of goods will help us
understand the classification of goods.
Excludable Non-excludable
Rivalrous A B
Private goods food, Common resources such as fish
clothing, cars stocks, forest resources, coal
Non-rivalrous C D
Club goods, cinemas, Pure public goods such as
private parks, satellite national defence
television
• Goods in category A are rival in consumption and are excludable. These are
also known as pure private goods.
• Goods in category D which are characterized by both non-excludability and
non-rivalry properties are called pure public goods. A pure public good is non
-rival as well as non- excludable. The benefit that an individual gets from a pure
public good does not depend on the number of users. The clarity of your radio
reception, for example, is generally independent of the number of other
listeners. Knowledge is another non-rivalrous good. Once something has been
discovered, one person's use of that knowledge does not preclude others from
applying the same knowledge. But, this is not the case with most private goods.
• Consumption goods that fall in category B are rival but not excludable.
Common resources would come under this (explained in section 2.4.6 below)
Let us take another example. Bees from the hives of different bee keepers
collect nectar from the nearby orange garden. The blossom is rival as the nectar

collected for one hive is unavailable to another. Even so, it may be

inconceivable to try to deny any particular honey bee access i.e. the situation
is non-excludable. The examples include public parks, public roads in a
city etc.
• Goods in category C are non rival in consumption but are excludable. A toll
booth may exclude vehicles unless payment is made. Yet, if the road is not
congested, one car may utilize it with no loss of benefit even though the other
cars are also consuming the road service. Similarly, admission to a cinema,
swimming pool, music concert etc. has potential for exclusion, but if there is
no congestion, each individual admitted may consume the services without
subtracting from the benefit of others. A good example of this is DTH cable TV
service or Digital goods. The consumption of these is non-rival in nature but
exclusion of houlseholds who do not pay is feasible.
2.4.4 Pure and Impure Public Goods
The concept of pure public good is often criticized by many who point out that
such goods are not in fact observable in the real world. They argue that goods
which perfectly satisfy non rivalness and non-excludability are not easy to come
across. For example, if the government provides law and order or medical care, the
use of law courts or medical care by some individuals subtracts the consumption
of others if they need to wait. As another example, we may take defence. If armies
are mostly deployed in the northern borders, it may not result in the same amount
of protection to people in the south.
There are many hybrid goods that possess some features of both public and private
goods. These goods are called impure public goods and are partially rivalrous or
congestible. Because of the possibility of congestion, the benefit that an individual
gets from an impure public good depends on the number of users. Consumption
of these goods by another person reduces, but does not eliminate, the benefits that
other people receive from their consumption of the same good. For example, open-
access Wi-Fi networks become crowded when more people access it. Impure public
goods also differ from pure public goods in that they are often excludable.
An example of an impure public good would be cable television. It is non-rivalrous
because the use of cable television by other individuals will in no way reduce your
enjoyment of it. The good is excludable since the cable TV service providers can
refuse connection if you do not pay for set top box and recharge it regularly..

MARKET FAILURE 2.31
We have seen above that impure public goods only partially satisfy the two public
good characteristics of non-rivalry in consumption and non-excludability. The
possibility of exclusion from the use of an impure public good has two implications.
1. Since free riding can be eliminated, the impure public good may be provided
either by the market or by the government at a price or fee. If the consumption
of a good can be excluded, then, the market would provide a price mechanism
for it.
2. The provider of an impure public good may be able to control the degree of
congestion either by regulating the number of people who may use it , or the
frequency with which it may be used or both.
Two broad classes of goods have been included in the studies related to impure
public goods.
1. Club goods; first studied by Buchanan
2. Variable use public goods; first analyzed by Oakland and Sandmo
Examples of club goods are: facilities such as swimming pools, fitness centres etc.
These goods are replicable and, therefore, individuals who are excluded from one
facility may get similar services from an equivalent provider.
Variable use public goods include facilities such as roads, bridges etc. Once they
are provided, everybody can use it. They can be excludable or non excludable. If
they are excludable, some people can be discouraged from using it frequently by
making them pay for its consumption. In doing so, the frequency of usage of the
public good can be controlled. Since they are not replicable, the facility should be
accessible to all potential users. Why should we exclude the enjoyment of roads,
bridges etc of some people? The reason is the possibility of congestion due to large
number of vehicles and the potential reduction of benefit to the users.
2.4.5. Quasi Public Goods (Mixed Goods)
This second approach to classification of impure public goods focuses on the mix
of services that arise from the provision of the good. For example, if one gets
inoculated against measles, it confers not only a private benefit to the individual,
but also an external benefit because it reduces the chances getting infected of
other persons who are in contact with him. You can observe here that the external
effect associated with the consumption of a private good may have the
characteristics of a public good.

Similarly, education will improve the individual’s earning potential and at the same
time, it may facilitate basic research creating nonrival non excludable knowledge
and information which are public goods. Other examples of benefits to the society
through education are improvement in decision making behaviour, provision of a
screening device for the labour market to determine the quality of labour and
better cultural environment and heritage for future generations. For example, other
things remaining the same, the students pursuing the chartered accountancy
programme will have a demand curve for the programme at various prices. This
reflects the private benefits which the students believe they would enjoy as a result
of this education. These may be viewed as ‘private return’ on education and they
depend in part on the income differential that students expect during their working
life as a result of chartered accountancy education. However, there are likely other
benefits such as, the possible addition which you may make to accounting
knowledge and practices, the consultancy services you give to others, the policy
recommendations that you may be able to put forth for a better tax or budgeting
system etc. to mention a few. These have the characteristics of public good as
everyone in the society can consume them without reducing the amount available
for consumption by others. Obviously, your demand curve for the CA programme
did not incorporate all these external effects.
The quasi-public goods or services, also called a near public good (for e.g.
education, health services) possess nearly all of the qualities of the private goods
and some of the benefits of public good. It is easy to keep people away from them
by charging a price or fee. However, it is undesirable to keep people away from
such goods because the society would be better off if more people consume them.
This particular characteristic namely, the combination of virtually infinite benefits
and the ability to charge a price results in some quasi-public goods being sold
through markets and others being provided by government. As such, people argue
that these should not be left to the market alone.
Markets for the quasi public goods are considered to be incomplete markets and
their lack of provision by free markets would be considered as inefficiency and
market failure.
2.4.6 Common Access Resources
Common access resources or common pool resources are a special class of impure
public goods which are non-excludable as people cannot be excluded from using
them. These are rival in nature and their consumption lessens the benefits available
for others. This rival nature of common resources is what distinguishes them from

MARKET FAILURE 2.33
pure public goods, which exhibit both non-excludability and non-rivalry in

consumption. They are generally available free of charge. Some important natural
resources fall into this category.
Since price mechanism does not apply to common resources, producers and
consumers do not pay for these resources and therefore, they overuse them and
cause their depletion and degradation. This creates threat to the sustainability of
these resources and, therefore, the availability of common access resources for
future generations.
Economists use the term ‘tragedy of the commons’ to describe the problem which
occurs when rivalrous but non excludable goods are overused, to the disadvantage
of the entire world.
Examples of common access resources are fisheries, common pastures, rivers, sea,
backwaters biodiversity etc. The earth’s atmosphere is perhaps the best example.
Emissions of carbon dioxide and other greenhouse gases have led to the depletion
of the ozone layer endangering environmental sustainability. Although nations are
aware of the fact that reduced global warming would benefit everyone, they have
an incentive to free ride, with the result that nothing positive is likely to be done to
correct the problem. .
2.4.7. Global Public Goods
There are several public goods benefits of which accrue to everyone in the world.
These goods have widespread impact on different countries and regions,
population groups and generations. These are goods whose impacts are indivisibly
spread throughout the entire globe.
The WHO delineates two categories of global public goods namely, final public
goods which are ‘outcomes’, (e.g. the eradication of polio) and intermediate public
goods, which contribute to the provision of final public goods.( e.g. International
Health Regulations aimed at stopping the cross-border movement of
communicable diseases and thus reducing cross-border health risks). Similarly, the
World Bank identifies five areas of global public goods which it seeks to address:
namely, the environmental commons (including the prevention of climate change
and biodiversity), communicable diseases (including HIV/AIDS, tuberculosis,
malaria, and avian influenza), international trade, international financial
architecture, and global knowledge for development. The distinctive characteristic
of global public goods is that there is no mechanism (either market or government)
to ensure an efficient outcome.

2.4.8 The Free Rider Problem

We may be unfamiliar with the jargon ‘free riding’ but it is a familiar phenomenon
in our day to day life. You might have noticed that when students are required to
do a group project, some group members tend to escape the work and make others
do the entire work. Those who escape assignment ‘free ride’ on the efforts of others.
The incentive to let other people pay for a good or service, the benefits of which
are enjoyed by an individual is known as the free rider problem. In other words,
free riding is ‘benefiting from the actions of others without paying’. A free rider is
a consumer or producer who does not pay for a nonexclusive good in the
expectation that others will pay.
Public goods provide a very important example of market failure, in which the self
interested behaviour of individuals does not produce efficient results. We shall now
see how free riding is applicable in the case of public goods. Consumers can take
advantage of public goods without contributing sufficiently to their production.
The absence of excludability in the case of public goods and the tendency of people
to act in their own self interest will lead to the problem of free riding. If individuals
cannot be excluded from the benefit of a public good, then they are not likely to
express the value of the benefits which they receive as an offer to pay. In other
words, they will not express to buy a particular quantity at a price. Briefly put, there
is no incentive for people to pay for the good because they can consume it without
paying for it. There is an important implication for this behaviour. If every individual
plays the same strategy of free riding, the strategy will fail because nobody is willing
to pay and therefore, nothing will be provided by the market. Then, a free ride for
any one becomes impossible.
On account of the free rider problem, there is no meaningful demand curve for
public goods. If individuals make no offers to pay for public goods, then the profit
maximizing firms will not produce them.
In fact, the public goods are valuable for people. If there is no free rider problem,
people would be willing to pay for them and they will be produced by the market.
As such, if the free-rider problem cannot be solved, the following two outcomes
are possible:
1. No public good will be provided in private markets
2. Private markets will seriously under produce public goods even though these
goods provide valuable service to the society.

MARKET FAILURE 2.35
2.5. INCOMPLETE INFORMATION

Complete information is an important element of competitive market. Perfect
information implies that both buyers and sellers have complete information about
anything that may influence their decision making. However, this assumption is not
fully satisfied in real markets due to the following reasons.
• Often, the nature of products and services tends to be highly complex e.g.
Cardiac surgery, financial products (such as pension products mutual funds
etc).
• In many cases consumers are unable to quickly / cheaply find sufficient
information on the best prices as well as quality for different products.
Sometimes they misunderstand the true costs or benefits of a product or are
uncertain about the true costs and benefits.
• People are ignorant or not aware of many matters in the market. Generally
they have inaccurate or incomplete data and consequently make potentially
‘wrong’ choices / decisions.
Information failure is widespread in numerous market exchanges. When this
happens misallocation of scarce resources takes place and equilibrium price and
quantity is not established through price mechanism. This results in market failure.
2.5.1 Asymmetric Information
Asymmetric information occurs when there is an imbalance in information between
buyer and seller i.e. when the buyer knows more than the seller or the seller knows
more than the buyer. This can distort choices. For example, the landlords know
more about their properties than tenants, a borrower knows more about their
ability to repay a loan than the lender, a used-car seller knows more about vehicle
quality than a buyer and some traders may possess insider information in financial
markets. These are situations in which one party to a transaction knows a material
fact that the other party does not. This phenomenon, which is sometimes referred
to as the ‘lemons problem’, is an important source of market failure. With
asymmetric information, low-quality goods can drive high-quality goods out of the
market.
2.5.2 Adverse Selection and Moral Hazard
Adverse selection is a situation in which asymmetric information about quality
eliminates high-quality goods from a market. One example of adverse selection is
that of health insurance. The people who are most likely to purchase health

insurance are those who are most likely to use it, i.e. people with unhealthy life
styles and those with underlying health issues. The insurance company being aware
of this raises the average price of insurance cover. This prices healthy consumers
out of the market as healthy people will be unwilling to pay such high premium.
The result is that only high risk individuals buy insurance. This is a market failure.
Another example is the used car market i.e. the ‘market for lemons’. The owner of
a car knows much more about its quality than anyone else. The buyer’s willingness
to pay for any particular car will be based on the ‘average quality’ of used cars.
Anyone who sells a ‘lemon’ (an unusually poor car) stands to gain. The market
becomes flooded with lemons. Eventually the market may offer nothing but lemons.
The good-quality cars disappear because they are kept by their owners or sold only
to friends. Briefly put, buyers expect hidden problems in items offered for sale,
leading to low prices and the best items being kept off the market.
Moral hazard is opportunism characterized by an informed person’s taking
advantage of a less-informed person through an unobserved action. It arises from
lack of information about someone’s future behavior. Moral hazard occurs when an
individual knows more about his or her own actions than other people do. This
leads to a distortion of incentives to take care or to exert effort when someone else
bears the costs of the lack of care or effort.
When someone is protected from paying the full costs of their harmful actions, they
tend to act irresponsibly, making the harmful consequences more likely. Moral
hazard occurs when a party whose actions are unobserved can affect the probability
or magnitude of a payment associated with an event. For example: the insured
consumers are likely to take greater risks, knowing that a claim will be paid for by
the insurance company. The more of one’s costs that are covered by the insurance
company, the less a person cares whether the doctor charges excessive fees or uses
inefficient and costly procedures as part of his health care. This causes insurance
premiums to rise for everyone, driving many potential customers out of the market.
This became a big issue in India when the health insurance providers and big
private hospitals came in conflict and the issue was resolved by putting in place a
‘third party administration’ to settle the medical claims.
Asymmetric information, adverse selection and moral hazard affect the ability of
markets to efficiently allocate resources and therefore lead to market failure
because the party with better information has a competitive advantage.

MARKET FAILURE 2.37
2.6 CONCLUSION
Markets, do not always lead to efficiency. When there is a market failure, the market
outcomes may be inefficient and government intervention can improve society’s
welfare. Government can ensure economic efficiency by providing the necessary
legal and regulatory system that facilitates efficiency and /or it can intervene to
correct specific market failures. The role of the government in combating market
failures will be discussed in the next unit.
SUMMARY
• Market failure is a situation in which the free market fails to allocate resources
efficiently in the sense that there is either overproduction or underproduction
of particular goods and services leading to less than optimal market outcomes.
• The demand-side market failures are said to occur when demand curves do not
take into account the full willingness of consumers to pay for a product. The
supply -side market failures happen when supply curves do not incorporate
the full cost of producing the product.
• The price system and markets work efficiently only if market prices convey
information to both producers and consumers.
• There are four major reasons for market failure. They are: market power,
externalities, public goods, and incomplete information.
• Excessive market power causes the single producer or small number of
producers to produce and sell less output than would be produced and charge
a higher price in a competitive market.
• Externalities, also referred to as ‘spillover effects’, ‘neighbourhood effects’
‘third-party effects’, or ‘side-effects’, occur when the actions of either
consumers or producers result in costs or benefits that do not reflect as part
of the market price.
• Externalities cause market inefficiencies because they hinder the ability of
market prices to convey accurate information about how much to produce and
how much to buy. Since externalities are not reflected in market prices, they
can be a source of economic inefficiency.
• Externalities are initiated and experienced, not through the operation of the
price system, but outside the market and therefore, are external to the market.

• Externalities may be unidirectional or reciprocal. Externalities can be positive

or negative. Negative externalities occur when the action of one party imposes
costs on another party. Positive externalities occur when the action of one party
confers benefits on another party.
• The four possible types of externalities are : Negative externality initiated in
production which imposes an external cost on others. Positive production
externality, less commonly seen, initiated in production that confers external
benefits on others. Negative consumption externalities initiated in
consumption which produce external costs on others. Positive consumption
externality initiated in consumption that confers external benefits on others.
Each of the above may be received by another in consumption or in production.
The firm or the consumer as the case may be , however, has no incentive to
account for the external costs that it imposes on consumers
• Private cost is the cost faced by the producer or consumer directly involved in
a transaction and includes direct cost of labour, materials, energy and other
indirect overheads and does not incorporate externalities.
• Social cost is the entire cost which the society bears. Social Cost =Private Cost
+ External Cost.
• When negative production externalities exist, social costs exceed private cost.
If producers do not take into account the externalities, there will be over-
production and market failure and unwarranted social consequences.
• When firms do not have to worry about negative externalities associated with
their production, the result is excess production and unnecessary social costs
• A public good (also referred to as a collective consumption good or a social
good) is defined as one which all individuals enjoy in common in the sense that
each individual’s consumption of such a good leads to no subtraction from any
other individual’s consumption of that good.
• Private goods are ‘rivalrous’ ‘and excludable’ and less likely to have the free
rider problem. Additional resource costs are involved for providing to another.
• Public goods consumption is indivisible, collective, nonrival, non-excludable
and vulnerable to externalities and free rider problems.
• Public goods do not conform to the settings of market exchange and left to
the market, they will not be produced at all or will be under produced. This is
because the price becomes zero

MARKET FAILURE 2.39
• A pure public good is non-rivalrous and non excludable. Impure public goods
are partially rivalrous or congestible. Because of the possibility of congestion,
the benefit that an individual gets from an impure public good depends on
the number of users.
• The provider of an impure public good may be able to control the degree of
congestion either by regulating the number of people who may use it, or the
frequency with which it may be used or both.
• The quasi-public goods or services, also called a near public good (for e.g.
education, health services) possess nearly all of the qualities of the private
goods and some of the benefits of public good. They exhibit market failure as
incomplete markets.
• Common access resources or common pool resources are a special class of
impure public goods which are non excludable as people cannot be excluded
from using them. These are rival in nature and their consumption lessens the
benefits available for others.
• Since price mechanism does not apply to ‘common resources’, producers and
consumers do not pay for these resources and therefore, they overuse them
and cause their depletion and degradation.
• Economists use the term ‘tragedy of the commons’ to describe the problem
which occurs when rivalrous but non excludable goods are overused to the
disadvantage of the entire universe.
• The incentive to let other people pay for a good or service, the benefits of
which are enjoyed by an individual is known as the free rider problem.
• If every individual plays the same strategy of free riding, the strategy will fail
because nobody is willing to pay and therefore nothing will be provided by the
market.
• Complete information is an essential element of competitive market. But it is
not fully satisfied in real world markets for goods or services due to highly
complex nature of products.
• Asymmetric information occurs when there is an imbalance in information
between buyer and seller i.e. when the buyer knows more than the seller or the
seller knows more than the buyer. This can distort choices. With asymmetric
information, low-quality goods can drive high-quality goods out of the market.

• Adverse selection is a situation in which asymmetric information about quality

eliminates high-quality goods from a market. Buyers expect hidden problems
in items offered for sale, leading to low prices and the best items being kept
off the market.
• Moral hazard is opportunism characterized by an informed person’s taking
advantage of a less-informed person through an unobserved action.
• Asymmetric information, adverse selection and moral hazard affect the ability
of markets to efficiently allocate resources and therefore, lead to market failure
because the party with better information has a competitive advantage. Due
to this the market collapses as transactions do not take place or very few
transactions occur:
TEST YOUR KNOWLEDGE

I Multiple Choice Type Question
1. ‘Market failure’ occurs
(a) when public goods are not sufficiently provided by public sector
(b) the market fails to allocate resources efficiently and therefore market
outcomes become inefficient.
(c ) people are not willing to pay and want to free ride
2. Markets fail because
(a) externalities are not accounted for in pricing and quantity decisions of
firms
(b) most often the prerequisites of competition are unlikely to be present in
an economy
(c) prices fail to reflect the true costs and benefits to the society
(d) all the above
3. Market power
(a) makes price equal marginal cost and produce a positive external benefit
on others
(b) can cause markets to be inefficient because it keeps price and output away
from equilibrium of supply and demand

MARKET FAILURE 2.41
(c) makes the firms price makers and restrict output so as to make allocation
inefficient
(d) (b) and(c) above
4. Markets do not exist
(a) for pure public goods
(b) for goods which have positive externalities
(c) for goods which have negative externalities
(d) none of the above
5. The unique feature of an externality is that it is
(a) initiated and experienced, not through the operation of the price system
but affects an external agent
(b) initiated and experienced, not through the operation of the price system,
but outside the market
(c) initiated and experienced by the same entity, but causes decrease in social
welfare
(d) causes decreases in social welfare through the system of prices prevailing
in the market
6. If a textile mill produces large amounts of negative externality, then which
one of the following is possible?
(a) The output of textile is too little when compared to the socially optimal
quantity
(b) The output of textile is too large when compared to the socially optimal
quantity
(c) The output of textile is not socially optimal as it is likely to be a regulated
one
(d) Any of the above
7. All but one of the following statements is incorrect. Identify the correct
statement.
(a) When there is a negative externality, the social marginal cost will exceed
private marginal cost

(b) When there is a positive externality the social marginal cost will exceed
private marginal cost
(c) Common property resources are non rival and non excludable public
goods so that the problem of sustainability becomes grave
(d) Goods that are rival in consumption and are non excludable are known as
private goods
8. In case of a positive externality
(a) the social marginal cost will exceed private marginal cost
(b) the social marginal cost will be equal to private marginal cost
(c) the social marginal cost will be less than private marginal cost
(d) the social marginal cost has no relation to private marginal cost
9. Which of the following statement is correct in respect of externalities?
(a) When social marginal costs are equal to private marginal costs, the level
of output will be equal to the socially optimal level
(b) When social marginal costs are less than private marginal costs, the level
of output will be lower than the socially optimal level
(c) When social marginal costs are greater than private marginal costs, the
level of output will be higher than the socially optimal level
(d) All of the above.
10. Match the following
(a) Pure public goods i) Excludable and rival

(b) Club goods ii) Non excludable and rival
(c) Common resources iii) Non excludable and non rival
(d) Private good iv) Non rival and excludable
(a) {a) i)}; {b) ii)}; {c) iv)}; {d) iii)}
(b) {a) ii)}; {b) i)}; {c) iii)}; {d) iv)}
(c) {a) iii)}; {b) i)}; {c)ii)}; {d) iv)}
(d) {a) iii)}; {b) iv)}; {c) ii)}; {d) i)}

MARKET FAILURE 2.43
11. Pollution is an instance of market failure

(a) because the equilibrium price is higher than the efficient price
(b) because the equilibrium price is less than the efficient price
(c) because property rights are poorly distributed
(d) because the market does not produce enough of the good
12. An adequate amount of a pure public good will not be provided by the private
market because of
(a) the existence of negative externalities
(b) governments would any way produce them
(c) There are restrictions as well as taxes on the private market
(d) The possibility of free riding
13. The free rider problem arises because of
(a) ability of participants to produce goods at zero marginal cost
(b) marginal benefit cannot be calculated due to externalities present
(c) the good or service is non excludable
(d) general poverty and unemployment of people
14. Which of the following is an example of an impure public good?
(a) a lighthouse provided by government
(b) a congested highway during peak hours
(c) a polio vaccination program sponsored by the government
(d) national defence and the security offered by it
15. A situation where a pharmaceutical company has full information regarding
the risks of a product, but continues to sell it is a case of
(a) asymmetric information
(b) moral hazard
(c) free riding
(d) and (c) above

16. If an individual tends to drive his car in a dangerously high speed because he
has a comprehensive insurance cover, it is a case of
(a) free riding
(b) moral hazard
(c) negative externality
(d) efficiency
17. Read the following statements
I. Common resources are pure public goods which are non rival
II. Since price mechanism does not apply to common resources, producers
and consumers do not pay for these resources
III. Self-interest makes them overuse the common resources and cause their
depletion and degradation
IV. The common resources impure public goods which are excludable but non
rival
(a) Statement I alone is correct
(b) Statements I and IV are correct
(c) Statements II and III are correct
(d) Statements I ,II and III are correct
18. Market failure will never occur in a
(a) Socialist economy which is developed
(b) Unplanned economy which is under developed
(c) Capitalist economy which is developed
1. Explain the term market failure
2. Explain, with the aid of examples, the main characteristics of private goods.
3. Identify a pure public good using the criteria for identification
4. Explain the free rider problem. Give examples

MARKET FAILURE 2.45
5. Public goods do not use up extra resources as additional people consume

them. Why?
6. Why do economists use the word external to describe third-party effects that
are harmful or beneficial?
7. Explain why environmental pollution is regarded as a source of market failure.
8. Define externalities. Why are they considered as a source of market failure?
9. Distinguish between positive and negative externalities.
10. Appraise the role of incomplete information in generating market failure.
11. What do you understand by externalities in consumption?
12. What criteria are used to distinguish between pure and impure public goods?
13. Explain the term quasi public goods
14. How can social costs be differentiated from private cost?
15. What is the consequence of a negative externality on price and output?
16. How does the presence of positive externality influence price and output?
17. Describe the term ‘Tragedy of Commons’
18. Define common resources. Why are they overused?
19. Discuss the importance of the distinction between private costs and social
costs.
20. Describe, using examples, common access resources
21. Why are health and education not pure public goods?
1. Define the concept of market failure. Describe the different sources of market
failure
2. Explain the different types of externalities? Illustrate how externalities lead to
welfare loss of markets
3. Describe why markets have incentives to produce private goods?
4. Why do markets fail to produce public goods? Illustrate your answer.
5. Distinguish between different types of public goods. How do public goods
cause market failure?

6. Explain using diagram and examples, the concepts of negative externalities of

production and consumption, and the welfare loss associated with the
production or consumption of a good or service.
7. Explain, with the aid of examples, the main characteristics of merit goods.
8. Describe the free rider problem associated with public goods. What would be
the outcome? Give examples
9. ‘The existence of poverty in economically less developed countries creates
negative externalities through over-exploitation of land for agriculture, and
this poses a threat to sustainability’. Elucidate
1. Identify the market outcomes for each of the following situations
(a) A few youngsters play loud music at night. Neighbours may not be able to
sleep.
(b) Ram buys a large SUV which is very heavy
(c) X smokes in a public place
(d) Rural school students given vaccination against measles
(e) Traffic congestion making travel very uncomfortable
(f) Piracy of computer programs
(g) Some species of fish are now getting extinct because they have been
caught indiscriminately.
(h) The municipality provides sirens four times a day
(i) Burglar alarms are installed by many in your locality
(j) Global warming increases due to emissions of fossil fuels
ANSWERS/HINTS
1. (b) 2. (d) 3. (d) 4. (a) 5. (b)
6. (b) 7. (a) 8. (c) 9. (c) 10. (d)
11. (b) 12. (d) 13. (c) 14. (b) 15. (a)
16 (b) 17 (c) 18. (d)

MARKET FAILURE 2.47

(a) Negative externality, overproduction
(b) Negative externality, environmental externality, wear and tear of roads,
increased fuel consumption, added insecurity imposed on others
(c) Negative externality, overproduction
(d) Public good, positive externality
(e) Negative externality
(f) Unpatented computer programs have characteristics very much like a public
good and therefore market failure.
(g) The problem of the commons –The tragedy of commons
(h) Sirens have all characteristics of public goods. People will free ride – market
failure.
(i) Positive externality, free riding.
(j) Negative externality.

UNIT III: GOVERNMENT
INTERVENTIONS TO CORRECT
MARKET FAILURE
LEARNING OUTCOMES

 Describe the different forms of government intervention for correcting
market failure
 Evaluate the outcomes of intervention in case of public goods, merit goods
and demerit goods
 Illustrate how intervention combat market power, externalities, inequalities
and information failure
 Elucidate the functioning and outcomes of price intervention
Public Finance
Government
Interventions to Correct
Market Failure
Minimize Merit & Correcting

Correct Equitable
Market Demerit Information
Externalities Distribution
Power Goods Failure
In the previous unit, we have seen that under a variety of circumstances the market
and the price system fail to achieve productive and allocative efficiency in an
economy. As such, it should be construed that the existence of a free market does
not altogether eliminate the need for government and that government
intervention is essential for the efficient functioning of markets. The focus of this
unit will be the intervention mechanisms which governments adopt to ensure

GOVERNMENT INTERVENTIONS TO CORRECT MARKET FAILURE 2.49
greater welfare to the society and the probable outcomes of such market
interventions.
Government plays a vital role in creating the basic framework within which fair and
open competitive markets can exist. It is indispensable that government
establishes the ‘rule of law’, and in this process, creates and protects property
rights, ensures that contracts are upheld and sets up necessary institutions for
proper functioning of markets. For achieving this, an appropriately framed
competition and consumer law framework that regulates the activities of firms and
individuals in their market exchanges should be in place.
We have seen in the previous unit that the major reasons for market failure are
market power, externalities, public goods, and incomplete information. Before we
go into the details of government intervention, we shall try to have a quick glimpse
of the forms of government intervention.
As Supplier
Public Goods/
Information
Direct
As buyer /
Government Procurement
Intervention
Taxes /Subsidies to
alter costs
Indirect
Regulation/influence
3.1 GOVERNMENT INTERVENTION TO MINIMIZE MARKET

POWER
As we are aware, market power—exercised either by sellers or buyers— is an
important factor that contributes to inefficiency because it results in higher prices
than competitive prices. In addition, market power also tends to restrict output and
leads to deadweight loss. Because of the social costs imposed by monopoly,
governments intervene by establishing rules and regulations designed to promote

competition and prohibit actions that are likely to restrain competition. These
legislations differ from country to country. For example, in India, we have the
Competition Act, 2002(as amended by the Competition (Amendment) Act, 2007) to
promote and sustain competition in markets. The Antitrust laws in the US and
the Competition Act, 1998 of UK etc are designed to promote competitive economy
by prohibiting actions that are likely to restrain competition. Such legislations
generally aim at prohibiting contracts, combinations and collusions among
producers or traders which are in restraint of trade and other anticompetitive
actions such as predatory pricing. On the contrary, some of the regulatory
responses of government to incentive failure tend to create and protect monopoly
positions of firms that have developed unique innovations. For example, patent
and copyright laws grant exclusive rights of products or processes to provide
incentives for invention and innovation.
Policy options for limiting market power also include price regulation in the form
of setting maximum prices that firms can charge. Price regulation is most often
used for natural monopolies that can produce the entire output of the market at a
cost that is lower than what it would be if there were several firms. If a firm is a
natural monopoly, it is more efficient to permit it serve the entire market rather
than have several firms who compete each other. Examples of such natural
monopoly are electricity, gas and water supplies. In some cases, the government‘s
regulatory agency determines an acceptable price, so as to ensure a competitive or
fair rate of return. This practice is called rate-of-return regulation. Another
approach to regulation is setting price-caps based on the firm’s variable costs, past
prices, and possible inflation and productivity growth.
3.2 GOVERNMENT INTERVENTION TO CORRECT

EXTERNALITIES
As you may easily recall, freely functioning markets produce externalities because
producers and consumers need to consider only their private costs and benefits
and not the costs imposed on or benefits accrued to others. Governments have
numerous methods to reduce the effects of negative externalities and to promote
positive externalities. We shall first examine how government regulation can deal
with the inefficiencies that arise from negative externalities. Since the most
commonly referred negative externality is pollution, we shall take it as an exemplar
in the following discussion.
Government initiatives towards negative externalities may be classified as:

1. Direct controls that openly regulate the actions of those involved in generating
negative externalities, and
2. Market-based policies that would provide economic incentives so that the self-
interest of the market participants would achieve the socially optimal solution.
Direct controls prohibit specific activities that explicitly create negative externalities
or require that the negative externality be limited to a certain level, for instance
limiting emissions. Production, use and sale of many commodities and services are
prohibited in our country. Smoking is completely banned in many public places.
Stringent rules are in place in respect of tobacco advertising, packaging and
labeling etc.
Governments may pass laws to alleviate the effects of negative externalities.
Government stipulated environmental standards are rules that protect the
environment by specifying actions by producers and consumers. For example, India
has enacted the Environment (Protection) Act, 1986. The government may, through
legislation, fix emissions standard which is a legal limit on how much pollutant a
firm can emit. The set standard ensures that the firm produces efficiently. If the firm
exceeds the limit, it can invite monetary penalties or/and criminal liabilities. The
firms have to install pollution-abatement mechanisms to ensure adherence to the
emission standards. This means additional expenditure to the firm leading to rise
in the firm’s average cost. New firms will find it profitable to enter the industry only
if the price of the product is greater than the average cost of production plus
abatement expenditure.
Another method is to charge an emissions fee which is levied on each unit of a
firm’s emissions. The firms can minimize costs and enhance their profitability by
reducing emissions. Governments may also form special bodies/ boards to
specifically address the problem: for instance the Ministry of Environment & Forest,
the Pollution Control Board of India and the State Pollution Control Boards.
The market-based approaches–environmental taxes and cap-and-trade – operate
through price mechanism to create an incentive for change. In other words, they
rely on economic incentives to accomplish environmental goals at lesser costs. The
market based approaches focus on generation of a market price for pollution. This
is achieved by:
1. Setting the price directly through a pollution tax
2. Setting the price indirectly through the establishment of a cap-and-trade
system.

The key to internalizing an externality (both external costs and benefits) is to ensure
that those who create the externalities include them while making decisions. One
method of ensuring internalization of negative externalities is imposing pollution
taxes. The size of the tax depends on the amount of pollution a firm produces.
These taxes are named Pigouvian taxes after A.C. Pigou who argued that an
externality cannot be alleviated by contractual negotiation between the affected
parties and therefore taxation should be resorted to. These taxes, by ‘making the
polluter pay’, seek to internalize external costs into the price of a product or activity.
More precisely, the tax is placed on the externality itself (the amount of pollution
emissions) rather than on output (say, amount of steel). For each unit of pollution,
the polluter must choose either to pay the tax or to reduce pollution through any
means at its disposal. Tax increases the private cost of production or consumption
as the case may be, and would decrease the quantity demanded and therefore the
output of the good which creates negative externality. The proceeds from the tax,
some argue, can be specifically earmarked for projects that protect or enhance
environment.
The following figure illustrates the market outcomes of pollution tax.
Figure 2.3.1
Market Outcomes of Pollution Tax

When negative production externalities exist, marginal social cost is greater than
marginal private cost. The free market outcome would be to produce a socially non
optimal output level Q at the level of equality between marginal private cost and
marginal private benefit. (Since externalities are not taken into account, marginal
private benefit would be contemplated as marginal social benefit). When
externalities are present, the welfare loss to the society or dead weight loss would
be the shaded area ABC. The tax imposed by government (equivalent to the vertical
distance AA1) would shift the cost curve up by the amount of tax, prices will rise to
P1 and a new equilibrium is established at point B, where the marginal social cost
is equal to marginal social benefit. Output level Q1 is socially optimal and eliminates
the whole of welfare loss on account of overproduction.
However, there are problems in administering an efficient pollution tax.
• Pollution taxes are difficult to determine and administer because it is difficult
to discover the right level of taxation that would ensure that the private cost
plus taxes will exactly equate with the social cost. If the demand for the good
is inelastic, the tax may only have an insignificant effect in reducing demand.
• The method of taxing the polluters has many limitations because it involves
the use of complex and costly administrative procedures for monitoring the
polluters.
• This method does not provide any genuine solutions to the problem. It only
establishes an incentive system for use of methods which are less polluting.
• In the case of goods which have inelastic demand, producers will be able to
easily shift the tax burden in the form of higher product prices. This will have
an inflationary effect and may reduce consumer welfare.
• Pollution taxes also have potential negative consequences on employment and
investments because high pollution taxes in one country may encourage
producers to shift their production facilities to those countries with lower taxes.
The second approach to establishing prices is tradable emissions permits (also
known as cap-and-trade). These are marketable licenses to emit limited quantities
of pollutants and can be bought and sold by polluters. Under this method, each
firm has permits specifying the number of units of emissions that the firm is allowed
to generate. A firm that generates emissions above what is allowed by the permit
is penalized with substantial monetary sanctions. These permits are transferable,
and therefore different pollution levels are possible across the regulated entities.
Permits are allocated among firms, with the total number of permits so chosen as

to achieve the desired maximum level of emissions. By allocating fewer permits

than the free pollution level, the regulatory agency creates a shortage of permits
which then leads to a positive price for permits. This establishes a price for
pollution, just as in the tax case. The high polluters have to buy more permits, which
increases their costs, and makes them less competitive and less profitable. The low
polluters receive extra revenue from selling their surplus permits, which makes
them more competitive and more profitable. Therefore, firms will have an incentive
not to pollute. India is experimenting with cap-and-trade in the form of Perform,
Achieve & Trade (PAT) scheme and carbon tax in the form of a cess on coal.
The advantages claimed for tradable permits are:
• The system allows flexibility and reward efficiency
• It is administratively cheap and simple to implement and ensures that
pollution is minimised in the most cost-effective way
• It also provides strong incentives for innovation.
• Consumers may benefit if the extra profits made by low pollution firms are
passed on to them in the form of lower prices.
The main argument in opposition to the employment of tradable emission permits
is that they do not in reality stop firms from polluting the environment; they only
provide an incentive to them to do so. Moreover, if firms have monopoly power
of some degree along with a relatively inelastic demand for its product, the extra
cost incurred for procuring additional permits so as to further pollute the
atmosphere, could easily be compensated by charging higher prices to consumers.
The two interventions mentioned above i.e. pemits and taxes make use of market
forces to encourage consumers and producers to take externalities into account
when planning their consumption and production. In other words, the polluters
are forced to consider pollution as a private cost.
We shall now look into the case of positive externalities. As we are aware, subsidies
involve government paying part of the cost to the firms in order to promote the
production of goods having positive externalities. This is in fact a market-based
policy as subsidies to producers would lower their cost of production. What would
be the outcome of government intervention through subsidy? A subsidy on a good
which has substantial positive externalities would reduce its cost and consequently
price, shift the supply curve to the right and increase its output. A higher output
that would equate marginal social benefit and marginal social cost is socially
optimal. The effect of a subsidy is shown in the following figure.

Figure 2.3.2
Effect of Subsidy on Output
A Pigouvian subsidy equal to the benefit of externality (S=E) is granted by

government to the producer. The output level post subsidy is Q* which equates
marginal social benefit with marginal social cost. This is socially optimum level of
output.
In the case of products and services whose externalities are vastly positive and
pervasive, government enters the market directly as an entrepreneur to produce
and provide them. For example, fundamental research to protect the futuristic
technology interest of the society is, in most cases, funded by government as the
market may not be willing to provide them. Governments also engage in direct
production of environmental quality. Examples are: aforestation, reforestation,
protection of water bodies, treatment of sewage and cleaning of toxic waste sites.
3.3 GOVERNMENT INTERVENTION IN THE CASE OF MERIT

GOODS
Merit goods are goods which are deemed to be socially desirable and therefore the
government deems that its consumption should be encouraged. Substantial
positive externalities are involved in the consumption of merit goods. Left to the

market, only private benefits and private costs would be reflected in the price paid
by consumers. This means, compared to what is socially desirable, people would
consume inadequate quantities. Examples of merit goods include education, health
care, welfare services, housing, fire protection, waste management, public libraries,
museum and public parks.
In contrast to pure public goods, merit goods are rival, excludable, limited in supply,
rejectable by those unwilling to pay, and involve positive marginal cost for
supplying to extra users. Merit goods can be provided through the market, but are
likely to be under-produced and under-consumed through the market mechanism
so that social welfare will not be maximized. The following diagram will show the
market outcome for merit goods.
Figure 2.3.3
Market Outcome for Merit Goods
In the absence of government intervention, the output of the merit good would be
Q where the marginal private cost (MPC) is equal to marginal private benefit (MPB).
The welfare loss to the society due to under production and under consumption is
the shaded area (ABC). On account of considerable positive externalities, the
optimal output is Q* at which marginal social (MSC) cost is equal to marginal social

benefit (MSB). This is a strong case for government intervention in the case of merit
goods.
The additional reasons for government provision of merit goods are:
• Information failure is widely prevalent with merit goods and therefore
individuals may not act in their best interest because of imperfect information.
• Equity considerations demand that merit goods such as health and education
should be provided free on the basis of need rather than on the basis of
individual’s ability to pay.
• There is a lot of uncertainty as to the need for merit goods E.g. health care.
Due to uncertainty about the nature and timing of healthcare required in
future, individuals may be unable to plan their expenditure and save for their
future medical requirements. The market is unlikely to provide the optimal
quantity of health care when consumers actually need it, because they may be
short of the necessary finances to pay the market price.
The possible government responses to under-provision of merit goods are
regulation, subsidies, direct government provision and a combination of
government provision and market provision. Regulation determines how a private
activity may be conducted. For example, the way in which education is to be
imparted is government regulated. Governments can prohibit some type of goods
and activities, set standards and issue mandates making others oblige. For example,
government may make it compulsory to avail insurance protection. Compulsory
immunization may be insisted upon as it helps not only the individual but also the
society at large. Government could also use legislation to enforce the consumption
of a good which generates positive externalities. E.g. use of helmets, seat belts
etc. The Right of Children to Free and Compulsory Education Act, 2009 which
mandates free and compulsory education for every child of the age of six to
fourteen years is another example. A variety of regulatory mechanisms may also be
set up by government to enhance consumption of merit goods and to ensure their
quality.
When governments provide merit goods, it may give rise to large economies of
scale and productive efficiency apart from generating substantial positive
externalities and overcoming the problems mentioned above.
When merit goods are directly provided free of cost by government, there will be
substantial demand for the same. As can be seen from the following diagram, when
people are required to pay the free market price, people would consume only OQ

quantity of healthcare. If provided free at zero prices, the demand OD far exceeds
supply.
Figure 2.3.4
Consumption of Merit Goods at Zero Price
3.4. GOVERNMENT INTERVENTION IN THE CASE OF DEMERIT

GOODS
Demerit goods are goods which are believed to be socially undesirable. Examples
of demerit goods are cigarettes, alcohol, intoxicating drugs etc. The consumption
of demerit goods imposes significant negative externalities on the society as a
whole and therefore the private costs incurred by individual consumers are less
than the social costs experienced by the society. The production and consumption
of demerit goods are likely to be more than optimal under free markets. The price
that consumers pay for a packet of cigarettes is market determined and does not
account for the social costs that arise due to externalities. In other words, the
marginal social cost will exceed the market price and overproduction and over-
consumption will occur, causing misallocation of society's scarce resources. (Refer
Figure 2.2.1 in unit 2). However, it should be kept in mind that all goods with

negative externalities are not essentially demerit goods; e.g. Production of steel
causes pollution, but steel is not a socially undesirable good.
The generally held argument is that consumers overvalue demerit goods because
of imperfect information and they are not the best judges of welfare with respect
to such goods. The government should therefore intervene in the marketplace to
discourage their production and consumption. How do governments correct
market failure resulting from demerit goods?
• At the extreme, government may enforce complete ban on a demerit good.
e.g. Intoxicating drugs. In such cases, the possession, trading or consumption
of the good is made illegal.
• Through persuasion which is mainly intended to be achieved by negative
advertising campaigns which emphasize the dangers associated with
consumption of demerit goods.
• Through legislations that prohibit the advertising or promotion of demerit
goods in whatsoever manner.
• Strict regulations of the market for the good may be put in place so as to limit
access to the good, especially by vulnerable groups such as children and
adolescents.
• Regulatory controls in the form of spatial restrictions e.g. smoking in public
places, sale of tobacco to be away from schools, and time restrictions under
which sale at particular times during the day is banned.
Imposing unusually high taxes on producing or purchasing the good making them
very costly and unaffordable to many is perhaps the most commonly used method
for reducing the consumption of a demerit good. For example, the GST Council has
bracketed four items namely, high end cars, pan masala, aerated drinks and
tobacco products into demerit goods category and therefore these would be taxed
(with a cess being added on to the basic tax) at much higher rates than the top
GST slab of 28 per cent.
However, there are various limitations for government to succeed in producing the
desired optimal effects in the case of demerit goods. There are many practical
difficulties in imposing taxes. In order to impose a tax which is equivalent to the
marginal external cost, the governments need to know the exact value of the
marginal external cost and then ascribe accurate monetary value to those negative
externalities. In practice, this is extremely difficult to do.

The government can fix a minimum price below which the demerit good should not
be exchanged. The effect of such minimum price fixation above equilibrium price
is shown in the figure below:
Figure 2.3.5
Outcomes of Minimum Price for a Demerit Good
Free market equates marginal private cost with marginal private benefit (point B)
and produces an output of a demerit good Q at which marginal social benefit (MSB)
is much less than marginal private benefit (MPB). At this level of output, there is a
divergence (BC) between marginal private benefit (MPB) and marginal social benefit
(MSB). The shaded area represents loss of social welfare. If the government
determined minimum price is P1, demand contracts and the quantity of alcohol
consumed would be reduced to Q1. At Q1level of output, marginal social benefit
(MSB) is equal to marginal social cost (MSC) and the quantity of alcohol consumed
is optimal from the society’s point of view.
The demand for demerit goods such as, cigarettes and alcohol is often highly
inelastic, so that any increase in price resulting from additional taxation causes a
less than proportionate decrease in demand. Also, sellers can always shift the taxes
to consumers without losing customers.
The effect of stringent regulation such as total ban is seldom realized in the form
of complete elimination of the demerit good; conversely such goods are secretly
driven underground and traded in a hidden market.

3.5 GOVERNMENT INTERVENTION IN THE CASE OF PUBLIC

GOODS
We have seen in the previous unit that public goods which are non excludable is
highly prone to free rider problem and therefore markets are unlikely to get
established. Direct provision of a public good by government can help overcome
free-rider problem which leads to market failure. The non-rival nature of
consumption provides a strong argument for the government rather than the
market to provide and pay for public goods. In the case of such pure public goods
where entry fees cannot be charged, direct provision by governments through the
use of general government tax revenues is the only option.
Excludable public goods can be provided by government and the same can be
financed through entry fees. A very commonly followed method is to grant licenses
to private firms to build a public good facility. Under this method, the goods are
provided to the public on payment of an entry fee. In such cases, the government
regulates the level of the entry fee chargeable from the public and keeps strict
watch on the functioning of the licensee to guarantee equitable distribution of
welfare.
Certain goods are produced and consumed as public goods and services despite
the fact that they can be produced or consumed as private goods. This is because,
left to the markets and profit motives, these may prove dangerous to the society.
Examples are scientific approval of drugs, production of strategic products such as
atomic energy, provision of security at airports etc.
3.6 PRICE INTERVENTION : NON MARKET PRICING

Price controls are put in place by governments to influence the outcomes of a
market. Very often, there is strong political demand for governments to intervene
in markets for various goods and services on grounds of fairness and equity. Price
intervention generally takes the form of price controls which are legal restrictions
on price. Price controls may take the form of either a price floor (a minimum price
buyers are required to pay) or a price ceiling (a maximum price sellers are allowed
to charge for a good or service). Fixing of minimum wages and rent controls are
examples of such market intervention.
Government usually intervenes in many primary markets which are subject to
extreme as well as unpredictable fluctuations in price. For example in India, in the
case of many crops the government has initiated the Minimum Support Price (MSP)
programme as well as procurement by government agencies at the set support

prices. The objective is to guarantee steady and assured incomes to farmers. In case
the market price falls below the MSP, then the guaranteed MSP will prevail. The
following diagram will illustrate the effects of a price floor. Nevertheless, mere
announcement of higher support prices for commodities, which are not effectively
backed up by procurement arrangement, does not serve the purpose of
remunerative levels of prices for producers.
Figure 2.3.6
Market Outcome of Minimum Support Price
When price floors are set above market clearing price, suppliers are encouraged
to over-supply and there would be an excess of supply over demand. At price
`150/ which is much above the market determined equilibrium price of ` 75/, the
market demand is only Q1, but the market supply is Q2.
When prices of certain essential commodities rise excessively, government may
resort to controls in the form of price ceilings (also called maximum price) for
making a resource or commodity available to all at reasonable prices. For example:
maximum prices of food grains and essential items are set by government during
times of scarcity. A price ceiling which is set below the prevailing market clearing
price will generate excess demand over supply. As can be seen in the following
figure, the price ceiling of ` 75/ which is below the market determined price of
` 150/leads to generation of excess demand over supply equal to Q1-Q2.

Figure 2.3.7
Market Outcome of Price Ceiling
With the objective of ensuring stability in prices and distribution, governments

often intervene in grain markets through building and maintenance of buffer
stocks. It involves purchases from the market during good harvest and releasing
stocks during periods when production is below average.
3.7 GOVERNMENT INTERVENTION FOR CORRECTING

INFORMATION FAILURE
For combating the problem of market failure due to information problems and
considering the importance of information in making rational choices, the following
interventions are resorted to:
• Government makes it mandatory to have accurate labeling and content
disclosures by producers. For example: SEBI requires that accurate information
be provided to prospective buyers of new stocks.
• Public dissemination of information to improve knowledge and subsidizing of
initiatives in that direction.

• Regulation of advertising and setting of advertising standards to make

advertising more responsible, informative and less persuasive.
3.8 GOVERNMENT INTERVENTION FOR EQUITABLE

DISTRIBUTION
One of the most important activities of the government is to redistribute incomes
so that there is equity and fairness in the society. Equity can be brought about by
redistribution of endowments with which the economic agents enter the market.
Some common policy interventions include: progressive income tax, targeted
budgetary allocations, unemployment compensation, transfer payments, subsidies,
social security schemes, job reservations, land reforms, gender sensitive budgeting
etc. Government also intervenes to combat black economy and market distortions
associated with a parallel black economy. Government intervention in a market
that reduces efficiency while increasing equity is often justified because equity is
greatly appreciated by society.
The discussion above is far from being comprehensive; yet it points toward the
numerous ways in which governments intervene in the markets. However, we
cannot be sure whether the government interventions would be effective or
whether it would make the functioning of the economy less efficient. Government
failures where government intervention in the economy to correct a market failure
creates inefficiency and leads to a misallocation of scarce resources occur very
often. Government failure occurs when:
• intervention is ineffective causing wastage of resources expended for the
intervention
• intervention produces fresh and more serious problems
There are costs and benefits associated with any Government intervention in a
market, and it is important that policy makers consider all of the costs and benefits
of a policy intervention.

SUMMARY
• Governments intervene in various ways to correct the distortions in the market
which occur when there are deviations from the ideal perfectly competitive
state.
• Because of the social costs imposed by monopoly, governments intervene by
establishing rules and regulations designed to promote competition and
prohibit actions that are likely to restrain competition.
• Natural monopolies such as electricity, gas and water supplies are usually
subject to price controls.
• Government initiatives towards combating market failures due to negative
externalities are either direct controls or market-based policies that would
provide economic incentives.
• Direct controls prohibit specific activities that explicitly create negative
externalities or require that the negative externality be limited to a certain level,
for instance limiting emissions.
• Government may pass laws to alleviate the effects of negative externalities or
fix emissions standard which is a legal limit on how much pollutant a firm can
emit. It may charge an emissions fee which is levied on each unit of a firm’s
emissions.
• The market-based approaches– environmental taxes and cap-and-trade –
operate through price mechanism to create an incentive for change.
• The key is to internalizing an externality (both external costs and benefits) is to
ensure that those who create the externalities include them while making
decisions.
• One method of ensuring internalization of negative externalities is imposing
pollution taxes. Pigouvian taxes by ‘making the polluter pay’, seek to internalize
external costs into the price of a product or activity.
• Pollution taxes are difficult to determine and administer due to difficulty to
discover the right level of taxation, problems associated with inelastic nature of
demand for the good and the problem of possible capital flight.
• Tradable emissions permits are marketable licenses to emit limited quantities
of pollutants and can be bought and sold by polluters. The high polluters have

to buy more permits and the low polluters receive extra revenue from selling
their surplus permits.
• The system is administratively cheap and simple, allows flexibility and reward
efficiency and provides strong incentives for innovation
• Subsidy is market-based policy and involves the government paying part of the
cost to the firms in order to promote the production of goods having positive
externalities
• Merit goods such as education, health care etc are socially desirable and have
substantial positive externalities. They are rival, excludable, limited in supply,
rejectable by those unwilling to pay, and involve positive marginal cost for
supplying to extra users.
• Left to the market, merit goods are likely to be under-produced and under-
consumed so that social welfare will not be maximized.
• The possible government responses to under-provision of merit goods are
regulation, legislation, subsidies, direct government provision and a combination
of government provision and market provision.
• When governments provide merit goods, it may give rise to large economies
of scale and productive efficiency and there will be substantial demand for the
same.
• Demerit goods are goods which impose significant negative externalities on
the society as a whole and are believed to be socially undesirable.
• The production and consumption of demerit goods are likely to be more than
optimal under free markets. The government should therefore intervene in the
marketplace to discourage their production and consumption.
• Steps taken by government include complete ban of the good, legislations,
persuasion and advertising campaigns, limiting access to the good, especially
by vulnerable groups,
• In the case of pure public goods where entry fees cannot be charged, direct
provision by governments through the use of general government tax revenues is
the only option. Excludable public goods can be provided by government and the
same can be financed through entry fees.
• A very commonly followed method in the case of public good is to grant licenses
to private firms to build a facility and then the government regulates the level of
the entry fee chargeable from the public.

• Due to strategic and security reasons, certain goods are produced and
consumed as public goods and services despite the fact that they can be
produced or consumed as private goods.
• Price controls may take the form of either a price floor (a minimum price buyers
are required to pay) or a price ceiling (a maximum price sellers are allowed to
charge for a good or service).
• When prices of certain essential commodities rise excessively government may
resort to controls in the form of price ceilings (also called maximum price) for
making a resource or commodity available to all at reasonable prices.
• With the objective of ensuring stability in prices and distribution, governments
often intervene in grain markets through building and maintenance of buffer
stocks.
• Government failures where government intervention in the economy to correct
a market failure creates inefficiency and leads to a misallocation of scare
resources occur very often.
• Government failure occurs when intervention is ineffective causing wastage of
resources expended for the intervention and/or when intervention produces
fresh and more serious problems.
TEST YOUR KNOWLEDGE

1. A thermal power plant uses coal and creates pollution in an otherwise
unpolluted area. Which of the following would ensure that a socially optimal
output of electricity is produced?
(a) Where marginal private cost equals marginal private benefit.
(b) Where marginal private cost equals marginal social benefit.
(c) Where marginal social cost equals marginal private benefit.
(d) Where marginal social cost equals marginal social benefit.
2. Which of the following statements is true?
I The market-based approaches to control externalities operate through
price mechanism
II. When externalities are present, the welfare loss would be eliminated

III. The key is to internalizing an externality is to ensure that those who

create the externalities include them while making decisions
(a) Both II and III
(b) I only
(c) II only
(d) Both I and III
3. Which of the following statements is false?
(a) Tradable permits provide incentive to innovate
(b) A subsidy on a good which has substantial positive externalities would
reduce its cost and consequently price
(c) Substantial negative externalities are involved in the consumption of merit
goods.
(d) Merit goods are likely to be under-produced and under
consumed through the market mechanism
4. A Pigouvian subsidy
(a) cannot be present when externalities are present
(b) is a good solution for negative externality as prices will increase
(c) is not measurable in terms of money and therefore not practical
(d) may help production to be socially optimal when positive externalities are
present
5. If governments make it compulsory to avail insurance protection, it is because
(a) Insurance companies need to be running profitably
(b) Insurance will generate moral hazard and adverse selection
(c) Insurance is a merit good and government wants people to consume it
6. If merit goods are provided free by the government
(a) The quantity demanded of merit good will be less than supply
(b) The quantity demanded of merit good will be equal to supply
(c) The quantity demanded of merit good is likely to be more than supply

(d) Any of the above can happen

7. The government should intervene in the marketplace to discourage the
production and consumption of ---------------
(a) Goods which are not necessary
(b) Demerit goods
(c) Goods having no externalities
(d) Goods which the markets produce less
8. If government produces and supplies a public good
(a) It may correct market failure as there will be no externalities
(b) It may correct market failure caused by free riding
(c) It may correct market failure because people may free ride
(d) It may correct market failure because people may not free ride
9. Rules regarding product labeling
(a) Seeks to correct market failure due to externalities
(b) Is a method of solving the problem of public good
(c) May help solve market failure due to information failure
(d) Reduce the problem of monopolies in the product market
10. Identify the incorrect statement
(a) A minimum support price for agricultural goods is a market intervention
method to guarantee steady and assured incomes to farmers.
(b) A price ceiling which is set below the prevailing market clearing price will
generate excess demand over supply.
(c) Excludable public goods can be provided by government and the same
can be financed through entry fees.
(d) The production and consumption of demerit goods are likely to be less
than optimal under free markets
1. How do governments ensure that market power does not create distortions in
the market?

2. Describe direct government actions to solve negative externalities.

3. What are the relative advantages of market based interventions?
4. Account for the difficulties in determination of level of taxes to solve the
problems associated with market failure?
5. Why do governments provide public goods?
6. Define demerit good and point out its characteristics
7. What are the different options for providing merit goods to the public?
8. What are the consequences if demerit goods are left to free market?
9. Explain why governments impose taxes on goods and services?
10. Explain why governments provide subsidies? Illustrate a few examples of
subsidies.
11. Explain why governments impose price ceilings?
12. How do you justify food price controls and rent controls?
13. Describe the effects of price ceilings with examples
14. Illustrate the impact of a price ceiling on market outcomes.
15. Explain why governments impose price floors?
16. Describe the concept of price floors with examples.
17. Explain the rationale for price support for agricultural products
18. Why do governments fix minimum wages?
1. Do you think government intervention in markets will help enhance social
welfare? Substantiate your arguments
2. Explain the intervention strategies of government to bring about efficient
market outcomes
3. Explain how government intervention can solve the problem of externalities?
4. Explain the market based methods for solving the problems of negative
externalities?
5. Explain the effectiveness of regulatory mechanisms for mitigating market
failure?

6. What is the rationale behind the argument that public goods should be
provided by government?
7. Why do you think it is necessary for the government to manipulate the price
and output of commodities and services? What consequences do you foresee
in the absence of government intervention?
1. The pharmaceutical industry is involved in innovation, development,
production, and marketing of medicines in India. Ensuring the availability of
lifesaving drugs at reasonable prices is the duty of the government. The
National Pharmaceutical Pricing Authority (NPPA) is the watchdog in India,
which controls the prices of drugs. Government has to consider the interest of
both the producers and the buyers.
Questions
(i) Elucidate the market outcomes if matters relating to drugs are entirely left
to the pharmaceutical industry.
(ii) Appraise the need for government action in the above case. Do you
consider government action necessary in the case of medicines? Why?
(iii) What are the different policy options available to government to meet its
public health objectives?
2. The draft of New Education Policy, 2016 proposes key changes in government’s
policy towards education. Explain the rationale for government action to
streamline the education system in the county.
3. The Commission for Agricultural Costs and Prices (CACP) advises the
government on minimum support prices of 23 agricultural commodities which
comprise 7 cereals, 5 pulses, 7 oilseeds, and 4 commercial crops.
(i) What is the underlying principle of minimum support prices? Do you think
MSP is a form of market intervention? Why?
(ii) Why do you consider free markets undesirable for the above mentioned
agricultural commodities?
ANSWERS/HINTS
1. (d) 2. (d) 3. (c) 4. (b) 5. (c)

6. (c) 7. (b) 8. (c) 9. (c) 10. (a)

1. (i) Essential commodity – Left to market there may be inefficiency and
possible market power – likely to charge higher prices than competitive
prices- Price controls are put in place by governments to influence the
outcomes of a market- Policy options for limiting market power also
include price regulation in the form of setting maximum prices that firms
can charge- In some cases, the government‘s regulatory agency
determines an acceptable rate-of return - setting price-caps based on the
firm’s variable costs, past prices, and possible inflation and productivity
growth regulation price, so as to ensure a competitive or fair rate of return.
Legislation, regulation in terms of price controls, selection and listing of
items to be included in price control, care to be taken not to damage the
incentives of producers. Illustrate with figures
(ii) Merit good- merit goods are rival, excludable, limited in supply, rejectable
by those unwilling to pay, and involve positive marginal cost for supplying
to extra users. Positive externalities- Left to the market, only private
benefits and private costs would be reflected in the price paid by
consumers. This means, compared to what is socially desirable, people
would consume inadequate quantities.
(iii) Merit goods can be provided through the market, but are likely to be under
produced and under-consumed through the market mechanism so that
social welfare will not be maximized - This is a strong case for government
intervention. Government intervention in the form of direct provision,
regulation, licensing and controls. Illustrate with figure: Market outcome
for merit goods.
2. Merit good (Refer hints to question 1 above ) Illustrate with figure: Market
outcome for merit goods.
3. (i) Influence the outcomes of a market on grounds of fairness and equity-
strong political demand for government intervention - Price intervention
for ensuring stable prices and stable incomes to producers - market-based
incentives to ensure steady output, outcomes of higher than equilibrium
price. Illustrate with figures
(ii) Markets for primary products are subject to extreme as well as
unpredictable fluctuations in price – Income elasticity of demand for

primary products is less than one – need to guarantee steady and assured
incomes to farmers - Minimum Support Price (MSP) programme as well as
procurement by government agencies at the set support prices - Illustrate
with figure : Market outcome of minimum support price- When price floors
are set above market clearing price, suppliers are encouraged to over-
supply and there would be an excess of supply over demand – limitations
-possible government failure

UNIT IV: FISCAL POLICY
LEARNING OUTCOMES

 Define fiscal policy and list out its objectives
 Distinguish between discretionary and non- discretionary fiscal policy
 Explain the various instruments of fiscal policy
 Describe the expansionary and contractionary fiscal policies
 Illustrate the use of fiscal policy for redistribution and economic growth
 Elucidate the limitations fiscal policy
Public Finance
Fiscal Policy
Automatic
Objectives of Stabilizers Versus Instruments of Types of Fiscal
Fiscal Policy Discretionary Fiscal Policy Policy
Fiscal Policy
4.1 INTRODUCTION
In the previous unit, we have studied the nature of governments’ intervention in
markets to provide public goods, remedy externalities, ensure efficient allocation

FISCAL POLICY 2.75
and to enable redistribution of income. We have also looked into how taxes and
subsidies influence the incentives for private economic activity. We have been
doing this from the microeconomic point of view. From the macroeconomic
perspective, the focus is on the aggregate economic activity of governments, say,
aggregate expenditure, taxes, transfers and issues of government debts and deficits
and their effects on aggregate economic variables such as total output, total
employment, inflation, overall economic growth etc . These, in fact, form the subject
matter of fiscal policy.
The significance of fiscal policy as a strategy for achieving certain socio economic
objectives was not recognized or widely acknowledged before 1930 due to the faith
in the limited role of government advocated by the then prevailing laissez-faire
approach. Great Depression and the consequent instabilities made policymakers
support a more proactive role for governments in the economy. However, later on,
markets started demonstrating an enhanced role in the allocation of goods and
services in the economy. In the previous unit, we have seen situations under which
markets fail to achieve optimal outcomes and the need for government
intervention to combat those market failures. In recent times, especially after being
threatened by the global financial crisis and recession, many countries have
preferred to have a more active fiscal policy.
Governments of all countries pursue innumerable policies to accomplish their
economic goals such as rapid economic growth, equitable distribution of wealth
and income, reduction of poverty, price stability, exchange rate stability, full-
employment, balanced regional development etc. Government budget is one
among the most powerful instruments of economic policy. The important tools in
the budgetary policy could be broadly classified into public revenue including
taxation, public expenditure, public debt and finally deficit financing to bridge the
gap between public receipts and payments. When all these tools are used for
achieving certain goals of economic policy, public finance is transformed into what
is called fiscal policy. In other words, through the use of these instruments
governments intend to favourably influence the level of economic activity of a
country.
Fiscal policy involves the use of government spending, taxation and borrowing to
influence both the pattern of economic activity and level of growth of aggregate
demand, output and employment. It includes any design on the part of the
government to change the price level, composition or timing of government

expenditure or to alter the burden, structure or frequency of tax payment. In other

words, fiscal policy is designed to influence the pattern and level of economic
activity in a country. Fiscal policy is in the nature of a demand-side policy. An
economy which is producing at full-employment level does not require government
action in the form of fiscal policy.
4.2 OBJECTIVES OF FISCAL POLICY

The objectives of fiscal policy, like those of other economic policies of the
government, are derived from the aspirations and goals of the society. Since
nations differ in numerous aspects, the objectives of fiscal policy also may vary from
country to country. However, the most common objectives of fiscal policy are:
• Achievement and maintenance of full employment,
• maintenance of price stability,
• acceleration of the rate of economic development, and
• equitable distribution of income and wealth,
The importance as well as order of priority of these objectives may vary from
country to country and from time to time. For instance, while stability and equality
may be the priorities of developed nations, economic growth, employment and
equity may get higher priority in developing countries. Also, these objectives are
not always compatible; for instance the objective of achieving equitable
distribution of income may conflict with the objective of economic growth and
efficiency.
Before we go into the details of fiscal policy, we need to know the difference
between discretionary fiscal policy and non-discretionary fiscal policy of automatic
stabilizers.
4.3 AUTOMATIC STABILIZERS VERSUS DISCRETIONARY

FISCAL POLICY
Non-discretionary fiscal policy or automatic stabilizers are part of the structure of
the economy and are ‘built-in’ fiscal mechanisms that operate automatically to
reduce the expansions and contractions of the business cycle. Changes in fiscal
policy do not always require explicit action by government. In most economies,
changes in the level of taxation and level of government spending tend to occur
automatically. These are dependent on and are determined by the level of

FISCAL POLICY 2.77
aggregate production and income, such that the instability caused by business
cycle is automatically dampened without any need for discretionary policy action.
Any government programme that automatically tends to reduce fluctuations in
GDP is called an automatic stabilizer. Automatic stabilizers have a tendency for
increasing GDP when it is falling and reducing GDP when it is rising. In automatic
or non discretionary fiscal policy, the tax policy and expenditure pattern are so
framed that taxes and government expenditure automatically change with the
change in national income. It involves built- in- tax or expenditure mechanism that
automatically increases aggregate demand when recession is there and reduces
aggregate demand when there is inflation in the economy. Personal income taxes,
corporate income taxes and transfer payments (unemployment compensation,
welfare benefits) are prominent automatic stabilizers.
Automatic stabilisation occurs through automatic adjustments in government
expenditures and taxes without any deliberate governmental action. These
automatic adjustments work towards stimulating aggregate spending during the
recessionary phase and reducing aggregate spending during economic expansion.
As we know, during recession incomes are reduced; with progressive tax structure,
there will be a decline in the proportion of income that is taxed. This would result
in lower tax payments as well as some tax refunds. Simultaneously, government
expenditures increase due to increased transfer payments like unemployment
benefits. These two together provide proportionately more disposable income
available for consumption spending to households. In the absence of such
automatic responses, household spending would tend to decrease more sharply
and the economy would in all probability fall into a deeper recession.
On the contrary, when an economy expands, employment increases, with
progressive system of taxes people have to pay higher taxes as their income rises.
This leaves them with lower disposable income and thus causes a decline in their
consumption and therefore aggregate demand. Similarly, corporate profits tend to
be higher during an expansionary phase attracting higher corporate tax payments.
With higher income taxes, firms are left with lower surplus causing a decline in their
consumption and investments and thus in the aggregate demand. Again, during
expansion unemployment falls, therefore government expenditure by way of
transfer payments falls and with lower government expenditure inflation gets
controlled to a certain extent. Briefly put, during an expansionary phase, all types
of incomes rise and the amount of transfer payments decline resulting in

proportionately less disposable income available for consumption expenditure. The

built-in stabilisers automatically remove spending from the economy to reduce
demand-pull inflationary pressures and further expansionary stimulation. In brief,
automatic stabilizers work through limiting the increase in disposable income
during an expansionary phase and limiting the decrease in disposable income
during the contraction phase of the business cycle. Since automatic stabilizers
affect disposable personal income directly, and because changes in disposable
personal income are closely linked to changes in consumption, these stabilizers act
swiftly to reduce the extent of changes in real GDP.
However, automatic stabilizers that depend on the level of economic activity alone
would not be sufficient to correct instabilities. The government needs to resort to
discretionary fiscal policies. Discretionary fiscal policy for stabilization refers to
deliberate policy actions on the part of government to change the levels of
expenditure, taxes to influence the level of national output, employment and
prices. Governments influence the economy by changing the level and types of
taxes, the extent and composition of spending, and the quantity and form of
borrowing.
Governments may directly as well as indirectly influence the way resources are used
in an economy. We shall now see how this happens by investigating into the
fundamental equation of national income accounting that measures the output of
an economy, or gross domestic product (GDP), according to expenditures.
GDP = C + I + G + NX.
We know that GDP is the value of all final goods and services produced in an
economy during a given period of time. The right side of the equation shows the
different sources of aggregate spending or demand namely, private consumption
(C), private investment (I), government expenditure i.e purchases of goods and
services by the government (G), and net exports, (exports minus imports) (NX). It is
evident from the equation that governments can influence economic activity (GDP)
by controlling G directly and influencing C, I, and NX indirectly, through changes in
taxes, transfer payments and expenditure.
4.4 INSTRUMENTS OF FISCAL POLICY

Fiscal policy is a vital component of the general economic framework of a country
and is therefore closely connected with its overall economic policy strategy. The
ability of fiscal policy to influence output by affecting aggregate demand makes it

FISCAL POLICY 2.79
a potential instrument for stabilization of the economy. The Keynesian school is of

the opinion that fiscal policy can have very powerful effects in altering aggregate
demand, employment and output in an economy when the economy is operating
at less than full employment levels and when there is need to offer stimulus to
demand. As such, there is a significant and justifiable role for the government to
institute relevant fiscal policy measures. In fact the global financial crisis about the
year 2008 has caused fiscal policy to be at centre of the public policy debate.
The tools of fiscal policy are taxes, government expenditure, public debt and the
government budget. We shall discuss each of them in the following paragraphs.
4.4.1. Government Expenditure as an Instrument of Fiscal Policy
Public expenditures are income generating and include all types of government
expenditure such as capital expenditure on public works, relief expenditures,
subsidy payments of various types, transfer payments and other social security
benefits. Government expenditure is an important instrument of fiscal policy. It
includes governments’ expenditure towards consumption, investment, and transfer
payments. Government expenditures include:
1. current expenditures to meet the day to day running of the government,
2. capital expenditures which are in the form of investments made by the
government in capital equipments and infrastructure, and
3. transfer payments i.e. government spending which does not contribute to GDP
because income is only transferred from one group of people to another
without any direct contribution from the receivers.
Government may spend money on performance of its large and ever-growing
functions and also for deliberately bringing in stabilization. During a recession, it
may initiate a fresh wave of public works, such as construction of roads, irrigation
facilities, sanitary works, ports, electrification of new areas etc. Government
expenditure involves employment of labour as well as purchase of multitude of
goods and services. These expenditures directly generate incomes to labour and
suppliers of materials and services. Apart from the direct effect, there is also indirect
effect in the form of working of multiplier. The incomes generated are spent on
purchase of consumer goods. The extent of spending by people depends on
their marginal propensity to consume (MPC). There is generally surplus capacity in
consumer goods industries during recession and an increase in demand for various
goods leads to expansion in production in those industries as well. Additionally, a

programme of public investment will strengthen the general confidence of

businessmen and consequently their willingness to invest. Primary employment in
public works programmes will induce secondary and tertiary employment, and
before long the economy is put on an expansion track.
A distinction is made between the two concepts of public spending during
depression, namely, the concept of ‘pump priming’ and the concept of
'compensatory spending'. Pump priming assumes that when private spending
becomes deficient, certain volumes of public spending will help to revive the
economy. Compensatory spending is said to be resorted to when the government
spending is carried out with the obvious intention to compensate for the deficiency
in private investment.
Public expenditure is also used as a policy instrument to reduce the severity of
inflation and to bring down the prices. This is done by reducing government
expenditure when there is a fear of inflationary rise in prices. Reduced incomes on
account of decreased public spending helps to eliminate excess aggregate
demand.
4.4.2 Taxes as an Instrument of Fiscal Policy
Taxes form the most important source of revenue for governments. Taxation
policies are effectively used for establishing stability in an economy. Tax as an
instrument of fiscal policy consists of changes in government revenues or in rates
of taxes aimed at encouraging or restricting private expenditures on consumption
and investment. Taxes determine the size of disposable income in the hands of the
general public which in turn determines aggregate demand and possible
inflationary and deflationary gaps. The structure of tax rates is varied in the context
of the overall economic conditions prevailing in an economy. During recession and
depression, the tax policy is framed to encourage private consumption and
investment. A general reduction in income taxes leaves higher disposable incomes
with people inducing higher consumption. Low corporate taxes increase the
prospects of profits for business and promote further investment. The extent of tax
reduction and /or increase in government spending required depends on the size
of the recessionary gap and the magnitude of the multiplier.
During inflation, new taxes can be levied and the rates of existing taxes are raised
to reduce disposable incomes and to wipe off the surplus purchasing power.
However, excessive taxation usually stifles new investments and therefore the
government has to be cautious about a policy of tax increase.

FISCAL POLICY 2.81
4.4.3 Public Debt as an Instrument of Fiscal Policy

A rational policy of public borrowing and debt repayment is a potent weapon to
fight inflation and deflation. Public debt may be internal or external; when the
government borrows from its own people in the country, it is called internal debt.
On the other hand, when the government borrows from outside sources, the debt
is called external debt. Public debt takes two forms namely, market loans and small
savings.
In the case of market loans, the government issues treasury bills and government
securities of varying denominations and duration which are traded in debt markets.
For financing capital projects, long-term capital bonds are floated and for meeting
short-term government expenditure, treasury bills are issued.
The small savings represent public borrowings, which are not negotiable and are
not bought and sold in the market. In India, various types of schemes are
introduced for mobilising small savings e.g., National Savings Certificates, National
Development Certificates, etc. Borrowing from the public through the sale of bonds
and securities curtails the aggregate demand in the economy. Repayments of debt
by governments increase the availability of money in the economy and increase
aggregate demand.
4.4.4 Budget as an Instrument of Fiscal Policy
Government’s budget is widely used as a policy tool to stimulate or contract
aggregate demand as required. The budget is simply a statement of revenues
earned from taxes and other sources and expenditures made by a nation’s
government in a year. The net effect of a budget on aggregate demand depends
on the government’s budget balance. A government’s budget can either be
balanced, surplus or deficit. A balanced budget results when expenditures in a year
equal its revenues for that year. Such a budget will have no net effect on aggregate
demand since the leakages from the system in the form of taxes collected are equal
to the injections in the form of expenditures made. A budget surplus that occurs
when the government collects more than what it spends, though sounds like a
highly attractive one, has in fact a negative net effect on aggregate demand since
leakages exceed injections. A budget deficit wherein the government expenditure
in a year is greater than the tax revenue it collects has a positive net effect on
aggregate demand since total injections exceed leakages from the government
sector.

While a budget surplus reduces national debt, a budget deficit will add to the
national debt. A nation’s debt is the difference between its total past deficits and
its total past surpluses. If a government has borrowed money over the years to
finance its deficits and has not paid it back through accumulated surpluses, then it
is said to be in debt. Deliberate changes to the composition of revenue and
expenditure components of the budget are extensively used to change macro
economic variables such as level of economic growth, inflation, unemployment and
external stability. For instance, a budget surplus reduces government debt,
increases savings and reduces interest rates. Higher levels of domestic savings
decrease international borrowings and lessen the current account deficit.
4.5 TYPES OF FISCAL POLICY

According to the classical economists, fiscal policy may be unnecessary because
market mechanisms eventually cure instability without government intervention.
These market forces, they argue, are dynamic and help to keep the economy always
at or near the natural level of real GDP. For example they believed that prices and
wages are flexible and that they would guarantee that markets adjust to equilibrium
and eliminate shortages and surpluses.
Fiscal policy measures to correct different problems created by business-cycle
instability are of two basic types namely, expansionary and contractionary.
Expansionary fiscal policy is designed to stimulate the economy during the
contractionary phase of a business cycle or when there is an anticipation of a
business cycle contraction. This is accomplished by increasing aggregate
expenditures and aggregate demand through an increase in all types of
government spending and / or a decrease in taxes.
Contractionary fiscal policy is basically the opposite of expansionary fiscal policy.
Contractionary fiscal policy is designed to restrain the levels of economic activity
of the economy during an inflationary phase or when there is anticipation of a
business-cycle expansion which is likely to induce inflation. This is carried out by
decreasing the aggregate expenditures and aggregate demand through a decrease
in all types of government spending and/ or an increase in taxes. Contractionary
fiscal policy should ideally lead to a smaller government budget deficit or a larger
budget surplus. In other words, if the state of the economy is such that its growth
rate is extraordinarily high causing inflation and asset bubbles, contractionary fiscal
policy can be used to confine it into sustainable levels.

FISCAL POLICY 2.83
We have understood in general that governments influence the economy through

their policies in respect of taxation, expenditure and borrowing. The essence of
what we learn in the rest of the unit is that:
• during inflation or when there is excessive levels of utilization of resources,
fiscal policy aims at controlling excessive aggregate spending, and
• during deflation or during a period of sluggish economic activity when the rate
of utilization of resources is less, fiscal policy aims to compensate the
deficiency in effective demand by boosting aggregate spending.
We shall now describe the application of each of the fiscal policy tools.
4.5.1 Expansionary Fiscal Policy
A recession is said to occur when overall economic activity declines, or in other
words, when the economy ‘contracts’. A recession sets in with a period of declining
real income, as measured by real GDP simultaneously with a situation of rising
unemployment. If an economy experiences a fall in aggregate demand during a
recession, it is said to be in a demand-deficient recession. Due to decline in real
GDP, the aggregate demand falls and therefore, lesser quantity of goods and
services will be produced. To combat such a slump in overall economic activity, the
government can resort to expansionary fiscal policies.
An expansionary fiscal policy is used to address recession and the problem of
general unemployment on account of business cycles. We may technically refer to
this as a policy measure to close a ‘recessionary gap’. A recessionary gap, also
known as a contractionary gap, is said to exist if the existing levels of aggregate
production is less than what would be produced with full employment of resources.
It is a measure of output that is lost when actual national income falls short of
potential income, and represents the difference between the actual aggregate
demand and the aggregate demand which is required to establish the equilibrium
at full employment level of income .This gap occurs during the contractionary
phase of business-cycle and results in higher rates of unemployment. In other
words, recessionary gap occurs when the aggregate demand is not sufficient to
create conditions of full employment. Now the question is how do changes in
government expenditure (G), and taxes (T) eliminate a recessionary gap?
We shall now look into the Keynesian arguments for combating recession using
expansionary fiscal policy. When the aggregate demand (i.e. economy’s appetite
for buying goods and services) falls short of aggregate supply (the economy’s

capacity to produce goods and services), it results in unemployment of resources,

especially labour. In that case, the government intervenes through an expansionary
fiscal policy. The following figure illustrates the operation of expansionary fiscal
policy.
Figure 2.4.1
Expansionary Fiscal policy for Combating Recession
Real GDP at Y1 level lies below the natural level, Y 2. This represents a situation
where the economy is initially in a recession. There is less than full employment of
the resources in the economy. The classical economists held the view that in such
a condition flexibility of wages would cause wages to fall resulting in reduction in
costs. Consequently, suppliers would increase supply and the short run aggregate
supply curve SAS1 will shift to the right say SAS 2 and bring the economy back to the
level of full employment at Y2. However, according to Keynes, wages are not as
flexible as what the classical economists believed and are ‘sticky downward,’
meaning wages will not adjust rapidly to accommodate the unemployed. Therefore,
recession, once set in, would persist for a long time. How does the government
intervene? The government responds by increasing government expenditures in

FISCAL POLICY 2.85
adequate quantities as to cause a shift in the aggregate demand curve to the right
from AD 1 to AD 2. In doing so, the government may have to incur a budget deficit
by spending more than its current receipts. As a response to the shift in AD, output
increases as the total demand in the economy increases. Firms respond to growing
demand by producing more output. In order to increase their output in the short-
run, firms must hire more workers. This has the effect of reducing unemployment
in the economy.
A relevant question here is how much should be the increase in government
expenditure? Should it be exactly the same amount as the required level of increase
in output? (Y 2 - Y 1 )? The answer is that it depends upon the GNP gap created due
to recession and also on the size of multiplier which depends upon marginal
propensity to consume. The increase in government expenditures need not be
equal to the difference between Y 2 and Y 1, it can be much less. The concept of
‘fiscal multiplier,’ i.e. the response of gross domestic product to an exogenous
change in government expenditures is of use to determine the required level of
government expenditure. Any increase in autonomous aggregate expenditures
(including government expenditures) has a multiplier effect on aggregate demand.
As such, the government needs to incur only a lesser amount of expenditure to
cause aggregate demand to increase by the amount necessary to achieve the
natural level of real GDP.
A pertinent question here is; from where will the government find resources to
increase its expenditure? We know that if government resorts to increase in taxes,
it is self- defeating as increased taxes will reduce the disposable incomes and
therefore aggregate demand. The government should in such cases go for a deficit
budget which may be financed either through borrowing or through monetization
(creation of additional money to finance expenditure). The former runs the risk of
crowding out private spending.
It may however be noted that expansionary fiscal policy will be successful only
if there is accommodative monetary policy. If interest rates rise as a result of
increased demand for money but money supply does not rise concurrently,
then private investment will be adversely affected. If interest rates remain
unchanged, private investment will not be affected badly and a rise in
government expenditure will have full effect on national income and
employment.

4.5.2 Contractionary Fiscal Policy

When aggregate demand rises beyond what the economy can potentially produce
by fully employing it’s given resources, it gives rise to inflationary pressures in the
economy. The aggregate demand may rise due to large increase in consumption
demand by households or investment expenditure by entrepreneurs, or
government expenditure. In these circumstances inflationary gap occurs which
tends to bring about rise in prices. Under such circumstances, a contractionary fiscal
policy will have to be used.
Contractionary fiscal policy refers to the deliberate policy of government applied
to curtail aggregate demand and consequently the level of economic activity. In
other words, it is fiscal policy aimed at eliminating an inflationary gap. This is
achieved by adopting policy measures that would result in the aggregate demand
curve (AD) shift the to the left so the equilibrium may be established at the full
employment level of real GDP. This can be achieved either by:
1. Decrease in government spending: With decrease in government spending, the
total amount of money available in the economy is reduced which in turn trim
down the aggregate demand.
2. Increase in personal income taxes and/or business taxes: An increase in
personal income taxes reduces disposable incomes leading to fall in
consumption spending and aggregate demand. An increase in taxes on
business profits reduces the surpluses available to businesses, and as a result,
firms’ investments shrink causing aggregate demand to fall. Increased taxes
also dampen the prospects of profits of potential entrants who will respond by
holding back fresh investments.
3. A combination of decrease in government spending and increase in personal
income taxes and/or business taxes
We shall analyze the overall impact of these abovementioned measures with the
help of the following figure.

FISCAL POLICY 2.87
Figure 2.4.2
Contractionary Fiscal policy for Combating Inflation
As real GDP rises above its natural level, (Y in the above figure), prices also rise,
prompting an increase in wages and other resource prices. This causes
the SAS curve to shift from SAS 1 to SAS 2. As a result, the price level goes up
from P 1 to P 3. Nevertheless, the real GDP remains the same at Y. The government
now needs to intervene to control inflation by engaging in a contractionary fiscal
policy designed to reduce aggregate demand so that the aggregate demand curve
(AD1) does not shift to AD2 . The government needs to reduce expenditures or raise
taxes only by a small amount because of the multiplier effects that such actions
may have. Even as expenditures are reduced, the government may attempt to
enhance public revenues in order to generate a budget surplus. In any economy,
on account of political, social and defence considerations government spending
cannot be reduced beyond a particular limit. However, the government can change
its expenditure in response to inflationary pressures.
4.6 FISCAL POLICY FOR LONG-RUN ECONOMIC GROWTH

We have been discussing so far about how fiscal policy acts as an effective tool for
managing aggregate demand in the short-run to help maintain price stability and
employment levels. However, demand-side policies unaccompanied by policies to
stimulate aggregate supply cannot produce long-run economic growth. Fiscal
policies such as those involving infrastructure spending generally have positive

supply-side effects. When government supports building a modern infrastructure,

the private sector is provided with the requisite overheads it needs. Government
provision of public goods such as education, research and development etc.
provide momentum for long-run economic growth. A well designed tax policy that
rewards innovation and entrepreneurship, without discouraging incentives will
promote private businesses who wish to invest and thereby help the economy
grow.
4.7 FISCAL POLICY FOR REDUCTION IN INEQUALITIES OF

INCOME AND WEALTH
Many developed and developing economies are facing the challenge of rising
inequality in incomes and opportunities. Fiscal policy is a chief instrument available
for governments to influence income distribution and plays a significant role in
reducing inequality and achieving equity and social justice. The distribution of
income in the society is influenced by fiscal policy both directly and indirectly. While
current disposable incomes of individuals and corporates are dependent on direct
taxes, the potential for future earnings is indirectly influenced by the nation’s fiscal
policy choices.
Government revenues and expenditure have traditionally been regarded as
important instruments for carrying out desired redistribution of income. We shall
see a few such measures as to how each of these can be manipulated to achieve
desired distributional effects.
• A progressive direct tax system ensures that those who have greater ability to
pay contribute more towards defraying the expenses of government and that
the tax burden is distributed fairly among the population.
• Indirect taxes can be differential: for example, the commodities which are
primarily consumed by the richer income group, such as luxuries, are taxed
heavily and the commodities the expenditure on which form a larger
proportion of the income of the lower income group, such as necessities, are
taxed light.
• A carefully planned policy of public expenditure helps in redistributing income
from the rich to the poorer sections of the society. This is done through
spending programmes targeted on welfare measures for the disadvantaged ,
such as
(i) poverty alleviation programmes

FISCAL POLICY 2.89
(ii) free or subsidized medical care, education, housing, essential commodities

etc. to improve the quality of living of poor
(iii) infrastructure provision on a selective basis
(iv) various social security schemes under which people are entitled to old-age
pensions, unemployment relief, sickness allowance etc.
(v) subsidized production of products of mass consumption
(vi) public production and/ or grant of subsidies to ensure sufficient supply of
essential goods, and
(vii) strengthening of human capital for enhancing employability etc.
Choice of a progressive tax system with high marginal taxes may act as a strong
deterrent to work save and invest. Therefore, the tax structure has to be carefully
framed to mitigate possible adverse impacts on production and efficiency.
Additionally, the redistributive fiscal policy and the extent of spending on
redistribution should be consistent with the macroeconomic policy objectives of
the nation.
4.8 LIMITATIONS OF FISCAL POLICY

We have seen above that discretionary fiscal policy is the conscious manipulation
of government spending and taxes to influence the economy. However, there are
some significant limitations in respect of choice and implementation of fiscal policy.
1. One of the biggest problems with using discretionary fiscal policy to counteract
fluctuations is the different types of lags involved in fiscal-policy action. There
are significant lags are:
• Recognition lag: The economy is a complex phenomenon and the state of
the macro economic variables is usually not easily comprehensible. Just
as in the case of any other policy, the government must first recognize the
need for a policy change.
• Decision lag: Once the need for intervention is recognized, the
government has to evaluate the possible alternative policies. Delays are
likely to occur to decide on the most appropriate policy.

• Implementation lag: even when appropriate policy measures are decided

on, there are possible delays in bringing in legislation and implementing
them.
• Impact lag: impact lag occurs when the outcomes of a policy are not
visible for some time.
2. Fiscal policy changes may at times be badly timed due to the various lags so
that it is highly possible that an expansionary policy is initiated when the
economy is already on a path of recovery and vice versa.
3. There are difficulties in instantaneously changing governments’ spending and
taxation policies.
4. It is practically difficult to reduce government spending on various items such
as defence and social security as well as on huge capital projects which are
already midway.
5. Public works cannot be adjusted easily along with movements of the trade
cycle because many huge projects such as highways and dams have long
gestation period. Besides, some urgent public projects cannot be postponed
for reasons of expenditure cut to correct fluctuations caused by business
cycles.
6. Due to uncertainties, there are difficulties of forecasting when a period of
inflation or deflation may set in and also promptly determining the accurate
policy to be undertaken.
7. There are possible conflicts between different objectives of fiscal policy such
that a policy designed to achieve one goal may adversely affect another. For
example, an expansionary fiscal policy may worsen inflation in an economy
8. Supply-side economists are of the opinion that certain fiscal measures will
cause disincentives. For example, increase in profits tax may adversely affect
the incentives of firms to invest and an increase in social security benefits may
adversely affect incentives to work and save.
9. Deficit financing increases the purchasing power of people. The production of
goods and services, especially in under developed countries may not catch
up simultaneously to meet the increased demand. This will result in prices
spiraling beyond control.
10. Increase is government borrowing creates perpetual burden on even future
generations as debts have to be repaid. If the economy lags behind in

FISCAL POLICY 2.91
productive utilization of borrowed money, sufficient surpluses will not be

generated for servicing debts. External debt burden has been a constant
problem for India and many developing countries.
11. If governments compete with the private sector to borrow money for spending,
it is likely that interest rates will go up, and firms’ willingness to invest may be
reduced. Individuals too may be reluctant to borrow and spend and the desired
increase in aggregate demand may not be realized. This phenomenon is
described below.
4.8.1 Crowding Out
Some economists are of the opinion that government spending would sometimes
substitute private spending and when this happens the impact of government
spending on aggregate demand would be smaller than what it should be and
therefore fiscal policy may become ineffective. An increase in the size of
government spending during recessions will ‘crowd-out’ private spending in an
economy and lead to reduction in an economy’s ability to self-correct from the
recession, and possibly also reduce the economy’s prospects of long-run economic
growth .
Crowding out effect is the negative effect fiscal policy may generate when money
from the private sector is ‘crowded out’ to the public sector. In other words, when
spending by government in an economy replaces private spending, the latter is said
to be crowded out. For example, if government provides free computers to
students, the demand from students for computers may not be forthcoming. When
government increases it’s spending by borrowing from the loanable funds from
market, the demand for loans increases and this pushes the interest rates up.
Private investments are sensitive to interest rates and therefore some private
investment spending is discouraged. Similarly, when government increases the
budget deficit by selling bonds or treasury bills, the amount of money with the
private sector decreases and consequently interest rates will be pushed up. As a
result, private investments, especially the ones which are interest –sensitive, will be
reduced. Fiscal policy becomes ineffective as the decline in private spending
partially or completely offset the expansion in demand resulting from an increase
in government expenditure. Nevertheless, during deep recessions, crowding-out
is less likely to happen as private sector investment is already minimal and therefore
there is only insignificant private spending to crowd out. Moreover, during a

recession phase the government would be able to borrow from the market without
increasing interest rates.
4.9 CONCLUSION
Well designed and timely fiscal responses are necessary for an economy which is
either going through stages of recession or inflation or on a drive to achieve
economic growth and/ or equitable distribution of income. During periods of
recession when there are idle productive capacity and unemployed workers, an
increase in aggregate demand will generally bring about an increase in total output
without changing the level of prices. On the contrary, if an economy is functioning
at full employment, an expansionary fiscal policy will exert pressure on prices to
go up and will have no impact on total output. Fiscal policy is also a potent
instrument for bringing in economic growth and equality in distribution of income.
SUMMARY
• From a macro-economic perspective, the focus of fiscal policy is on the
aggregate economic activity of governments, say, aggregate expenditure,
taxes, transfers and issues of government debts and deficits and their effects
on aggregate economic variables such as total output total employment,
unemployment rate, inflation, overall economic growth etc.
• Laissez-faire approach advocated limited role of government resulting in non
recognition of the significance of fiscal policy as a strategy for achieving certain
socio economic objectives till 1930.
• Through the use of budgetary instruments, such as public revenue, public
expenditure, public debt and deficit financing, governments intend to
favourably influence the level of economic activity of a country.
• The objectives of fiscal policy may vary from country to country, but generally
they are: achievement and maintenance of full employment, maintenance of
price stability, acceleration of the rate of economic development and equitable
distribution of income and wealth.
• Fiscal policy involves the use of government spending, taxation and borrowing
to influence both the pattern of economic activity and level of growth of
aggregate demand, output and employment.

FISCAL POLICY 2.93
• Non-discretionary fiscal policy or automatic stabilizers are part of the

structure of the economy and are ‘built-in’ fiscal mechanisms that operate
automatically to reduce the expansions and contractions of the business cycle.
• Automatic stabilisation occurs through automatic adjustments in government
expenditures and taxes without any deliberate governmental action i.e. by
limiting the increase in disposable income during an expansionary phase and
limiting the decrease in disposable income during the contraction phase of the
business cycle.
• During recession incomes are reduced leading to lower tax payments.
Government expenditures increase due to increased transfer payments. These
together provide proportionally more disposable income available for
consumption spending to household
• When an economy expands, employment increases, incomes rise and the
amount of transfer payments decline resulting in proportionally less disposable
income available for consumption expenditure
• Discretionary fiscal policy refers to deliberate policy actions on the part of the
government to change the levels of expenditure and taxes to influence the
level of national output, employment and prices.
• Since GDP = C + I + G + NX, governments can influence economic activity
(GDP), by controlling G directly and influencing C, I, and NX indirectly, through
changes in taxes, transfer payments and expenditure.
• The Keynesian school is of the opinion that fiscal policy can have very powerful
effects in altering aggregate demand, employment and output in an economy
when the economy is operating at less than full employment levels and when
there is a need to offer stimulus to demand.
• The tools of fiscal policy are taxes, government expenditure, public debt and
the budget.
• Expansionary fiscal policy is designed to stimulate the economy during the
contractionary phase of a business cycle and is accomplished by increasing
aggregate expenditures and aggregate demand through an increase in all
types of government spending and / or a decrease in taxes
• Contractionary fiscal policy is designed to restrain the levels of economic
activity of the economy during an inflationary phase by decreasing the

aggregate expenditures and aggregate demand through a decrease in all types

of government spending and/ or an increase in taxes
• A recession sets in with a period of declining real income, as measured by real
GDP and a situation of rising unemployment.
• A recessionary gap, also known as a contractionary gap, is said to exist if the
existing levels of aggregate production is less than what would be produced
with the full employment of resources
• Government expenditure, an important instrument of fiscal policy, generates
incomes and also has indirect effect in the form of working of multiplier.
• Pump priming means that when private spending becomes deficient, certain
volumes of public spending will help to revive the economy.
• Compensatory spending is said to be resorted to when the government
spending is carried out with the obvious intention to compensate the
deficiency in private investment.
• Taxes determine the size of disposable income in the hands of general public
which in turn determines aggregate demand and possible inflationary and
deflationary gaps
• During recession and depression, the tax policy is framed to encourage private
consumption and investment. A general reduction in income taxes, low
corporate taxes increase aggregate demand and investments respectively.
• During inflation new taxes can be levied and the rates of existing taxes are
raised to reduce disposable incomes and to wipe off the surplus purchasing
power
• Borrowing from the public through the sale of bonds and securities curtails the
aggregate demand in the economy. Repayments increase the availability of
money in the economy and increase aggregate demand.
• Budget is widely used as a policy tool to stimulate or contract aggregate
demand as required.
• Fiscal policy also aims to attain long-run economic growth through policies to
stimulate aggregate supply. Fiscal policy is a chief instrument available for
governments to influence income distribution and plays a significant role in
reducing inequality and achieving equity and social justice.

FISCAL POLICY 2.95
• Contrationary fiscal policy is aimed at eliminating inflationary gaps and to trim

down the aggregate demand by decrease in government spending and an
increase in personal income taxes and/or business taxes causing less
disposable incomes and lower incentives to invest.
• Fiscal policy suffers from limitations such as limitations in respect of choice of
appropriate policy, recognition lag, decision lag, implementation lag, impact
lag, inappropriate timing, difficulties of forecasting due to uncertainties,
possible conflicts between different objectives, possibility of generating
disincentives , practical difficulty to reduce government expenditures and the
possibility of certain fiscal measures replacing private spending or crowding
out private spending.
TEST YOUR KNOWLEDGE

1. If Real GDP is continuously declining and the rate of unemployment in the
economy is increasing , the appropriate policy should be to
(a) Increase taxes and decrease government spending
(b) Decrease both taxes and government spending
(c) Decrease taxes and increase government spending
(d) Either ( a) or (c)
2. Which of the following are likely to occur when an economy is in an
expansionary phase of a business cycle?
A. Rising unemployment rate
B. Falling unemployment rate
C. Rising inflation rate
D. Deflation
E. Falling or stagnant wage for workers
F. Increasing tax revenue
G. Falling tax revenue
(a) A, B and F are most likely to occur

(b) B, C and F and are most likely to occur

(c) D, E and F are most likely to occur
(d) A, E and G are most likely to occur
3. Fiscal policy refers to
(a) use of government spending, taxation and borrowing to influence the level
of economic activity
(b) government activities related to use of government spending for supply
of essential goods
(c) use of government spending, taxation and borrowing for reducing the
fiscal deficits
4. During recession fiscal policy of the government should be directed towards
(a) Increasing the taxes and reducing the aggregate demand
(b) Decreasing taxes to ensure higher disposable income
(c) Increasing government expenditure and increasing taxes
5. Automatic stabilizers
(a) work towards stimulating aggregate spending during economic expansion
and reducing aggregate spending during the recessionary phase.
(b) provide proportionally more disposable income available for
consumption spending to households during expansion
(c) work towards stimulating aggregate spending during the recessionary
phase and reducing aggregate spending during economic expansion.
(d) provide proportionally less disposable income available for
consumption spending to households during contraction
6. Discretionary fiscal policy
(a) refers to the working of built in stabilizers to change the levels of
expenditure and taxes to influence the level of national output,
employment and prices

FISCAL POLICY 2.97
(b) refers to how governments may directly as well as indirectly influence the
level of taxes to attain export competitiveness
(c) refers to deliberate policy actions on the part of the government to change
the levels of expenditure and taxes to influence the level of national
output, employment and prices
(d) refers to deliberate policy actions on the part of the government to change
the composition of taxes to influence compliance
7. Keynesian economists believe that
(a) fiscal policy can have very powerful effects in altering aggregate demand,
employment and output in an economy
(b) when the economy is operating at less than full employment levels and
when there is a need to offer stimulus to demand fiscal policy is of great
use
(c) Wages are flexible and therefore business fluctuations would be
automatically adjusted
(d) (a) and(b) above
8. Which of the following may ensure a decrease in aggregate demand during
inflation
(a) decrease in all types of government spending and/ or an increase in taxes
(b) increase in government spending and/ or a decrease in taxes
(c) decrease in government spending and/ or an decrease in taxes
(d) All the above
9. A recession is characterized by
(a) Declining prices and rising employment
(b) Declining unemployment and rising prices
(c) Declining real income and rising unemployment.
(d) Rising real income and rising prices
10. Discretionary fiscal policy differs from non discretionary fiscal policy in which
of the following manner?

(a) Discretionary fiscal policy is concerned with government spending and

non discretionary fiscal policy deals with tax policy
(b) Discretionary fiscal policy is concerned with government spending and
non discretionary fiscal policy deals government revenues
(c) Discretionary fiscal policy is concerned with deliberate actions on the part
of the government and non discretionary fiscal policy works automatically
(d) Discretionary fiscal policy is built into the system and non discretionary
fiscal policy is concerned with deliberate actions on the part of
government
11. Which one of the following is an example of discretionary fiscal policy?
(a) A tax cut aimed at increasing the disposable income and spending
(b) A reduction in government expenditure to contain inflation
(c) An increase in taxes and decrease in government expenditure to control
inflation
(d) All the above
12. Which of the following would illustrate a recognition lag?
(a) The time required to identify the appropriate policy
(b) The time required to identify to pass a legislation
(c) The time required to identify the need for a policy change
(d) The time required to establish the outcomes of fiscal policy
13. An expansionary fiscal policy, taking everything else constant, would in the
short-run have the effect of
(a) a relative large increase in GDP and a smaller increase in price
(b) a relative large increase in price , a relatively smaller increase in GDP
(c) both GDP and price will be increasing in the same proportion
(d) both GDP and price will be increasing in a smaller proportion
14. Which statement (s) is (are) correct about crowding out?
I. A decline in private spending may be partially or completely offset the
expansion of demand resulting from an increase in government
expenditure.

FISCAL POLICY 2.99
II. Crowding out effect is the negative effect fiscal policy may generate when
money from the private sector is ‘crowded out’ to the public sector.
III When spending by government in an economy increases government
spending would be crowded out.
IV. Private investments, especially the ones which are interest –sensitive, will
be reduced if interest rates rise due to increased spending by government
(a) I and III only
(b) I, II, and III
(c) I, II, and IV
(d) III only
15. Which of the following policies is likely to shift an economy’s aggregate
demand curve to the right?
(a) Increase in government spending
(b) Decrease in taxes
(c) A tax cut along with increase in public expenditure
(d) All the above
16. Identify the incorrect statement
(a) A progressive direct tax system ensures economic growth with stability
because it distributes the burden of taxes equally
(b) A carefully planned policy of public expenditure helps in redistributing
income from the rich to the poorer sections of the society.
(c) There are possible conflicts between different objectives of fiscal policy
such that a policy designed to achieve one goal may adversely affect
another
(d) An increase in the size of government spending during recessions may
possibly ‘crowd-out’ private spending in an economy.
1. Define fiscal policy.
2. What are the objectives of fiscal policy?

3. Distinguish between discretionary and non discretionary fiscal policy

4. Explain how automatic stabilization brings in stability in an economy.
5. How do built-in stabilizers combat demand-pull inflationary pressures?
6. What are the symptoms of the beginning of a recession?
7. Explain the term recessionary gap’.
8. What should be the tax policy during recession and depression?
9. What is the consequence excessive taxation will have on business?
10. Distinguish between pump priming and the 'compensatory spending'.
11. Describe the term expansionary fiscal policy.
12. What is meant by crowding out?
13. Explain the use of fiscal policy for economic growth.
14. What types of fiscal policy measures are useful for redistribution of income in
an economy?
15. What are the measures undertaken in a contractionary fiscal policy?
16. Point out the limitations fiscal policy.
1. Explain the role of fiscal policy in achieving economic stability.
2. Define the terms ‘recessionary gap’ and ‘inflationary gap’. What would be the
appropriate fiscal policy measures to eliminate recessionary gap’ and
‘inflationary gap’? Illustrate your answer.
3. Explain the term contractionary fiscal policy. What are limitations in pursuing
a contractionary fiscal policy?
4. Under what circumstances do governments pursue expansionary fiscal policy?
What are the instruments for expansionary fiscal policy?
5. List out the factors that limit the effectiveness of fiscal policy? Explain the
possible impacts on private sector?
6. Using aggregate demand and supply diagrams, examine the impact of fiscal
policy on national output.

FISCAL POLICY 2.101
7. Unemployment and recessionary trends can be solved through the use of fiscal
policies. Do you agree? Justify your answer.
1. The government of Country X, an underdeveloped country, having a severe
problem of unemployment of labour embarks on a massive development
programme. It has recognized the imminent need for boosting up investments
to take the country to a higher than average growth trajectory. The following
steps were taken by the government:
i) Invited tenders for a huge net work of highways, solar energy generation,
communication systems ad computerized systems
ii) Large number of schools throughout the country
iii) Research grants for universities and private research institutes
iv) Announced a number of free health care programmes for all
v) All citizens assured of social security
vi) Increase in payments under existing social security schemes
vii) Tax exemption limit raised for individuals, instituted progressive taxes with
high marginal rates - increased corporate taxes
Very soon prices started spiraling and there was general unrest among people
especially the poor.
i) Analyze each of the above measures from a fiscal policy perspective.
ii) Why did overall prices increase?
iii) What policies do you suggest to solve the problem of price rise?
iv) What are the limitations?
2. In the above example, suppose that the increase in government spending has
been ` 5 billion. Assume that the marginal propensity to consume of people
is equal to 0.6.
(i) what will be the government spending multiplier
(ii) What impact would a ` 5 billion increase in government expenditure have
on equilibrium GDP?

ANSWERS/HINTS
I. Multiple Choice Type Questions
1. (c) 2. (b) 3. (a) 4. (b) 5. (c) 6 (c)
7. (d) 8. (a) 9. (c) 10. (c) 11. (d) 12 (c)
13. (a) 14. (c) 15. (d) 16. (a)
1. Use of government spending, taxation and borrowing to influence both the
pattern of economic activity and level of growth of aggregate demand, output
and employment.
2. Objectives vary from country to country- achievement and maintenance of full
employment, maintenance of price stability, acceleration of the rate of
economic development, and equitable distribution of income and wealth
3. Automatic stabilisation occurs through automatic adjustments in government
expenditures and taxes (non-discretionary policy) without any deliberate
governmental action - stimulate aggregate spending during the recessionary
phase and reduce aggregate spending during economic expansion.
Discretionary fiscal policy ( refer hint (1) above)
4. Refer hint (3 )above
5. Employment increases, with progressive system of taxes - higher taxes - lower
disposable incomes - higher corporate tax payments- lower surplus - decline
in consumption and investments – decline in aggregate demand.
6. Declining GDP - growing unemployment- declining prices – lower aggregate
demand
7. Also known as a contractionary gap, the difference between the actual
aggregate demand and the aggregate demand which is required to establish
the equilibrium at full employment level of income.
8. Tax policy to encourage private consumption and investment - general
reduction in income taxes -higher disposable incomes -higher consumption-
low corporate taxes –further investment.
9. Less potential profits - disincentives- stifles new investments less growth
10. Pump priming - certain volumes of public spending to revive the economy-
compensatory spending is government spending to compensate for the
deficiency in private investment

FISCAL POLICY 2.103
11. Designed to stimulate the economy – aim to increase aggregate expenditures

and aggregate demand- increase in government spending and / or a decrease
in taxes.
12. Negative effect fiscal policy when spending by government in an economy
replaces private spending -money from private sector is ‘crowded out’ to the
public sector- decline in private spending - fiscal policy becomes ineffective
13. Expenditure on developmental activities- public goods such as education,
research and development etc.-tax policy that rewards innovation and
entrepreneurship
14. Progressive direct tax system - differential indirect taxes –use of tax proceeds
for social development.
15. Deliberate policy to curtail aggregate demand - eliminate an inflationary gap
– reduce the level of economic activity -decrease in government spending -
increase in personal income taxes and/or business taxes -a combination of
decrease in government spending and increase in personal income taxes
and/or business taxes.
16. See 4.8
IV Application Oriented Questions.
1. (i) Fiscal policy aimed at economic growth and desired redistribution of
income - This is done through spending programmes targeted on welfare
measures for the disadvantaged for e.g. poverty alleviation programmes,
free or subsidized amenities to improve the quality of living of poor,
infrastructure provision on a selective basis, strengthening of human
capital for enhancing employability, Government provision of public goods
such as education, research and development etc. provide momentum for
long-run economic growth - A well designed tax policy that rewards
innovation and entrepreneurship, without discouraging incentives will
promote private businesses who wish to invest and thereby help the
economy grow- A progressive direct tax system ensures that those who
have greater ability to pay contribute more towards defraying the
expenses of government and that the tax burden is distributed fairly
among the population- carefully planned policy of public expenditure
helps in redistributing income from the rich to the poorer sections of the
society-

(ii) Conflict with stabilization functions of state policy - Government

expenditure injects more money into the economy and stimulates demand
in each case, disposable incomes increase- aggregate demand increases –
illustrate with shift in AD curve- No corresponding increase in output--
inflation sets in
(iii) Remedy through fiscal policy- reduce aggregate demand – contractionary
fiscal policy–increase aggregate supply - illustrate using figure
(iv) Conflict of objectives -Possible lags - long gestation periods - politically
unviable to reduce expenditure-high taxes lead to disincentives to invest.
2. (i) The government spending multiplier when the MPC is 0.6, is 1/1- MPC =
2.5.
(ii) A ` 5 billion increase in government expenditure will change the GDP by
` 12.5 billion if the MPC = 0.6.

CHAPTER 3
MONEY MARKET
UNIT I: THE CONCEPT OF MONEY DEMAND:
IMPORTANT THEORIES
LEARNING OUTCOMES

 Define money and describe its nature and characteristics
 Explain the functions performed by money
 Describe the various theories related to demand for money
 Identify the factors that affect the demand for money.
 Distinguish between the different variables considered by each of the

theories of demand for money

Money
Market
The Concept of
Money Demand
Post-Keynesian
Theories of Developments in
Functions of The Demand for
Demand for the Theory of
Money Money
Money Demand for
Money
1.1 INTRODUCTION
Money is at the centre of every economic transaction and plays a significant role in
all economies. In simple terms money refers to assets which are commonly used
and accepted as a means of payment or as a medium of exchange or of transferring
purchasing power. For policy purposes, money may be defined as the set of liquid
financial assets, the variation in the stock of which will have impact on aggregate
economic activity.
Money has generalized purchasing power and is generally acceptable in settlement
of all transactions and in discharge of other kinds of business obligations including
future payments. Anything that would act as a medium of exchange is not
necessarily money. For example, a bill of exchange may also be a medium of
exchange, but it is not money since it is not generally accepted as a means of
payment. Money is a totally liquid asset as it can be used directly, instantly,
conveniently and without any costs or restrictions to make payments. At the
fundamental level, money provides us with a convenient means to access goods
and services. Money represents a certain value, but currency which represents
money does not necessarily have intrinsic value. As you know, fiat money has no
intrinsic value, but is used as a medium of exchange because the government has,
by law, made them “legal tender,” which means that they serve by law as means of

CONCEPT OF MONEY DEMAND 3.3
payment. In modern days, money is not necessarily a physical item; it may also
constitute electronic records. Money is, in fact, only one among many kinds of
financial assets which households, firms, governments and other economic units
hold in their asset portfolios. Unlike other financial assets, money is an essential
element in conducting most of the economic transactions in an economy.
‘There is no unique definition of ‘money’, either as a concept in economic theory

or as measured in practice. Money can be defined for policy purposes as the set of
liquid financial assets, the variation in the stock of which could impact on aggregate
economic activity. As a statistical concept, money could include certain liquid
liabilities of a particular set of financial intermediaries or other issuers’. (Reserve
Bank of India Manual on Financial and Banking Statistics, 2007)
1.2 FUNCTIONS OF MONEY

Money performs many important functions in an economy.
(i) Money is a convenient medium of exchange or it is an instrument that
facilitates easy exchange of goods and services. Money, though not having
any inherent power to directly satisfy human wants, by acting as a medium of
exchange, it commands purchasing power and its possession enables us to
purchase goods and services to satisfy our wants. By acting as an intermediary,
money increases the ease of trade and reduces the inefficiency and transaction
costs involved in a barter exchange. By decomposing the single barter
transaction into two separate transactions of sale and purchase, money
eliminates the need for double coincidence of wants. Money also facilitates
separation of transactions both in time and place and this in turn enables us
to economize on time and efforts involved in transactions.
(ii) Money is an explicitly defined unit of value or unit of account. Put differently,
money is a ‘common measure of value’ or ‘common denominator of value’ or
money functions as a numeraire. We know, Rupee is the unit of account in India
in which the entire money is denominated. The monetary unit is the unit of
measurement in terms of which the value of all goods and services is measured
and expressed. The value of each good or service is expressed as price, which
is nothing but the number of monetary units for which the good or service can
be exchanged. It is convenient to trade all commodities in exchange for a single
commodity. So also, it is convenient to measure the prices of all commodities
in terms of a single unit, rather than record the relative price of every good in
terms of every other good. An obvious advantage of having a single unit of

account is that it greatly reduces the number of exchange ratios between

goods and services. Use of money as a unit of account can encourage trade by
making it easier for individuals to know how much one good is worth in terms
of another.
A common unit of account facilitates a system of orderly pricing which is crucial
for rational economic choices. Goods and services which are otherwise not
comparable are made comparable through expressing the worth of each in
terms of money. Money is a useful measuring rod of value only if the value of
money remains constant. The value of money is linked to its purchasing power.
Purchasing power is the inverse of the average or general level of prices as
measured by the consumer price index.
(iii) Money serves as a unit or standard of deferred payment i.e money facilitates
recording of deferred promises to pay. Money is the unit in terms of which
future payments are contracted or stated. However, variations in the
purchasing power of money due to inflation or deflation, reduce the efficacy
of money in this function.
Like nearly all other assets, money is a store of value. People prefer to hold it
as an asset, that is, as part of their stock of wealth. The splitting of purchases
and sale into two transactions involves a separation in both time and space.
This separation is possible because money can be used as a store of value or
store of means of payment during the intervening time. Again, rather than
spending one’s money at present, one can store it for use at some future time.
Thus, money functions as a temporary abode of purchasing power in order to
efficiently perform its medium of exchange function.
Money also functions as a permanent store of value. There are many other
assets such as government bonds, deposits and other securities, land, houses
etc. which also store value. Despite having the advantages of potential income
yield and appreciation in value over time, these other assets are subject to
limitations such as storage costs, lack of liquidity and possibility of
depreciation in value. Money is the only asset which has perfect liquidity.
Additionally, money also commands reversibility as its value in payment equals
its value in receipt. All assets other than money lack perfect reversibility in the
sense that their value in payment is not equal to their value in receipt. Even
financial assets like the riskless government bonds do not command perfect
reversibility as their purchase and sale are subject to certain brokerage costs
although this may be quite small.

The effectiveness of an asset as a store of value depends on the degree and

certainty with which the asset maintains its value over time. Hence, in order to
serve as a permanent store of value in the economy, the purchasing power or
the value of money should either remain stable or should monotonically rise
over time.
There are some general characteristics that money should possess in order to
make it serve its functions as money. Money should be:
• generally acceptable
• durable or long-lasting
• effortlessly recognizable.
• difficult to counterfeit i.e. not easily reproducible by people
• relatively scarce, but has elasticity of supply
• portable or easily transported
• possessing uniformity; and
• divisible into smaller parts in usable quantities or fractions without losing
value
1.3 THE DEMAND FOR MONEY

Having understood the role of money in an economy, we shall now examine the
concept of demand for money. If people desire to hold money, we say there is
demand for money. As we are aware, the demand for money is in the nature of
derived demand; it is demanded for its purchasing power. Basically, people demand
money because they wish to have command over real goods and services with the
use of money. Demand for money is actually demand for liquidity and demand to
store value. The demand for money is a decision about how much of one’s given
stock of wealth should be held in the form of money rather than as other assets
such as bonds. Although it gives little or no return, individuals, households as well
as firms hold money because it is liquid and offers the most convenient way to
accomplish their day to day transactions.
One might think why is it important to study about demand for money? Demand
for money has an important role in the determination of interest, prices and income
in an economy. The role of money in the macro economy is usually examined in a
supply/demand framework.

Before we go into the theories of demand for money, we shall have a quick look at
some important variables on which demand for money depends on. The quantity
of nominal money or how much money people would like to hold in liquid form
depends on many factors, such as income, general level of prices, rate of interest,
real GDP, and the degree of financial innovation etc. Higher the income of
individuals, higher the expenditure and richer people hold more money to finance
their expenditure. The quantity is directly proportional to the prevailing price level;
higher the prices, higher should be the holding of money. As mentioned above,
one may hold his wealth in any form other than money, say as an interest yielding
asset. It follows that the opportunity cost of holding money is the interest rate a
person could earn on other assets. Therefore, higher the interest rate, higher would
be opportunity cost of holding cash and lower the demand for money. Innovations
such as internet banking, application based transfers and automatic teller machines
reduce the need for holding liquid money. Just as households do, firms also hold
money essentially for the same basic reasons.
1.4 THEORIES OF DEMAND FOR MONEY

1.4.1 Classical Approach: The Quantity Theory of Money (QTM)
The quantity theory of money, one of the oldest theories in Economics, was first
propounded by Irving Fisher of Yale University in his book ‘The Purchasing Power
of Money’ published in 1911 and later by the neoclassical economists. Both versions
of the QTM demonstrate that there is strong relationship between money and price
level and the quantity of money is the main determinant of the price level or the
value of money. In other words, changes in the general level of commodity prices
or changes in the value or purchasing power of money are determined first and
foremost by changes in the quantity of money in circulation.
Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is
formally stated as follows:
MV = PT
Where, M= the total amount of money in circulation (on an average) in an
economy
V = transactions velocity of circulation i.e. the average number of
times across all transactions a unit of money(say Rupee) is spent in
purchasing goods and services
P = average price level (P= MV/T)

T = the total number of transactions.

Later, Fisher extended the equation of exchange to include demand (bank) deposits
(M’) and their velocity (V’) in the total supply of money. Thus, the expanded form
of the equation of exchange becomes:
MV + M'V' = PT
Where M' = the total quantity of credit money
V' = velocity of circulation of credit money
The total supply of money in the community consists of the quantity of actual
money (M) and its velocity of circulation (V). Velocity of money in circulation (V) and
the velocity of credit money (V') remain constant. T is a function of national income.
Since full employment prevails, the volume of transactions T is fixed in the short
run. Briefly put, the total volume of transactions (T) multiplied by the price level (P)
represents the demand for money. The demand for money (PT) is equal to the
supply of money (MV + M'V)'. In any given period, the total value of transactions
made is equal to PT and the value of money flow is equal to MV+ M'V'.
We shall now look into the classical idea of the demand for money. Fisher did not
specifically mention anything about the demand for money; but the same is
embedded in his theory as dependent on the total value of transactions undertaken
in the economy. Thus, there is an aggregate demand for money for transactions
purpose and more the number of transactions people want, greater will be the
demand for money. The total volume of transactions multiplied by the price level
(PT) represents the demand for money.
1.4.2 The Neo classical Approach: The Cambridge approach
In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou, D.H.
Robertson and John Maynard Keynes (then associated with Cambridge) put forward
a fundamentally different approach to quantity theory, known as neoclassical
theory or cash balance approach. The Cambridge version holds that
money increases utility in the following two ways:
1. enabling the possibility of split-up of sale and purchase to two different points
of time rather than being simultaneous ,and
2. being a hedge against uncertainty.
While the first above represents transaction motive, just as Fisher envisaged, the
second points to money’s role as a temporary store of wealth. Since sale and

purchase of commodities by individuals do not take place simultaneously, they

need a ‘temporary abode’ of purchasing power as a hedge against uncertainty. As
such, demand for money also involves a precautionary motive in Cambridge
approach. Since money gives utility in its store of wealth and precautionary modes,
one can say that money is demanded for itself.
Now, the question is how much money will be demanded? The answer is: it depends
partly on income and partly on other factors of which important ones are wealth
and interest rates. The former determinant of demand i.e. income, points to
transactions demand such that higher the income, the greater the quantity of
purchases and as a consequence greater will be the need for money as a temporary
abode of value to overcome transactions costs. The Cambridge equation is stated
as:
Md = k PY
Where
Md = is the demand for money
Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash
balances
The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above
explains that the demand for money (M) equals k proportion of the total money
income.
Thus we see that the neoclassical theory changed the focus of the quantity theory
of money to money demand and hypothesized that demand for money is a function
of only money income. Both these versions are chiefly concerned with money as a
means of transactions or exchange, and therefore, they present models of the
transaction demand for money.
1.4.3 The Keynesian Theory of Demand for Money
Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’.
‘Liquidity preference’, a term that was coined by John Maynard Keynes in his
masterpiece ‘The General Theory of Employment, Interest and Money’

(1936), denotes people’s desire to hold money rather than securities or long-term
interest-bearing investments.
According to Keynes, people hold money (M) in cash for three motives:
(i) Transactions motive ,
(ii) Precautionary motive, and
(iii) Speculative motive.
(a) The Transactions Motive
The transactions motive for holding cash relates to ‘the need for cash for current
transactions for personal and business exchange.’ The need for holding money
arises because there is lack of synchronization between receipts and expenditures.
The transaction motive is further classified into income motive and business (trade)
motive, both of which stressed on the requirement of individuals and businesses
respectively to bridge the time gap between receipt of income and planned
expenditures.
Keynes did not consider the transaction balances as being affected by interest rates.
The transaction demand for money is directly related to the level of income. The
transactions demand for money is a direct proportional and positive function of
the level of income and is stated as follows:
Lr = kY
Where
Lr, is the transactions demand for money,
k is the ratio of earnings which is kept for transactions purposes
Y is the earnings.
Keynes considered the aggregate demand for money for transaction purposes as
the sum of individual demand and therefore, the aggregate transaction demand
for money is a function of national income.
(b) The Precautionary Motive
Many unforeseen and unpredictable contingencies involving money payments
occur in our day to day life. Individuals as well as businesses keep a portion of
their income to finance such unanticipated expenditures. The amount of money
demanded under the precautionary motive depends on the size of income,

prevailing economic as well as political conditions and personal characteristics of

the individual such as optimism/ pessimism, farsightedness etc. Keynes regarded
the precautionary balances just as balances under transactions motive as income
elastic and by itself not very sensitive to rate of interest.
(c) The Speculative Demand for Money
The speculative motive reflects people’s desire to hold cash in order to be equipped
to exploit any attractive investment opportunity requiring cash expenditure.
According to Keynes, people demand to hold money balances to take advantage
of the future changes in the rate of interest, which is the same as future changes in
bond prices. It is implicit in Keynes theory, that the ‘rate of interest’, i, is really the
return on bonds. Keynes assumed that that the expected return on money is zero,
while the expected returns on bonds are of two types, namely:
(i) the interest payment
(ii) the expected rate of capital gain.
The market value of bonds and the market rate of interest are inversely related. A
rise in the market rate of interest leads to a decrease in the market value of the
bond, and vice versa. Investors have a relatively fixed conception of the ’normal’ or
‘critical’ interest rate and compare the current rate of interest with such ‘normal’
or ‘critical’ rate of interest.
If wealth-holders consider that the current rate of interest is high compared to the
‘normal or critical rate of interest’, they expect a fall in the interest rate (rise in bond
prices). At the high current rate of interest, they will convert their cash balances
into bonds because:
(i) they can earn high rate of return on bonds
(ii) they expect capital gains resulting from a rise in bond prices consequent upon
an expected fall in the market rate of interest in future.
Conversely, if the wealth-holders consider the current interest rate as low,
compared to the ‘normal or critical rate of interest’, i.e., if they expect the rate of
interest to rise in future (fall in bond prices), they would have an incentive to hold
their wealth in the form of liquid cash rather than bonds because:
(i) the loss suffered by way of interest income forgone is small,
(ii) they can avoid the capital losses that would result from the anticipated increase
in interest rates, and

(iii) the return on money balances will be greater than the return on alternative
assets
(iv) If the interest rate does increase in future, the bond prices will fall and the idle
cash balances held can be used to buy bonds at lower price and can thereby
make a capital-gain.
Summing up, so long as the current rate of interest is higher than the critical rate
of interest, a typical wealth-holder would hold in his asset portfolio only
government bonds while if the current rate of interest is lower than the critical rate
of interest, his asset portfolio would consist wholly of cash. When the current rate
of interest is equal to the critical rate of interest, a wealth-holder is indifferent to
holding either cash or bonds. The inference from the above is that the speculative
demand for money and interest are inversely related.
The speculative demand for money of individuals can be diagrammatically
presented as follows:
Figure: 2.1.1
Individual’s Speculative Demand for Money
The discontinuous portfolio decision of a typical individual investor is shown in the

figure above. When the current rate of interest rn is higher than the critical rate
of interest rc, the entire wealth is held by the individual wealth-holder in the form

of government bonds. If the rate of interest falls below the critical rate of interest
rc, the individual will hold his entire wealth in the form of speculative cash balances.
When we go from the individual speculative demand for money to the aggregate
speculative demand for money, the discontinuity of the individual wealth-holder's
demand curve for the speculative cash balances disappears and we obtain a
continuous downward sloping demand function showing the inverse relationship
between the current rate of interest and the speculative demand for money as
shown in figure below:
Figure: 2.1.2
Aggregate Speculative Demand for Money
According to Keynes, higher the rate of interest, lower the speculative demand for
money, and lower the rate of interest, the higher the speculative demand for
money. The sum of the transaction and precautionary demand, and the speculative
demand, is the total demand for money.
To sum up, an increase in income increases the transaction and precautionary
demand for money and a rise in the rate of interest decreases the demand for
speculative demand money.

1.5 POST-KEYNESIAN DEVELOPMENTS IN THE THEORY OF

DEMAND FOR MONEY
Most post-Keynesian theories of demand for money emphasize the store-of-value
or the asset function of money.
1.5.1 Inventory Approach to Transaction Balances
Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction
demand for money, known as Inventory Theoretic Approach, in which money or
‘real cash balance’ was essentially viewed as an inventory held for transaction
purposes.
Inventory models assume that there are two media for storing value: money and
an interest-bearing alternative financial asset. There is a fixed cost of making
transfers between money and the alternative assets e.g. broker charges. While
relatively liquid financial assets other than money (such as, bank deposits) offer a
positive return, the above said transaction cost of going between money and these
assets justifies holding money.
Baumol used business inventory approach to analyze the behaviour of individuals.
Just as businesses keep money to facilitate their business transactions, people also
hold cash balance which involves an opportunity cost in terms of lost interest.
Therefore, they hold an optimum combination of bonds and cash balance, i.e., an
amount that minimizes the opportunity cost.
Baumol’s propositions in his theory of transaction demand for money hold that
receipt of income, say Y takes place once per unit of time but expenditure is spread
at a constant rate over the entire period of time. Excess cash over and above what
is required for transactions during the period under consideration will be invested
in bonds or put in an interest-bearing account. Money holdings on an average will
be lower if people hold bonds or other interest yielding assets.
The higher the income, the higher is the average level or inventory of money
holdings. The level of inventory holding also depends also upon the carrying cost,
which is the interest forgone by holding money and not bonds, net of the cost to
the individual of making a transfer between money and bonds, say for example
brokerage fee. The individual will choose the number of times the transfer between
money and bonds takes place in such a way that the net profits from bond
transactions are maximized.

The average transaction balance (money) holding is a function of the number of

times the transfer between money and bonds takes place. The more the number of
times the bond transaction is made, the lesser will be the average transaction
balance holdings. In other words, the choice of the number of times the bond
transaction is made determines the split of money and bond holdings for a given
income.
The inventory-theoretic approach also suggests that the demand for money and
bonds depend on the cost of making a transfer between money and bonds e.g. the
brokerage fee. An increase the brokerage fee raises the marginal cost of bond
market transactions and consequently lowers the number of such transactions. The
increase in the brokerage fee raises the transactions demand for money and lowers
the average bond holding over the period. This result follows because an increase
in the brokerage fee makes it more costly to switch funds temporarily into bond
holdings. An individual combines his asset portfolio of cash and bond in such
proportions that his cost is minimized.
1.5.2 Friedman's Restatement of the Quantity Theory
Milton Friedman (1956) extended Keynes’ speculative money demand within the
framework of asset price theory. Friedman treats the demand for money as nothing
more than the application of a more general theory of demand for capital assets.
Demand for money is affected by the same factors as demand for any other asset,
namely
1. Permanent income.
2. Relative returns on assets. (which incorporate risk)
Friedman maintains that it is permanent income – and not current income as in the
Keynesian theory – that determines the demand for money. Permanent income
which is Friedman’s measure of wealth is the present expected value of all future
income. To Friedman, money is a good as any other durable consumption good
and its demand is a function of a great number of factors.
Friedman identifies the following four determinants of the demand for money. The
nominal demand for money:
• is a function of total wealth, which is represented by permanent income divided
by the discount rate, defined as the average return on the five asset classes in
the monetarist theory world, namely money, bonds, equity, physical capital and
human capital.

• is positively related to the price level, P. If the price level rises the demand for
money increases and vice versa.
• rises if the opportunity costs of money holdings (i.e. returns on bonds and
stock) decline and vice versa.
• is influenced by inflation, a positive inflation rate reduces the real value of
money balances, thereby increasing the opportunity costs of money holdings.
1.5.3 The Demand for Money as Behavior toward Risk
In his classic article, ‘Liquidity Preference as Behavior towards Risk’ (1958), Tobin
established that the theory of risk-avoiding behavior of individuals. provided the
foundation for the liquidity preference and for a negative relationship between the
demand for money and the interest rate. The risk-aversion theory is based on the
principles of portfolio management. According to Tobin, the optimal portfolio
structure is determined by
(i) the risk/reward characteristics of different assets
(ii) the taste of the individual in maximizing his utility consistent with the existing
opportunities
In his theory which analyzes the individual's portfolio allocation between money
and bond holdings, the demand for money is considered as a store of wealth. Tobin
hypothesized that an individual would hold a portion of his wealth in the form of
money in the portfolio because the rate of return on holding money was more
certain than the rate of return on holding interest earning assets and entails no
capital gains or losses. It is riskier to hold alternative assets vis-à-vis holding interest
just money alone because government bonds and equities are subject to market
price volatility, while money is not. Thus, bonds pay an expected return of r, but as
asset, they are unlike money because they are risky; and their actual return is uncertain.
Despite this, the individual will be willing to face this risk because the expected rate
of return from the alternative financial assets exceeds that of money.
According to Tobin, rational behaviour of a risk-averse economic agent induces
him to hold an optimally structured wealth portfolio which is comprised of both
bonds and money. The overall expected return on the portfolio would be higher if
the portfolio were all bonds, but an investor who is ‘risk-averse’ will be willing to
exercise a trade- off and sacrifice to some extent the higher return for a reduction
in risk. Tobin's theory implies that the amount of money held as an asset depends
on the level of interest rate. An increase in the interest rate will improve the terms
on which the expected return on the portfolio can be increased by accepting

greater risk. In response to the increase in the interest, the individual will increase
the proportion of wealth held in the interest-bearing asset, say bonds, and will
decrease the holding of money. Within Tobin's framework, an increase in the rate
of interest can be considered as an increase in the payment received for
undertaking risk. When this payment is increased, the individual investor is willing
to put a greater proportion of the portfolio into the risky asset, (bonds) and thus a
smaller proportion into the safe asset, money. His analysis implies that the demand
for money as a store of wealth will decline with an increase in the interest rate.
Tobin's analysis also indicates that uncertainty about future changes in bond prices,
and hence the risk involved in buying bonds, may be a determinant of money
demand. Just as Keynes’ theory, Tobin's theory implies that the demand for money
as a store of wealth depends negatively on the interest rate.
1.6 CONCLUSION
We have discussed the important theories pertaining to demand for money. All the
theories have provided significant insights into the concept of demand for money.
While the transactions version of Fisher focused on the supply of money as
determining prices, the cash balance approach of the Cambridge University
economists established the formal relationship between demand for real money
and the real income. Keynes developed the money demand theory on the basis of
explicit motives for holding money and formally introduced the interest rate as an
additional explanatory variable that determines the demand for real balances. The
post-Keynesian economists developed a number of models to provide alternative
explanations to confirm the formulation relating real money balances with real
income and interest rates. However, we find that all these theories establish a
positive relation of demand for money to real income and an inverse relation to
the rate of return on earning assets, i.e. the interest rate. However, the propositions
in these theories need to be supported by empirical evidence. As countries differ
in respect of various determinants of demand for money, we cannot expect any
uniform pattern of behaviour. Broadly speaking, real income, interest rates and
expectations in respect to inflation are significant predictors of demand for money.

SUMMARY
• Money refers to assets which are commonly used and accepted as a means of
payment or as a medium of exchange or of transferring purchasing power.
• Money is totally liquid and has generalized purchasing power and is generally
acceptable in settlement of all transactions and in discharge of other kinds of
business obligations including future payments.
• The functions of money are: acting as a medium of exchange to facilitate easy
exchanges of goods and services, providing a ‘common measure of value’ or
‘common denominator of value’, serving as a unit or standard of deferred
payments and facilitating storing of value both as a temporary abode of
purchasing power and a permanent store of value.
• Money should be generally acceptable, durable, difficult to counterfeit,
relatively scarce, easily transported, divisible without losing value and
effortlessly recognizable.
• The demand for money is derived demand and is a decision about how much
of one’s given stock of wealth should be held in the form of money rather than
as other assets such as bonds.
• Both versions of the theory of money namely the classical approach and the
neoclassical approach demonstrate that there is strong relationship between
money and price level and the quantity of money is the main determinant of
the price level or the value of money.
• Keynes’ theory of demand for money is known as the ‘liquidity preference
theory’. ‘Liquidity preference’, is a term that was coined by John Maynard
Keynes in his masterpiece ‘The General Theory of Employment, Interest and
Money’ (1936).
• According to Keynes, people hold money (M) in cash for three motives: the
transactions, precautionary and speculative motives.
• The transaction motive for holding cash is directly related to the level of in-
come and relates to ‘the need for cash for the current transactions for personal
and business exchange.’
• The amount of money demanded under the precautionary motive is to meet
unforeseen and unpredictable contingencies involving money payments and
depends on the size of the income, prevailing economic as well as political

conditions and personal characteristics of the individual such as optimism/

pessimism, farsightedness etc.
• The speculative motive reflects people’s desire to hold cash in order to be
equipped to exploit any attractive investment opportunity requiring cash
expenditure. The speculative demand for money and interest are inversely
related.
• So long as the current rate of interest is higher than the critical rate of interest
(rc), a typical wealth-holder would hold in his asset portfolio only government
bonds while if the current rate of interest is lower than the critical rate of
interest, his asset portfolio would consist wholly of cash.
• Baumol (1952) and Tobin (1956) developed a deterministic theory of
transaction demand for ‘real cash balance’, known as Inventory Theoretic
Approach, in which money is essentially viewed as an inventory held for
transaction purposes.
• People hold an optimum combination of bonds and cash balance, i.e., an
amount that minimizes the opportunity cost.
• The optimal average money holding is: a positive function of income Y, a
positive function of the price level P, a positive function of transactions costs
c, and a negative function of the nominal interest rate i.
• Milton Friedman (1956) extending Keynes’ speculative money demand within
the framework of asset price theory holds that demand for money is affected
by the same factors as demand for any other asset, namely, permanent income
and relative returns on assets.
• The nominal demand for money is positively related to the price level, P; rises
if bonds and stock returns, rb and re, respectively decline and vice versa; is
influenced by inflation; and is a function of total wealth
• The Demand for Money as Behavior toward ‘aversion to risk’ propounded by
Tobin states that money is a safe asset but an investor will be willing to exercise
a trade-off and sacrifice to some extent, the higher return from bonds for a
reduction in risk
• According to Tobin, rational behaviour induces individuals to hold an optimally
structured wealth portfolio which is comprised of both bonds and money and
the demand for money as a store of wealth depends negatively on the interest
rate.

TEST YOUR KNOWLEDGE

1. Choose the incorrect statement
(a) Anything that would act as a medium of exchange is money
(b) Money has generalized purchasing power and is generally acceptable in
settlement of all transactions
(c) Money is a totally liquid asset and provides us with means to access goods
and services
(d) Currency which represents money does not necessarily have intrinsic value.
2. Money performs all of the three functions mentioned below, namely
(a) medium of exchange, price control, store of value
(b) unit of account, store of value , provide yields
(c) medium of exchange, unit of account, store of value
(d) medium of exchange, unit of account, income distribution
3. Demand for money is
(a) Derived demand
(b) Direct demand
(c) Real income demand
(d) Inverse demand
4. Higher the ----------------------, higher would be -----------------------of
holding cash and lower will be the --------------------------------
(a) demand for money, opportunity cost, interest rate
(b) price level , opportunity cost, interest rate
(c) real income , opportunity cost, demand for money
(d) interest rate, opportunity cost, demand for money
5. The quantity theory of money holds that
(a) changes in the general level of commodity prices are caused by changes
in the quantity of money

(b) there is strong relationship between money and price level and the
quantity of money is the main determinant of the price
(c) changes in the value of money or purchasing power of money are
determined first and foremost by changes in the quantity of money in
circulation
(d) All the above
6. The Cambridge approach to quantity theory is also known as
(a) Cash balance approach
(b) Fisher’s theory of money
(c) Classical approach
(d) Keynesian Approach
7. Fisher’s approach and the Cambridge approach to demand for money consider
(a) money’s role in acting as a store of value and therefore, demand for money
is for storing value temporarily.
(b) money as a means of exchange and therefore demand for money is
termed as for liquidity preference
(c) money as a means of transactions and therefore, demand for money is
only transaction demand for money.
8. Real money is
(a) nominal money divided by price level
(b) real national income
(c) money demanded at given rate of interest
(d) nominal GNP divided by price level
9. The precautionary money balances people want to hold
(a) as income elastic and not very sensitive to rate of interest
(b) as income inelastic and very sensitive to rate of interest

(c) are determined primarily by the level of transactions they expect to make
in the future.
(d) are determined primarily by the current level of transactions
10. Speculative demand for money
(a) is not determined by interest rates
(b) is positively related to interest rates
(c) is negatively related to interest rates
(d) is determined by general price level
11. According to Keynes, if the current interest rate is high
(a) people will demand more money because the capital gain on bonds would
be less than return on money
(b) people will expect the interest rate to rise and bond price to fall in the
future.
(c) people will expect the interest rate to fall and bond price to rise in the
future.
(d) Either a) or b) will happen
12. The inventory-theoretic approach to the transactions demand for money
(a) explains the negative relationship between money demand and the
interest rate.
(b) explains the positive relationship between money demand and the interest
rate.
(c) explains the positive relationship between money demand and general
price level
(d) explains the nature of expectations of people with respect to interest rates
and bond prices
13. According to Baumol and Tobin’s approach to demand for money, the optimal
average money holding is:
(a) a positive function of income Y and the price level P
(b) a positive function of transactions costs c,
(c) a negative function of the nominal interest rate i

(d) All the above

14. --------------- considered demand for money is as an application of a more
general theory of demand for capital assets
(a) Baumol
(b) James Tobin
(c) J M Keynes
(d) Milton Friedman
15. The nominal demand for money rises if
(a) the opportunity costs of money holdings – i.e. bonds and stock returns, rB
and rE , respectively- decline and vice versa
(b) the opportunity costs of money holdings – i.e. bonds and stock returns, rB
and rE , respectively- rises and vice versa
(c) the opportunity costs of money holdings – i.e. bonds and stock returns, rB
and rE , respectively remain constant
(d) b) and c) above
1. Define money.
2. What is meant by the term “legal tender,”
3. Write notes on the function of money as a medium of exchange,
4. Outline how money is useful as a ‘common denominator of value’.
5. Examine the relationship between purchasing power of money and general
price level
6. Critically examine money’s function as standard of deferred payment
7. List the general characteristics that money should possess?
8. Explain the concept of demand for money.
9. Why do we say that money demand is derived demand?
10. Why is it important to study about demand for money?
11. Explain how higher the interest rate affect the demand for money.
12. Describe the main postulates of quantity theory of money

13. Describe the Keynesian view of different motives of holding cash

14. Compare transaction demand for money according to Keynes and Baumol
&Tobin
III. Long answer Type Questions
1. Define money and describe its nature and characteristics
2. Explain the functions performed by money
3. ‘The quantity theory of money is not a theory about money at all, rather it is a
theory of the price-level’ Elucidate
4. Describe the various theories related to demand for money
5. Define ‘real cash balance’. Describe the Inventory Theoretic Approach to
demand for money
6. Explain why bond prices move inversely to market interest rates
7. Distinguish between classical and Cambridge version of quantity theory of
money
8. Explain the Keynesian theory of demand for money. What motives did Keynes
ascribe to demand for money? Illustrate your answer.
9. List out the factors that determine the demand for money in the Baumol-Tobin
analysis of transactions demand for money? How does a change in each factor
affect the quantity of money demanded?
10. To what extent does Friedman's Restatement of the Quantity Theory explain
the demand for money?
11. What factors determine demand for money in Friedman’s modern quantity
theory? How does each of eth factors affect demand for money?
12. Examine the influence of different variables on demand for money according
to Inventory Theoretic Approach ?
13. ‘Risk-avoiding behavior of individuals provided the foundation for the liquidity
preference and for a negative relationship between the demand for money and
the interest rate’ Elucidate with examples
14. Critically examine the post Keynesian theories of demand for money.
IV. Application Oriented Question
(a) Why should you hold money balances?

(b) Will you choose to hold only interest bearing assets?

(c) What would your choice be if you can pay for nearly all transactions through
online transfers?
(d) Do you think money is a unique store of value?
ANSWERS/HINTS
1. (a) 2. (c) 3. (a) 4. (d) 5. (d) 6 (a) 7. (c) 8. (a) 9. (a)

10. (c) 11. (c) 12 (a) 13. (d) 14. (d) 15. (a)
II. Short answer Type Questions

1. Assets which are commonly used and accepted as a means of payment or as a
medium of exchange or of transferring purchasing power/ The set of liquid
financial assets, the variation in the stock of which will have impact on
aggregate economic activity.
2. They serve by law as means of payment –legally bound to accept in settlement
of obligations
3. Money facilitate easy exchanges of goods and services increases the ease of
trade and reduces the inefficiency and transaction costs involved in a barter
exchange
4. The monetary unit is the unit of measurement in terms of which the value of
all goods and services is measured and expressed.
5. Value of money is linked to its purchasing power. Purchasing power is the
inverse of the average or general level of prices as measured by the consumer
price index.
6. Money facilitates recording of deferred promises to pay. Money is the unit in
terms of which future payments are contracted or stated.
7. Money should be generally acceptable, durable, difficult to counterfeit,
relatively scarce, uniform, easily transported, divisible without losing value,
elastic in supply and effortlessly recognizable.
8. The demand for money is a decision about how much of one’s given stock of
wealth should be held in the form of money rather than as other assets such

as bonds. Demand for money is actually demand for liquidity and a demand to
store value.
9. Demand for money is in the nature of derived demand; it is demanded for it
purchasing power. Basically people demand money because they wish to have
command over real goods and services with the use of money
10. Demand for money has an important role in the determination of interest,
prices and income in an economy.
11. Important determinant of demand for money. Higher the interest rate, higher
would be opportunity cost of holding cash and lower the demand for money.
12. The main postulates of the theory are: the proportionality of m and p, the active
or causal role of m, neutrality of money on real variables, exogenous nature of
nominal money supply and the monetary theory of the price level.
13. According to Keynes, people hold money in cash for three motives: the
transactions, precautionary and speculative motives.
14. In contrast to the Keynesian demand for transaction balances which is interest-
inelastic, the transaction demand of Baumol and Tobin is interest-elastic.
(a) Transaction, precautionary and speculative demand – depends on the nature
of the holder- institutional payments mechanisms and the gap between receipt
and use of money, amount of income and changes in incomes, general level of
prices, cost of conversion from near money to money etc.
(b) Not always- Partly held in assets- Depends on costs in terms of time and
resources to keep moving in and out of bonds or other assets, the levels of
interest payments, expectations about bond prices, future price levels- concept
of speculative demand for money
(c) Depends on financial infrastructure, how costless and immediate are transfers,
preferences, attitude towards risks and the opportunity costs.
(d) Financial assets other than money are also performing the function of store of
value. Just as money has, the financial assets have fixed nominal value over
time and represent generalized purchasing power. Therefore, money is not a
unique store of value.

UNIT II: CONCEPT OF MONEY SUPPLY
LEARNING OUTCOMES

 Define money supply and describe its different components
 List out the need for and rationale of measuring money supply
 Elucidate the different sources of money supply
 Illustrate the various measures of money supply
 Distinguish between money multiplier and credit multiplier, and
 Describe the different determinants of money supply
Money
Market
The concept
of Money
Supply
The Sources Measurement Determinants The concept

of Money of Money of Money of Money
Supply Supply Supply Multiplier

CONCEPT OF MONEY SUPPLY 3.27
2.1 INTRODUCTION
In the previous unit, we have discussed the theories related to demand for money.
Money plays a crucial role in the smooth functioning of an economy. Money supply
is considered as a very important macroeconomic variable responsible for changes
in many other significant macroeconomic variables in an economy and is therefore
considered as a matter of considerable interest to the economists and policy
makers. Economic stability requires that the supply of money at any time should
to be maintained at an optimum level. A pre-requisite for achieving this is to
accurately estimate the stock of money supply on a regular basis and appropriately
regulate it in accordance with the monetary requirements of the country. In this
unit, we shall look into various aspects related to the supply of money.
The term money supply denotes the total quantity of money available to the people
in an economy. The quantity of money at any point of time is a measurable
concept. It is important to note two things about any measure of money supply:
(i) The supply of money is a stock variable i.e. it refers to the total amount of
money at any particular point of time. It is the change in the stock of money
(say, increase or decrease per month or year,) , which is a flow.
(ii) The stock of money always refers to the stock of money available to the ‘public’
as a means of payments and store of value. This is always smaller than the total
stock of money that really exists in an economy.
The term ‘public’ is defined to include all economic units (households, firms and
institutions) except the producers of money (i.e. the government and the banking
system). The government, in this context, includes the central government and all
state governments and local bodies; and the banking system means the Reserve
Bank of India and all the banks that accept demand deposits (i.e. deposits from
which money can be withdrawn by cheque mainly CASA deposits). The word ‘public’
is inclusive of all local authorities, non-banking financial institutions, and non-
departmental public-sector undertakings, foreign central banks and governments
and the International Monetary Fund which holds a part of Indian money in India
in the form of deposits with the RBI. In other words, in the standard measures of
money, interbank deposits and money held by the government and the banking
system are not included.

2.2 RATIONALE OF MEASURING MONEY SUPPLY

Empirical analysis of money supply is important for two reasons:
1. It facilitates analysis of monetary developments in order to provide a deeper
understanding of the causes of money growth.
2. It is essential from a monetary policy perspective as it provides a framework to
evaluate whether the stock of money in the economy is consistent with the
standards for price stability and to understand the nature of deviations from
this standard. The central banks all over the world adopt monetary policy to
stabilise price level and GDP growth by directly controlling the supply of
money. This is achieved mainly by managing the quantity of monetary base.
The success of monetary policy depends to a large extent on the controllability
of money supply and the monetary base.
2.3 THE SOURCES OF MONEY SUPPLY

The supply of money in the economy depends on:
(a) the decision of the central bank based on the authority conferred on it , and
(b) the supply responses of the commercial banking system of the country to the
changes in policy variables initiated by the central bank to influence the total
money supply in the economy.
The central banks of all countries are empowered to issue currency and, therefore,
the central bank is the primary source of money supply in all countries. In effect,
high powered money issued by monetary authorities is the source of all other forms
of money. The currency issued by the central bank is ‘fiat money’ and is backed by
supporting reserves and its value is guaranteed by the government. The currency
issued by the central bank is, in fact, a liability of the central bank and the
government. Therefore, in principle, it must be backed by an equal value of assets
mainly consisting of gold and foreign exchange reserves. In practice, however, most
countries have adopted a ‘minimum reserve system ’wherein the central bank is
empowered to issue currency to any extent by keeping only a certain minimum
reserve of gold and foreign securities.
The second major source of money supply is the banking system of the country.
The total supply of money in the economy is also determined by the extent of credit
created by the commercial banks in the country. Banks create money supply in the

process of borrowing and lending transactions with the public. Money so created
by the commercial banks is called 'credit money’. The high powered money and
the credit money broadly constitute the most common measure of money supply,
or the total money stock of a country. (For a brief note on the process of creation
of credit money, refer to Box 1, end of this chapter).
2.4 MEASUREMENT OF MONEY SUPPLY

There is virtually a profusion of different types of money, especially credit money,
and this makes measurement of money supply a difficult task. Different countries
follow different practices in measuring money supply. The measures of money
supply vary from country to country, from time to time and from purpose to
purpose. Reference to such different measures is beyond the scope of this unit. Just
as other countries do, a range of monetary and liquidity measures are compiled
and published by the RBI. Money supply will change if the magnitude of any of its
constituents changes.
In this unit, we shall be concentrating on the Indian case only and in the following
discussion, we shall focus on alternative measures of money supply prepared and
published by the Reserve Bank of India.
Since July 1935, the Reserve Bank of India has been compiling and disseminating
monetary statistics. Till 1967-68, the RBI used to publish only a single ‘narrow
measure of money supply’ (M1) defined as the sum of currency and demand
deposits held by the public. From 1967-68, a 'broader' measure of money supply,
called 'aggregate monetary resources' (AMR) was additionally published by the RBI.
From April 1977, following the recommendations of the Second Working Group on
Money Supply (SWG), the RBI has been publishing data on four alternative
measures of money supply denoted by M1, M2, M3 and M4 besides the reserve
money. The respective empirical definitions of these measures are given below:
M1 = Currency notes and coins with the people + demand

deposits of banks (Current and Saving deposit accounts)
+ other deposits of the RBI.
M2 = M1 + savings deposits with post office savings banks.
M3 = M1 + net time deposits with the banking system.
M4= M3 + total deposits with the Post Office Savings
Organization (excluding National Savings Certificates).

The RBI regards these four measures of money stock as representing different
degrees of liquidity. It has specified them in the descending order of liquidity, M1
being the most liquid and M4the least liquid of the four measures.
We shall briefly discuss the important components of each. Currency consists of
paper currency as well as coins. Demand deposits comprise the current-account
deposits and the demand deposit portion of savings deposits, all held by the public.
These are also called CASA deposits and these are cheapest sources of finance for
a commercial bank. It should be noted that it is the net demand deposits of banks,
and not their total demand deposits that get included in the measure of money
supply. The total deposits include both deposits from the public as well as inter-
bank deposits. Money is deemed as something held by the ‘public’. Since inter-
bank deposits are not held by the public, they are netted out of the total demand
deposits to arrive at net demand deposits.
'Other deposits’ of the RBI are its deposits other than those held by the government
(the Central and state governments), and include demand deposits of quasi-
government institutions, other financial institutions, balances in the accounts of
foreign central banks and governments, and accounts of international agencies
such as IMF and the World Bank. Empirically, whatever the measure of money
supply, these 'other deposits' of the RBI constitute a very small proportion (less
than one per cent) of the total money supply.
Following the recommendations of the Working Group on Money (1998), the RBI
has started publishing a set of four new monetary aggregates on the basis of the
balance sheet of the banking sector in conformity with the norms of progressive
liquidity. The new monetary aggregates are:
Reserve Money = Currency in circulation + Bankers’ deposits

with the RBI + Other deposits with the RBI
= Net RBI credit to the Government + RBI credit
to the Commercial sector + RBI’s Claims on
banks + RBI’s net Foreign assets +
Government’s Currency liabilities to the public
– RBI’s net non - monetary Liabilities

NM1 = Currency with the public + Demand deposits with the

banking system + ‘Other’ deposits with the RBI.
NM2 = NM1 + Short-term time deposits of residents (including
and up to contractual maturity of one year).
NM3 = NM2 + Long-term time deposits of residents + Call/Term
funding from financial institutions
In the monetary literature, money is usually defined in alternative ways ranging

from narrow to broad money. Empirically the M1 (narrow money) is defined as the
sum of currency held by the public, demand deposits of the banks and other
deposits of RBI. Reserve money is comprised of the currency held by the public,
cash reserves of banks and other deposits of RBI. On comparison, we find that the
difference between M1 and reserve money is that the former includes the demand
deposits while the latter includes the cash reserves of banks. Reserves are
commercial banks’ deposits with the central bank for maintaining cash reserve ratio
(CRR) and as working funds for clearing adjustments.
Reserve money, also known as central bank money, base money or high-powered
money, needs a special mention as it plays a critical role in the determination of
the total supply of money. Reserve money determines the level of liquidity and
price level in the economy and, therefore, its management is of crucial importance
to stabilize liquidity, growth, and price level in an economy.
The central bank also measures macroeconomic liquidity by formulating various
‘liquidity’ aggregates in addition to the monetary aggregates. While the
instruments issued by the banking system are included in ‘money’, instruments,
those which are close substitutes of money but are issued by the non-banking
financial institutions are also included in liquidity aggregates.
L1= NM3 + All deposits with the post office savings banks (excluding National
Savings Certificates).
L2= L1 +Term deposits with term lending institutions and refinancing
institutions (FIs) + Term borrowing by FIs + Certificates of deposit issued by
FIs.
L3 = L2+ Public deposits of non-banking financial companies

2.5 DETERMINANTS OF MONEY SUPPLY

There are two alternate theories in respect of determination of money supply.
According to the first view, money supply is determined exogenously by the central
bank. The second view holds that the money supply is determined endogenously
by changes in the economic activities which affect people’s desire to hold currency
relative to deposits, rate of interest, etc. The current practice is to explain the
determinants of money supply based on ‘money multiplier approach’ which focuses
on the relation between the money stock and money supply in terms of the
monetary base or high-powered money. This approach holds that total supply of
nominal money in the economy is determined by the joint behaviour of the central
bank, the commercial banks and the public. Before we discuss the determinants of
money supply, it is necessary that we know the concept of money multiplier.
2.6 THE CONCEPT OF MONEY MULTIPLIER

The money supply is defined as
M = m X MB
Where M is the money supply, m is money multiplier and MB is the monetary base
or high powered money. From the above equation we can derive the money
multiplier (m) as
Money supply
Money Multiplier (m)=
Monetary base
Money multiplier m is defined as a ratio that relates the changes in the money
supply to a given change in the monetary base. It denotes by how much the money
supply will change for a given change in high-powered money. The multiplier
indicates what multiple of the monetary base is transformed into money supply.
If some portion of the increase in high-powered money finds its way into currency,
this portion does not undergo multiple deposit expansion. In other words, as a rule,
an increase in the monetary base that goes into currency is not multiplied, whereas
an increase in monetary base that goes into supporting deposits is multiplied.

2.7 THE MONEY MULTIPLIER APPROACH TO SUPPLY OF

MONEY
The money multiplier approach to money supply propounded by Milton Friedman
and Anna Schwartz, (1963) considers three factors as immediate determinants of
money supply, namely:
(a) the stock of high-powered money (H)
(b) the ratio of reserves to deposites, e = {ER/D} and
(c) the ratio of currency to depoists, c ={C/D}
You may note that these represent the behaviour of the central bank, behaviour of
the commercial banks and the behaviour of the general public respectively. We
shall now describe how each of the above contributes to the determination of
aggregate money supply in an economy.
a) The Behaviour of the Central Bank
The behaviour of the central bank which controls the issue of currency is reflected
in the supply of the nominal high-powered money. Money stock is determined by
the money multiplier and the monetary base is controlled by the monetary
authority. If the behaviour of the public and the commercial banks remains
unchanged over time, the total supply of nominal money in the economy will vary
directly with the supply of the nominal high-powered money issued by the central
bank.
b) The Behaviour of Commercial Banks
By creating credit, the commercial banks determine the total amount of nominal
demand deposits. The behaviour of the commercial banks in the economy is
reflected in the ratio of their cash reserves to deposits known as the ‘reserve ratio’.
If the required reserve ratio on demand deposits increases while all the other vari-
ables remain the same, more reserves would be needed. This implies that banks
must contract their loans, causing a decline in deposits and hence in the money
supply. If the required reserve ratio falls, there will be greater expansions of
deposits because the same level of reserves can now support more deposits and
the money supply will increase.
In actual practice, however, the commercial banks keep only a part or fraction of
their total deposits in the form of cash reserves. However, for the commercial
banking system as a whole, the actual reserves ratio is greater than the required

reserve ratio since the banks keep with them a higher than the statutorily required
percentage of their deposits in the form of cash reserves. The additional units of
high-powered money that goes into ‘excess reserves’ of the commercial banks do
not lead to any additional loans, and therefore, these excess reserves do not lead
to creation of money. Therefore, if the central bank injects money into the banking
system and these are held as excess reserves by the banking system, there will be
no effect on deposits or currency and hence no effect on money supply.
When the costs of holding excess reserves rise, we should expect the level of excess
reserves to fall; when the benefits of holding excess reserves rise, we would expect
the level of excess reserves to rise. Two primary factors namely market interest rates
and expected deposit outflows affect these costs and benefits and hence in turn
affect the excess reserves ratio.
We know that the cost to a bank while holding excess reserves is in terms of its
opportunity cost, i.e. the interest that could have been earned on loans or securities
if the bank had chosen to invest in them instead of excess reserves. If interest rate
increases, it means that the opportunity cost of holding excess reserves rises
because the banks have to sacrifice possible higher earnings and hence the desired
ratio of excess reserves to deposits falls. Conversely, a decrease in interest rate will
reduce the opportunity cost of excess reserves, and excess reserves will rise.
Therefore, we conclude that the banking system's excess reserves ratio e is neg-
atively related to the market interest rate.
If banks fear that deposit outflows are likely to increase (that is, if expected deposit
outflows increase), they will want more assurance against this possibility and will
increase the excess reserves ratio. Conversely, a decline in expected deposit
outflows will reduce the benefit of holding excess reserves and excess reserves will
fall.
As we know, money is mostly held in the form of deposits with commercial banks.
Therefore, money supply may become subject to ‘shocks’ on account of behaviour
of commercial banks which may present variations overtime either cyclically and
more permanently. For instance, in times of financial crises, banks may be unwilling
to lend to the small and medium scale industries who may become credit
constrained facing a higher risk premia on their borrowings. The rising interest rates
on bank credit to the commercial sector reflecting higher risk premia can co-exist
with the lowering of policy rates by the central bank. The lower credit demand can
lead to a sharp deceleration in monetary growth at a time when the central bank
pursues an easy monetary policy.

c) The Behaviour of the Public

We shall now turn to the next determinant viz. the behaviour of the public. The
public, by their decisions in respect of the amount of nominal currency in hand
(how much money they wish to hold as cash) is in a position to influence the
amount of the nominal demand deposits of the commercial banks. The behaviour
of the public influences bank credit through the decision on ratio of currency to
the money supply designated as the ‘currency ratio’.
What would be the behaviour of money supply when depositors decide to increase
currency holding, with all other variables unchanged? In other words, you decide
to keep more money in your pocket and less money in your bank. That means you
are converting some of your demand deposits into currency. If many people like
you do so, technically we say there is an increase in currency ratio. As we know,
demand deposits undergo multiple expansions while currency in your hands does
not. Hence, when bank deposits are being converted into currency, banks can
create only less credit money. The overall level of multiple expansion declines, and
therefore, money multiplier also falls. Therefore, we conclude that money multiplier
and the money supply are negatively related to the currency ratio c.
The currency-deposit ratio (c) represents the degree of adoption of banking habits
by the people. This is related to the level of economic activities or the GDP growth
and is influenced by the degree of financial sophistication in terms of ease and
access to financial services, availability of a richer array of liquid financial assets,
financial innovations, institutional changes etc.
The time deposit-demand deposit ratio i.e. how much money is kept as time
deposits compared to demand deposits, also has an important implication for the
money multiplier and, hence for the money stock in the economy. An increase in
TD/DD ratio means that greater availability of free reserves and consequent
enlargement of volume of multiple deposit expansion and monetary expansion.
To summarise the money multiplier approach, the size of the money multiplier is
determined by the required reserve ratio (r) at the central bank, the excess reserve
ratio (e) of commercial banks and the currency ratio (c) of the public. The lower
these ratios are, the larger the money multiplier is. In other words, the money
supply is determined by high powered money (H) and the money multiplier (m)
and varies directly with changes in the monetary base, and inversely with the
currency and reserve ratios. Although these three variables do not completely
explain changes in the nominal money supply, nevertheless they serve as useful

devices for analysing such changes. Consequently, these variables are designated
as the ‘proximate determinants’ of the nominal money supply in the economy.
2.8 EFFECT OF GOVERNMENT EXPENDITURE ON MONEY

SUPPLY
Whenever the central and the state governments’ cash balances fall short of the
minimum requirement, they are eligible to avail of a facility called Ways and Means
Advances (WMA)/overdraft (OD) facility. When the Reserve Bank of India lends to
the governments under WMA /OD, it results in the generation of excess reserves
(i.e., excess balances of commercial banks with the Reserve Bank). This happens
because when government incurs expenditure, it involves debiting the government
balances with the Reserve Bank and crediting the receiver (for e.g., salary account
of government employee) account with the commercial bank. The excess reserves
thus created can potentially lead to an increase in money supply through the
money multiplier process.
The Credit Multiplier

The Credit Multiplier also referred to as the deposit multiplier or the deposit
expansion multiplier, describes the amount of additional money created by
commercial bank through the process of lending the available money it has in
excess of the central bank's reserve requirements. The deposit multiplier is, thus
inextricably tied to the bank's reserve requirement. This measure tells us how much
new money will be created by the banking system for a given increase in the high-
powered money. It reflects a bank's ability to increase the money supply.
The credit multiplier is the reciprocal of the required reserve ratio. If reserve ratio
is 20%, then credit multiplier = 1/0.20 = 5.
1
Credit Multiplier=
Required Reserve Ratio
The existence of the credit multiplier is the outcome of fractional reserve banking.
It explains how increase in money supply is caused by the commercial banks’ use
of depositors’ funds to lend money. When a bank uses the deposited money for
lending, the bank generates another claim on a given amount of deposited money.
For example, if A deposits ` 1000/ in cash at a bank (Bank X), this constitutes the
bank's current total cash deposits. If the required reserve is 10 percent, the bank
would lend` 900/ to B. By lending B ` 900/, the bank creates a deposit for ` 900/
that B can now use. It is as though B owns ` 900/. This in turn means that A will
continue to have a claim against ` 1000/ while B will have a claim against ` 900/.

The bank has ` 1000/ in cash against claims of `1900/. In short, the bank has created
` 900/ out of "thin air" since these ` 900/ are not supported by any genuine money.
At any time, the fractional reserve commercial banks have more cash liabilities than
cash in their vaults.
Now suppose B buys goods worth ` 900/ from C and pays C by cheque. C places
the cheque with his bank, Bank Y. After clearing the cheque, Bank Y will have an
increase in cash of ` 900/, which it may take advantage of and use to lend out `
810/ to D which may again be deposited in another bank, say Bank Z. Again 10 per
cent of ` 810 (` 81) has to be kept as required reserves and the remaining `. 719/
can be lent out, say to E. This sequence keeps on continuing until the initial deposit
amount `. 1,000 grows exactly by the multiple of required reserves(in this case,
10%). Ultimately, the expanded credit availability would be 1000 + 900 (90% of
1000) + 810 (90% of 900) + 729 (90% of 810) + (90% of 719) +… …. This summation
would end with an amount which is equivalent to 1/10% of 1000, which is `. 10,000.
Thus, in our example, the initial deposit is capable of multiplying itself out 10 times.
In short, we find that the fact that banks make use of demand deposits for lending
it sets in motion a series of activities leading to expansion of money that is not
backed by money proper. It is interesting to know that there is no difference
between the type of money created by commercial banks and that which are issued
by the central bank.
The deposit multiplier and the money multiplier though closely related are not
identical because :
a) generally banks do not lend out all of their available money but instead
maintain reserves at a level above the minimum required reserve.
b) all borrowers do not spend every Rupee they have borrowed. They are likely to
convert some portion of it to cash.

SUMMARY
• The measures of money supply vary from country to country, from time to time
and from purpose to purpose.
• The high-powered money and the credit money broadly constitute the most
common measure of money supply, or the total money stock of a country.
• High powered money is the source of all other forms of money. The second
major source of money supply is the banking system of the country. Money
created by the commercial banks is called 'credit money’.
• Measurement of money supply is essential from a monetary policy perspective
because it enables a framework to evaluate whether the stock of money in the
economy is consistent with the standards for price stability, to understand the
nature of deviations from this standard and to study the causes of money
growth.
• The stock of money always refers to the total amount of money at any
particular point of time i.e. it is the stock of money available to the ‘public’ as
a means of payments and store of value and does not include inter-bank
deposits.
• The monetary aggregates are:
 M1 = Currency and coins with the people + demand deposits of banks
(Current and Saving accounts) + other deposits of the RBI;
 M2 = M1 + savings deposits with post office savings banks,
 M3 = M1 + net time deposits of banks and
 M4 = M3 + total deposits with the Post Office Savings Organization
(excluding National Savings Certificates).
• Following the recommendations of the Working Group on Money (1998), the
RBI has started publishing a set of four new monetary aggregates as: Reserve
Money = Currency in circulation + Bankers’ deposits with the RBI + Other
deposits with the RBI, NM1 = Currency with the public + Demand deposits with
the banking system + ‘Other’ deposits with the RBI, NM2 = NM1 +Short-term
time deposits of residents (including and up to contractual maturity of one
year),NM3 = NM2 + Long-term time deposits of residents + Call/Term funding
from financial institutions
• The Liquidity aggregates are :

 L1 = NM3 + All deposits with the post office savings banks (excluding
National Savings Certificates).
 L2 = L1 +Term deposits with term lending institutions and refinancing
institutions (FIs) + Term borrowing by FIs + Certificates of deposit issued
by FIs.
• The Reserve money, also known as central bank money, base money or high
powered money determines the level of liquidity and price level in the
economy.
• The money multiplier approach showing relation between the money stock and
money supply in terms of the monetary base or high-powered money, holds
that total supply of nominal money in the economy is determined by the joint
behaviour of the central bank, the commercial banks and the public.
• M= m X MB; Where M is the money supply, m is money multiplier and MB is
the monetary base or high powered money. It shows the relationship between
the reserve money and the total money stock.
• The money multiplier is a function of the currency ratio which depends on the
behaviour of the public, excess reserves ratio of the banks and the required
reserve ratio set by the central bank.
• The additional units of high-powered money that goes into ‘excess reserves’
of the commercial banks do not lead to any additional loans, and therefore,
these excess reserves do not lead to the creation of deposits.
• When the required reserve ratio falls, there will be greater multiple expansions
for demand deposits.
• Excess reserves ratio e is negatively related to the market interest rate i. If
interest rate increases, the opportunity cost of holding excess reserves rises,
and the desired ratio of excess reserves to deposits falls.
• An increase in time deposit-demand deposit ratio (TD/DD) means that greater
availability of free reserves for banks and consequent enlargement of volume
of multiple deposit expansion and monetary expansion.
• When the Reserve Bank lends to the governments under WMA /OD it results
in the generation of excess reserves (i.e., excess balances of commercial banks
with the Reserve Bank).

TEST YOUR KNOWLEDGE

1. Reserve money is also known as
(a) central bank money
(b) base money
(c) high powered money
(d) all the above
2. Choose the correct statement from the following
(a) Money is deemed as something held by the public and therefore only
currency held by the public is included in money supply.
(b) Money is deemed as something held by the public and therefore inter-
bank deposits are included in money supply.
(c) Since inter-bank deposits are not held by the public, therefore inter-bank
deposits are excluded from the measure of money supply.
(d) Both a ) and c) above.
3. Reserve Money is composed of
(a) currency in circulation + demand deposits of banks (Current and Saving
accounts) + Other deposits with the RBI.
(b) currency in circulation + Bankers’ deposits with the RBI + Other deposits
with the RBI.
(c) currency in circulation + demand deposits of banks + Other deposits with
the RBI.
(d) currency in circulation + demand and time deposits of banks + Other
deposits with the RBI.
4. M1 is the sum of
(a) currency and coins with the people + demand deposits of banks (Current
and Saving accounts) + other deposits of the RBI.
(b) currency and coins with the people + demand and time deposits of banks
(Current and Saving accounts) + other deposits of the RBI.

(c) currency in circulation + Bankers’ deposits with the RBI + Other deposits
with the RBI
5. Under the ‘minimum reserve system’ the central bank is
(a) empowered to issue currency to any extent by keeping an equivalent
reserve of gold and foreign securities.
(b) empowered to issue currency to any extent by keeping only a certain
minimum reserve of gold and foreign securities.
(c) empowered to issue currency in proportion to the reserve money by
keeping only a minimum reserve of gold and foreign securities.
(d) empowered to issue currency to any extent by keeping a reserve of gold
and foreign securities to the extent of ` 350 crores
6. The primary source of money supply in all countries is
(a) the Reserve Bank of India
(b) the Central bank of the country
(c) the Bank of England
(d) the Federal Reserve
7. The supply of money in an economy depends on
(a) the decision of the central bank based on the authority conferred on it.
(b) the decision of the central bank and the supply responses of the
commercial banking system.
(c) the decision of the central bank in respect of high powered money.
(d) both a) and c) above.
8. Banks in the country are required to maintain deposits with the central bank
(a) to provide the necessary reserves for the functioning of the central bank
(b) to meet the demand for money by the banking system
(c) to meet the central bank prescribed reserve requirements and to meet
settlement obligations.
(d) to meet the money needs for the day to day working of the commercial
banks

9. If the behaviour of the public and the commercial banks is constant, then
(a) the total supply of nominal money in the economy will vary directly with
the supply of the nominal high-powered money issued by the central bank
(b) the total supply of nominal money in the economy will vary directly with
the rate of interest and inversely with reserve money
(c) the total supply of nominal money in the economy will vary inversely with
the supply of high powered money
(d) all the above are possible
10. Under the fractional reserve system
(a) the money supply is an increasing function of reserve money (or high
powered money) and the money multiplier.
(b) the money supply is an decreasing function of reserve money (or high
powered money) and the money multiplier.
(c) the money supply is an increasing function of reserve money (or high
powered money) and a decreasing function of money multiplier.
(d) none of the above as the determinants of money supply are different
11. The money multiplier and the money supply are
(a) positively related to the excess reserves ratio e.
(b) negatively related to the excess reserves ratio e.
(c) not related to the excess reserves ratio e.
(d) proportional to the excess reserves ratio e.
12. The currency ratio represents
(a) the behaviour of central bank in the issue of currency.
(b) the behaviour of central bank in respect cash reserve ratio.
(c) the behaviour of the public.
(d) the behaviour of commercial banks in the country.
13. The size of the money multiplier is determined by
(a) the currency ratio (c) of the public,
(b) the required reserve ratio (r) at the central bank, and

(c) the excess reserve ratio (e) of commercial banks.

(d) all the above
14. --------------- tells us how much new money will be created by the banking
system for a given increase in the high-powered money.
(a) The currency ratio
(b) The excess reserve ratio (e)
(c) The credit multiplier
(d) The currency ratio (c)
15. The money multiplier will be large
(a) for higher currency ratio (c), lower required reserve ratio (r) and lower
excess reserve ratio (e)
(b) for constant currency ratio (c), higher required reserve ratio (r) and lower
(c) for lower currency ratio (c), lower required reserve ratio (r) and lower
16. The ratio that relates the change in the money supply to a given change in the
monetary base is called the
(a) required reserve ratio.
(b) money multiplier.
(c) deposit ratio.
(d) discount rate.
17. For a given level of the monetary base, an increase in the required reserve ratio
will denote
(a) a decrease in the money supply.
(b) an increase in the money supply.
(c) an increase in demand deposits.
(d) Nothing precise can be said

18. For a given level of the monetary base, an increase in the currency ratio causes
the money multiplier to _____ and the money supply to _____.
(a) decrease; increase
(b) increase; decrease
(c) decrease; decrease
(d) increase; increase
19. If commercial banks reduce their holdings of excess reserves
(a) the monetary base increases.
(b) the monetary base falls.
(c) the money supply increases.
(d) the money supply falls.
(a) Explain the nature of currency issue under minimum reserve system
(b) Define ‘credit money’.
(c) List the components of M1
(d) Distinguish between M1 and M2
(e) What is the rationale behind inclusion of net demand deposits of banks in
money supply measurement?
(f) Define ‘Reserve Money’
(g) Write a note on two major components Reserve money?
(h) Describe the term ‘cash reserve ratio’ (CRR)
(i) Write a note on the liquidity aggregates compiled by RBI
(j) Define ‘money multiplier’
(k) What is the nature of relationship between money multiplier and the money
supply?
(l) What would be the effect on money multiplier if banks hold excess reserves?
(m) What effect does government expenditure have on money supply?
(n) What is the value of the money multiplier in a system of 100% reserve banking?

(o) Define credit multiplier. How is it calculated?

1. Define money supply. Describe the different components of money supply.
2. Explain the concept of money multiplier and bring out its impact on money
supply.
3. Explain the factors which determine excess reserves held by banks? How do
changes in each such factor affect the excess reserves, money multiplier, and
money supply?
4. Explain the money multiplier approach to money supply?
5. Describe with illustrations how changes in high powered money, required
reserves, excess reserves and currency ratio, influence the money supply in an
economy?
6. Describe the different determinants of money supply in a country.
IV. Application Oriented Questions
1. Prepare separate graphs using excel on ‘Money Stock: Components and
Sources’ and ‘Reserve Money: Components and Sources’ for four previous
months from the weekly statistical supplements published by Reserve Bank of
India. Identify the trends in each.
2. Compute Reserve Money from the following data published by RBI
Components (In billions of `) As on 7 July 2017
Currency in Circulation 15428.40
Bankers’ Deposits with RBI 4596.18
’Other’ Deposits with RBI 183.30
3. Compute M3 from the following data published by RBI
Components (In billions of `) As on 31 March, 2017
Currency with the Public 12637.1
Demand Deposits with Banks 14,106.3
Time Deposits with Banks 101,489.5
‘Other’ Deposits with Reserve Bank 210.9

4. What will be the total credit created by the commercial banking system for
an initial deposit of ` 1000/ for required reserve ratio 0.02, 0.05 and 0.10
percent respectively? Compute credit multiplier
5. How would each of the following affect money multiplier and money supply?
(i) Commercial banks in India decide to hold more excess reserves
(ii) Fearing shortage of money in ATMs, people decide to hoard money
(iii) Banks open large number ATMs all over the country
(iv) E banking becomes very common and nearly all people use them
(v) During festival season , people decide to use ATMs very often
(vi) If banks decide to keep 100% reserves. What would be the effect on money
multiplier and money supply?
(vii) Suppose banks need to keep no reserves only 0% reserves are there.
ANSWERS/HINTS
Multiple Choice Questions
1. (d) 2. (c) 3. (b) 4. (a) 5. (b) 6 (b)
7. (b) 8. (c) 9. (a) 10. (a) 11. (b) 12 (c)
13. (d) 14. (c) 15. (c) 16. (b) 17. (a) 18 (c)
19. (c)
Short Answer Type Questions
(a) Under the ‘minimum reserve system’ the central bank is empowered to issue
currency to any extent by keeping only a certain minimum reserve of gold
and foreign securities.
(b) 'Credit money’ refers to the fraction of money supply created by commercial
banks in the process of borrowing and lending transactions with the public.
(c) M1 is composed of currency and coins with the people, demand deposits of
banks (current and saving accounts) and other deposits of the RBI.
(d) M2 includes M1( as above) as well as savings deposits with post office savings
banks

(e) Money is deemed as something held by the ‘public’. Since inter-bank

deposits are not held by the public, they are netted out of the total demand
deposits to arrive at net demand deposits.
(f) Reserve Money is composed of currency in circulation , bankers’ deposits with
the RBI and other deposits with the RBI
(g) Reserve money has two major components – currency in circulation and
reserves. Currency in circulation comprises currency with the public and cash
in hand with banks. Reserves are bank deposits with the central bank.
(h) Banks in the country are required to maintain deposits with the central bank to
meet the central bank prescribed reserve requirements or cash reserve ratio
(CRR) as also to meet settlement obligations. They represent balances
maintained by banks in the current account with the Reserve Bank of India.
(i) The liquidity aggregates are: L1which is composed of NM3, all deposits with
the post office savings banks (excluding National Savings Certificates), L2
which comprises of L1,term deposits with term lending institutions and
refinancing institutions (FIs) ,term borrowing by FIs and certificates of deposit
issued by FIs and L3 consisting of L2 and Public deposits of non-banking
financial companies
(j) The money supply is defined as M= m X MB where M is the money supply, m
is money multiplier and MB is the monetary base or high powered money.
Money multiplier m is defined as a ratio that relates the change in the money
supply to a given change in the monetary base.
(k) The multiplier indicates what multiple of the monetary base is transformed into
money supply. The link from reserve money to money supply is through the
money multiplier. The multiplier process operates as long as banks have excess
reserves.
(l) The additional units of high-powered money that goes into ‘excess reserves’
of the commercial banks do not lead to any additional loans, and therefore,
these excess reserves do not lead to creation of deposits. In other words, excess
reserves may be considered as an idle component of reserves and therefore
has no effect on money multiplier.
(m) When the Reserve Bank lends to the governments under WMA /OD it results
in the generation of excess reserves (i.e., excess balances of commercial banks
with the Reserve Bank). The excess reserves thus created can potentially lead
to an increase in money supply through the money multiplier process.

(n) If banks keep the whole deposits as reserve, deposits simply replace currency
as reserves and therefore no new extra claims will be created and no new
money will be created by banks.
(o) The Credit Multiplier also referred to as the deposit multiplier or the deposit
expansion multiplier, describes the amount of additional money created by
commercial bank through the process of lending the available money it has in
excess of the central bank's reserve requirements. It is the reciprocal of the
required reserve ratio. If reserve ratio is 20%, then credit multiplier
= 1/0.20 = 5.
1
Credit Multiplier=
Required Reserve Ratio
1. From the RBI website, collect the relevant information from the ‘publications
(weekly) page.
2. Reserve Money=Currency in Circulation + Bankers’ Deposits with RBI+ ’Other’
Deposits with RBI 15428.40+4596.18+183.30= 20205.68
3. M3 = 128,443.9 Currency with the Public + Demand Deposits with Banks+ Time
Deposits with Banks+ ‘Other’ Deposits with Reserve Bank
=12637.1+14,106.3+101,489.5+210.9 = 128,443.9
4. Credit Multiplier =1/ Required Reserve Ratio
1000 x 1/0.02= 50,000
1000x 1/0.05 – 20,000
1000x1/0.10= 10,000
5. (i) Excess reserves are those reserves that the commercial banks hold with the
central bank in addition to the mandatory reserve requirements. Excess
reserves result in an increase in reserve-deposit ratio of banks; less money
for lending reduces money multiplier; money supply declines.
(ii) When people hold more money, it increases the currency-deposit ratio
;reduces money multiplier; money supply declines.
(iii) ATMs let people to withdraw cash from the bank as and when needed,
reduces cost of conversion of deposits to cash and makes deposits
relatively more convenient. People hold less cash and more deposits, thus

reducing the currency-deposit ratio; increasing the money multiplier

causing the money supply to increase
(iv) See iii) above
(v) If people, for any reason, are expected to withdraw money from ATMs with
more frequency, then banks will want to keep more reserves. This will raise
the reserve ratio, and lower the money multiplier. As a result money supply
will decline
(vi) If banks decides to keep 100% reserves, then the Money multiplier =
1/required reserve ratio = 1/100% = 1. No additional money supply as
there is no credit creation
(vii) If the required reserve ratio is 0 %, then money multiplier is infinite and
there will be unlimited money creation. There will be chaos with spiraling
prices as money supply is too much and real output cannot increase.

UNIT III: MONETARY POLICY
LEARNING OUTCOMES

 Define monetary policy and describe its objectives
 Elucidate different components of the monetary policy
framework
 Illustrate the analytics of monetary policy
 Explain the operating procedures and instruments of monetary
policy, and
 Describe the organizational structure for monetary policy
decisions
Money Market
Monetary Policy
The Organisational
The Monetary Policy
Structure for Monetary
Framework
Policy Decisions

MONETARY POLICY 3.51
3.1 INTRODUCTION
As citizens of a free nation, we have many dreams about what ought to be the state
of affairs in our economy. We value stable prices and low rates of inflation. We
share a quest for well-being through high levels of growth which ensure jobs and
prosperity and we work towards it. Unfortunately, in reality, we live in a crisis prone
economy with nightmares of financial downturns, of being laid- off or being
battered by financial crises. We observe that the Reserve Bank of India is
occasionally manipulating policy rates for maneuvering liquidity conditions with
reasons thereof explicitly notified. In fact, we have only a limited understanding of
the monetary phenomena which coutld strengthen or paralyse the domestic
economy. The discussion that follows is an attempt to throw light on the well-
acknowledged monetary measures undertaken by governments to fight economic
instability.
3.2 MONETARY POLICY DEFINED

Monetary policy refers to the use of monetary policy instruments which are at the
disposal of the central bank to regulate the availability, cost and use of money and
credit to promote economic growth, price stability, optimum levels of output and
employment, balance of payments equilibrium, stable currency or any other goal
of government's economic policy. In other words, monetary policy is essentially a
programme of action undertaken by the monetary authorities, normally the central
bank, to control and regulate the demand for and supply of money with the public
and the flow of credit with a view to achieving predetermined macroeconomic
goals. Monetary policy encompasses all actions of the central bank which are aimed
at directly controlling the money supply and indirectly at regulating the demand
for money. Monetary policy is in the nature of ‘demand-side’ macroeconomic
policy and works by stimulating or discouraging investment and consumption
spending on goods and services. It is no surprise that monetary policy is regarded
as an indispensable policy instrument in an economy.
3.3 THE MONETARY POLICY FRAMEWORK

The central bank, in its execution of monetary policy, functions within an articulated
monetary policy framework which has three basic components, viz.
(i) the objectives of monetary policy,
(ii) the analytics of monetary policy which focus on the transmission mechanisms,
and

(iii) the operating procedure which focuses on the operating targets and
instruments.
3.3.1 The Objectives of Monetary Policy
The objectives set for monetary policy are important because they provide explicit
guidance to policy makers. Monetary policy of a country is in fact a reflection of
its economic policy and therefore, the objectives of monetary policy generally
coincide with the overall objectives of economic policy. There are significant
differences among different countries in respect of the selection of objectives,
implementation procedures and tools of monetary policy either due to differences
in the underlying economies or due to differences in the financial systems and in
the infrastructure of financial markets. Coverage of aspects related to monetary
policies of different countries would be beyond the scope of this unit. Therefore,
the following discussions relate to the monetary policy situations in the context of
Indian economy.
In the pre-Keynesian period, monetary policy, with its conventional objective of
establishment and maintenance of stability in prices, was the single well-
acknowledged instrument of macroeconomic policy. The Great Depression in 1930s
and the associated economic crises marked a turning point resulting in a major
shift in the objective of governments’ economic policy in favour of maintenance of
full employment, more generally described as economic stability. The most
commonly pursued objectives of monetary policy of the central banks across the
world are maintenance of price stability (or controlling inflation) and achievement
of high level of economy’s growth and maintenance of full employment
The Reserve Bank of India Act, 1934, in its preamble sets out the objectives of the
Bank as ‘to regulate the issue of bank notes and the keeping of reserves with a view
to securing monetary stability in India and generally to operate the currency and
credit system of the country to its advantage’. It is to be noted that though price
stability as an objective is not explicitly spelt out, the monetary policy in India has
evolved towards maintaining price stability and ensuring adequate flow of credit
to the productive sectors of the economy. Price stability, as we know, is a necessary
precondition for sustainable growth. Fundamentally, the primary objective of
monetary policy has been maintenance of a judicious balance between price
stability and economic growth.
Multiple objectives, all of which are equally desirable, such as rapid economic
growth, debt management, moderate long-term interest rates, exchange rate
stability and external balance of payments equilibrium were incorporated as
objectives of monetary policy by policy makers in later years. The need for

simultaneous achievement of several objectives brings in the possibility of conflict

among the different monetary policy objectives. For example, there is often a
conflict between the objectives of holding down both inflation and unemployment;
a policy targeted at controlling inflation is very likely to generate unemployment.
As such, based on the set national priorities, the monetary policymakers have to
exercise appropriate trade-offs to balance the conflicting objectives.
Given the development needs of developing countries, the monetary policy of such
countries also incorporate explicit objectives such as:
(i) maintenance the economic growth,
(ii) ensuring an adequate flow of credit to the productive sectors,
(iii) sustaining - a moderate structure of interest rates to encourage investments,
and
(iv) creation of an efficient market for government securities.
Considerations of financial and exchange rate stability have assumed greater
importance in India recently on account of increasing openness of the economy
and the progressive economic and financial sector reforms.
3.3.2 Analytics of Monetary Policy
As we are aware, just as fiscal policy, monetary policy is intended to influence
macroeconomic variables such as the aggregate demand, quantity of money and
credit , interest rates etc , so as to influence overall economic performance. The
process or channels through which the change of monetary aggregates affects the
level of product and prices is known as ‘monetary transmission mechanism’. It
describes how policy-induced changes in the nominal money stock or in the short-
term nominal interest rates impact real variables such as aggregate output and
employment. Although we know that monetary policy does influence output and
inflation, we are not certain about how exactly it does so because the effects of
such policy are visible often after a time lag which is not completely predictable.
There are mainly four different mechanisms through which monetary policy
influences the price level and the national income. These are:
(a) the interest rate channel,
(b) the exchange rate channel,
(c) the quantum channel (e.g., relating to money supply and credit), and
(d) the asset price channel i.e. via equity and real estate prices.

We shall have a brief discussion on each of the above transmission mechanisms.

According to the traditional Keynesian interest rate channel, a contractionary
monetary policy‐induced increase in interest rates increases the cost of capital and
the real cost of borrowing for firms with the result that they cut back on their
investment expenditures. Similarly, households facing higher real borrowing costs,
cut back on their purchases of homes, automobiles, and all types of durable
goods. A decline in aggregate demand results in a fall in aggregate output and
employment. Conversely, an expansionary monetary policy induced decrease in
interest rates will have the opposite effect through decreases in cost of capital for
firms and cost of borrowing for households.
In open economies, additional real effects of a policy‐induced change in the short‐
term interest rate come about through the exchange rate channel. Typically, the
exchange rate channel works through expenditure switching between domestic and
foreign goods. Appreciation of the domestic currency makes domestically
produced goods more expensive compared to foreign‐produced goods. This
causes net exports to fall; correspondingly domestic output and employment also
fall.
Two distinct credit channels- the bank lending channel and the balance sheet
channel- also allow the effects of monetary policy actions to spread through the
real economy. Credit channel operates by altering access of firms and households
to bank credit. Most businsses and people mostly depend on bank for borrowing
money. “An open market operation” that leads first to a contraction in the supply
of bank reserves and then to a contraction in bank credit requires banks to cut back
on their lending. This, in turn makes the firms that are especially dependent on
banks loans to cut back on their investment spending. Thus, there is decline in the
aggregate output and employment following a monetary contraction.
Now we shall look into how the balance sheet channel works. Logically, as a firm’s
cost of credit rises, the strength of its balance sheet deteriorates. A direct effect of
monetary policy on the firm’s balance sheet comes through an increase in interest
rates leading to an increase in the payments that the firm must make to repay its
floating rate debts. An indirect effect occurs when the same increase in interest
rates works to reduce the capitalized value of the firm’s long‐lived assets. Hence,
a policy‐induced increase in the short‐term interest rate not only acts immediately
to depress spending through the traditional interest rate channel, it also acts,
possibly with a time-lag, to raise each firm’s cost of capital through the balance
sheet channel. These together aggravate the decline in output and employment.

The standard asset price channel suggests that asset prices respond to monetary
policy changes and consequently affect output, employment and inflation. A policy‐
induced increase in the short‐term nominal interest rates makes debt instruments
more attractive than equities in the eyes of investors leading to a fall in equity
prices. If stock prices fall after a monetary tightening, it leads to reduction in
household financial wealth, leading to fall in consumption, output, and
employment.
The manner in which these different channels function in a given economy depends
on:
(i) the stage of development of the economy, and
(ii) the underlying financial structure of the economy
3.3.3 Operating Procedures and Instruments
The operating framework relates to all aspects of implementation of monetary
policy. It primarily involves three major aspects, namely,
(i) choosing the operating target,
(ii) choosing the intermediate target, and
(iii) choosing the policy instruments.
The operating target refers to the variable (for e.g. inflation) that monetary policy
can influence with its actions. The intermediate target (e.g. economic stability) is a
variable which the central bank can hope to influence to a reasonable degree
through the operating target and which displays a predictable and stable
relationship with the goal variables. The monetary policy instruments are the
various tools that a central bank can use to influence money market and credit
conditions and pursue its monetary policy objectives.
The day-to-day implementation of monetary policy by central banks through
various instruments is referred to as ‘operating procedures’. For implementing
monetary policy, a central bank can act directly, using its regulatory powers, or
indirectly, using its influence on money market conditions as the issuer of reserve
money (currency in circulation and deposit balances with the central bank).
In general, the direct instruments comprise of:
(a) the required cash reserve ratios and liquidity reserve ratios prescribed from
time to time.

(b) directed credit which takes the form of prescribed targets for allocation of
credit to preferred sectors (for e.g. Credit to priority sectors), and
(c) administered interest rates wherein the deposit and lending rates are
prescribed by the central bank.
The indirect instruments mainly consist of:
(a) Repos
(b) Open market operations
(c) Standing facilities, and
(d) Market-based discount window.
We shall now discuss in detail how these instruments are put to use for meeting
the stated objectives of monetary policy.
1. Cash Reserve Ratio (CRR)
Cash Reserve Ratio (CRR) refers to the fraction of the total net demand and time
liabilities (NDTL) of a scheduled commercial bank in India which it should maintain
as cash deposit with the Reserve Bank. The RBI may set the ratio in keeping with
the broad objective of maintaining monetary stability in the economy. This
requirement applies uniformly to all scheduled banks in the country irrespective of
its size or financial position. Non Bank Financial Institution (NBFIs) are outside the
purview of this reserve requirement.
The Reserve Bank does not pay any interest on the CRR balances maintained by the
scheduled commercial banks (SCBs) with effect from the fortnight beginning March
31, 2007; however, failure of a bank to meet its required reserve requirements
would attract penalty in the form of penal interest charged by the RBI.
CRR has, in recent years, assumed significance as one of the important quantitative
tools aiding in liquidity management. Higher the CRR with the RBI, lower will be
the liquidity in the system and vice versa. During slowdown in the economy, the
RBI reduces the CRR in order to enable the banks to expand credit and increases
the supply of money available in the economy. In order to contain credit expansion
during periods of high inflation, the RBI increases the CRR. The cash reserve ratio
as on 8th July, 2017 was 4.0 per cent.
2. Statutory Liquidity Ratio (SLR)
The Statutory Liquidity Ratio (SLR) is a prudential measure. As per the Banking
Regulations Act 1949, all scheduled commercial banks in India are required to

maintain a stipulated percentage of their total Demand and Time Liabilities (DTL) /
Net DTL (NDTL) in one of the following forms:
(i) Cash
(ii) Gold, or
(iii) Investments in un-encumbered Instruments that include:
(a) Treasury-bills of the Government of India.
(b) Dated securities including those issued by the Government of India from
time to time under the market borrowings programme and the Market
Stabilization Scheme (MSS).
(c) State Development Loans (SDLs) issued by State Governments under their
market borrowings programme.
(d) Other instruments as notified by the RBI. These include mainly the
securities issued by PSEs.
While CRR has to be maintained by banks as cash with the RBI, the SLR requires
holding of assets in one of the above three categories by the bank itself. The banks
which fail to meet its SLR obligations are liable to be imposed penalty in the form
of a penal interest payable to RBI. As per the Second Bi-Monthly Monetary Policy
Statement 2017-18 of the RBI on June 7th 2017, it has been decided to reduce the
statutory Liquidity Ratio (SLR) from 20.5 percent to 20.0 per cent from June 24,
2017.
The SLR is also a powerful tool for controlling liquidity in the domestic market by
means of manipulating bank credit. Changes in the SLR chiefly influence the
availability of resources in the banking system for lending. A rise in the SLR which
is resorted to during periods of high liquidity, tends to lock up a rising fraction of
a bank’s assets in the form of eligible instruments, and this reduces the credit
creation capacity of banks. A reduction in the SLR during periods of economic
downturn has the opposite effect. The SLR requirement also facilitates a captive
market for government securities.
3. Liquidity Adjustment Facility(LAF)
A central bank is a ‘bankers’ bank.’ It provides liquidity to banks when the latter
face shortage of liquidity. This facility is provided by the Central Bank through its
discount window. The scheduled commercial banks can borrow from the discount
window against the collateral of securities like commercial bills, government
securities, treasury bills, or other eligible papers. This type of support earlier took

the form of refinance of loans given by commercial banks to various sectors (e.g.
Exports, agriculture etc). By varying the terms and conditions of refinance, the RBI
could employ the sector-specific refinance facilities as an instrument of credit
policy to encourage /discourage lending to particular sectors. In line with the
financial sector reforms, the system of sector-specific refinance schemes (except
export credit refinance scheme) was withdrawn. From June 2000, the RBI has
introduced Liquidity Adjustment Facility (LAF).
The Liquidity Adjustment Facility(LAF) is a facility extended by the Reserve Bank of
India to the scheduled commercial banks (excluding RRBs) and primary dealers to
avail of liquidity in case of requirement (or park excess funds with the RBI in case
of excess liquidity) on an overnight basis against the collateral of government
securities including state government securities.
The introduction of LAF is an important landmark since it triggered a rapid
transformation in the monetary policy operating environment in India. As a key
element in the operating framework of the RBI, its objective is to assist banks to
adjust their day to day mismatches in liquidity. Currently, the RBI provides financial
accommodation to the commercial banks through repos/reverse repos under the
Liquidity Adjustment Facility (LAF).
Repurchase Options or in short ‘Repo’, is defined as ‘an instrument for borrowing
funds by selling securities with an agreement to repurchase the securities on a
mutually agreed future date at an agreed price which includes interest for the funds
borrowed’. In other words, repo is a money market instrument, which enables
collateralised short term borrowing and lending through sale/purchase operations
in debt instruments. The Repo transaction in India has two elements: - in the first,
the seller sells securities and receives cash while the purchaser buys securities and
parts with cash. In the second, the securities are repurchased by the original holder.
The user pays to the counter party the amount originally received, plus the return
on the money for the number of days for which the money was used, which is
mutually agreed. All these transactions are reported on the electronic platform
called the Negotiated Dealing System (NDS). The Clearing Corporation of India Ltd.
(CCIL) has put in an anonymous online repo dealing system in India, with an
anonymous order matching electronic platform. Repo or repurchase option is a
collaterised lending. The rate charged by RBI for this transaction is called the ‘repo
rate’. Repo operations thus inject liquidity into the system.

The policy rate *

You might have read in business dailies about the ‘policy rate’. In India, the fixed
repo rate quoted for sovereign securities in the overnight segment of Liquidity
Adjustment Facility (LAF) is considered as the policy rate. (It may be noted that
India has many other repo rates in operation). The RBI uses the single independent
‘policy rate’ which is the repo rate (in the LAF window) for balancing liquidity. The
policy rate is in fact, the key lending rate of the central bank in a country. A change
in the policy rate gets transmitted through the money market to the entire the
financial system and alters all other short term interest rates in the economy,
thereby influencing aggregate demand – a key determinant of the level of inflation
and economic growth. If the RBI wants to make it more expensive for banks to
borrow money, it increases the repo rate. Similarly, if it wants to make it cheaper
for banks to borrow money, it reduces the repo rate. In other words, an increase in
the repo rate will lead to liquidity tightening and vice-versa, other things remaining
constant.
As per the Second Bi-Monthly Monetary Policy Statement 2017-18 of the RBI on
June 7th 2017, the Monetary Policy committee (MPC) has decided to keep the policy
repo rate under the liquidity adjustment facility (LAF) unchanged at 6.25 per cent,
the reserve repo rate at 6.00 per cent and the Marginal Standing Facility (MSF) rate
and the Bank rate at 6.50 per cent.
* Learners are requested to refer the RBI website (www.rbi.org.in) for up- to- date
information on the prevailing policy rates.
‘Reverse Repo’ is defined as an instrument for lending funds by purchasing
securities with an agreement to resell the securities on a mutually agreed future
date at an agreed price which includes interest for the funds lent . Reverse repo
operation takes place when RBI borrows money from banks by giving them
securities. The securities transacted here can be either government securities or
corporate securities or any other securities which the RBI permits for transaction.
The interest rate paid by RBI for such transactions is called the ‘reverse repo rate’.
Reverse repo operation in effect absorbs the liquidity in the system. The collaterals
used for repo and reverse repo operations consist of primarily Government of India
securities i.e. all SLR-eligible transferable Government of India dated
securities/treasury bills.
The ‘repo rate’ and the reverse repo rate’ are changed only through the
announcements made during the Monetary Policy Statements of the RBI. From
May, 2011 onwards, the reverse repo rate is not announced separately, it will be

linked to repo rate. The Reserve Bank also conducts variable interest rate reverse
repo auctions, as necessitated under the market conditions.
There are three types of repo markets operating in India namely:
(i) Repo on sovereign securities
(ii) Repo on corporate debt securities ,and
(iii) Other Repos
In addition to the existing overnight LAF (repo and reverse repo) and MSF, from
October 2013, the Reserve Bank has introduced ‘Term Repo’ (repos of duration
more than a day) under the Liquidity Adjustment Facility (LAF) for 14 days and 7
days tenors. LAF is conducted at a fixed time on a daily basis on all working days
in Mumbai (excluding Saturdays).
4. Marginal Standing Facility (MSF)
The Reserve Bank of India, being a bankers’ bank, acts as a lender of last
resort. The Marginal Standing Facility (MSF) announced by the Reserve Bank of
India (RBI) in its Monetary Policy, 2011-12 refers to the facility under which
scheduled commercial banks can borrow additional amount of overnight money
from the central bank over and above what is available to them through the LAF
window by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit
( a fixed per cent of their net demand and time liabilities deposits (NDTL) liable to
change every year ) at a penal rate of interest. This provides a safety valve against
unexpected liquidity shocks to the banking system. The scheme has been
introduced by RBI with the main aim of reducing volatility in the overnight lending
rates in the inter-bank market and to enable smooth monetary transmission in the
financial system.
Banks can borrow through MSF on all working days except Saturdays, between 7.00
pm and 7.30 pm, in Mumbai. The minimum amount which can be accessed through
MSF is ` 1 crore and more will be available in multiples of ` 1 crore.
The MSF would be the last resort for banks once they exhaust all borrowing options
including the liquidity adjustment facility on which the rates are lower compared
to the MSF. The MSF rate being a penal rate automatically gets adjusted to a fixed
per cent above the repo rate. MSF is at present aligned with the Bank rate.
Practically, MSF represents the upper band of the interest corridor with repo rate
at the middle and reverse repo at the lower band. In fact, the MSF rate and reverse
repo rate determine the corridor for the daily movement in the weighted average
call money rate.

5. Market Stabilisation Scheme (MSS)

This instrument for monetary management was introduced in 2004 following a
MoU between the Reserve Bank of India (RBI) and the Government of India (GoI)
with the primary aim of aiding the sterilization operations of the RBI. (Sterilization
is the process by which the monetary authority sterilizes the effects of significant
foreign capital inflows on domestic liquidity by off-loading parts of the stock of
government securities held by it). Under this scheme, the Government of India
borrows from the RBI (such borrowing being additional to its normal borrowing
requirements) and issues treasury-bills/dated securities for absorbing excess
liquidity from the market arising from large capital inflows.
Bank Rate
Under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been
defined as ‘the standard rate at which the Reserve Bank is prepared to buy or re-
discount bills of exchange or other commercial paper eligible for purchase under
the Act’. The bank rate once used to be the policy rate in India i.e. the key interest
rate based on which all other short term interest rates moved.
Discounting/rediscounting of bills of exchange by the Reserve Bank has been
discontinued on introduction of Liquidity Adjustment Facility (LAF). As a result, the
bank rate has become dormant as an instrument of monetary management. The
bank rate has been aligned to the Marginal Standing Facility (MSF) rate and,
therefore, as and when the MSF rate changes alongside policy repo rate changes,
the bank rate also changes automatically. Briefly put, MSF assumed the role of
bank rate and currently the bank rate is purely a signalling rate and most interest
rates are delinked from the bank rate. Now, bank rate is used only for calculating
penalty on default in the maintenance of Cash Reserve Ratio (CRR) and the
Statutory Liquidity Ratio (SLR).
6. Open Market Operations
Open Market Operations (OMO) is a general term used for market operations
conducted by the Reserve Bank of India by way of sale/ purchase of Government
securities to/ from the market with an objective to adjust the rupee liquidity
conditions in the market on a durable basis. When the RBI feels there is excess
liquidity in the market, it resorts to sale of securities thereby sucking out the rupee
liquidity. Similarly, when the liquidity conditions are tight, the RBI will buy securities
from the market, thereby releasing liquidity into the market.

3.4 THE ORGANISATIONAL STRUCTURE FOR MONETARY

POLICY DECISIONS
We have discussed above the instruments of monetary policy. An understanding of
the organisational structure for monetary policy decisions is necessary to
understand the way monetary policy is conducted in India.
3.4.1 The Monetary Policy Framework Agreement
The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for giving
a statutory backing to the Monetary Policy Framework Agreement and for setting
up a Monetary Policy Committee (MPC). The Monetary Policy Framework
Agreement is an agreement reached between the Government of India and the
Reserve Bank of India (RBI) on the maximum tolerable inflation rate that the RBI
should target to achieve price stability. The amended RBI Act (2016) provides for a
statutory basis for the implementation of the ‘flexible inflation targeting
framework’.
Announcement of an official target range for inflation is known as inflation
targeting. The Expert Committee under Urijit Patel to revise the monetary policy
framework, in its report in January, 2014 suggested that RBI abandon the ‘multiple
indicator’ approach and make inflation targeting the primary objective of its
monetary policy. The inflation target is to be set by the Government of India, in
consultation with the Reserve Bank, once in every five years. Accordingly,
• The Central Government has notified 4 per cent Consumer Price Index (CPI)
inflation as the target for the period from August 5, 2016 to March 31, 2021
with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2
per cent.
• The RBI is mandated to publish a Monetary Policy Report every six months,
explaining the sources of inflation and the forecasts of inflation for the coming
period of six to eighteen months.
• The following factors are notified by the central government as constituting a
failure to achieve the inflation target:
(a) the average inflation is more than the upper tolerance level of the inflation
target for any three consecutive quarters; or
(b) the average inflation is less than the lower tolerance level for any three
consecutive quarters.

The choice of CPI was made because it closely reflects cost of living and has larger
influence on inflation expectations compared to other anchors. With this step, India
is following countries such as the New Zealand, the USA, the UK, European Union,
and Brazil. Although in recent times many of the countries are moving away from
this approach and the targeting nominal GDP growth.
3.4.2. The Monetary Policy Committee (MPC)
An important landmark in India’s monetary history is the constitution of an
empowered six-member Monetary Policy Committee (MPC) in September, 2016
consisting of the RBI Governor (Chairperson), the RBI Deputy Governor in charge
of monetary policy, one official nominated by the RBI Board and the remaining
three central government nominees representing the Government of India who are
persons of ability, integrity and standing, having knowledge and experience in the
field of Economics or banking or finance or monetary policy.
The MPC shall determine the policy rate required to achieve the inflation target.
Accordingly, fixing of the benchmark policy interest rate (repo rate) is made
through debate and majority vote by this panel of experts. With the introduction
of the Monetary Policy Committee, the RBI will follow a system which is more
consultative and participative similar to the one followed by many of the central
banks in the world. The new system is intended to incorporate:
• diversity of views,
• specialized experience,
• independence of opinion ,
• representativeness , and
• accountability.
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in
formulating the monetary policy. The views of key stakeholders in the economy and
analytical work of the Reserve Bank contribute to the process for arriving at the
decision on the policy repo rate.
The Financial Markets Operations Department (FMOD) operationalises the
monetary policy, mainly through day-to-day liquidity management operations. The
Financial Markets Committee (FMC) meets daily to review the liquidity conditions
so as to ensure that the operating target of monetary policy (weighted average
lending rate) is kept close to the policy repo rate.

Before the constitution of the MPC, a Technical Advisory Committee (TAC) on

monetary policy with experts from Monetary Economics, Central Banking, Financial
Markets and Public Finance advised the RBI on the standpoint of monetary policy.
However, its role was only advisory in nature. With the formation of MPC, the TAC
on Monetary Policy ceased to exist.
3.5 CONCLUSION
The theoretical exposition of monetary policy might appear uncomplicated.
However, the choice of a monetary policy action is rather complicated in view of
the surrounding uncertainties and the need for exercising complex judgment to
balance growth and inflation concerns. Additional complexities arise in the case of
an emerging market like India. There are many challenges which need to be
addressed, such as rudimentary and noncompetitive financial systems, lack of
integrated money and interbank markets, external uncertainties and issues related
to operational autonomy of the central bank. Explicit inflation targeting requires a
good degree of operational autonomy for the central bank and a system in which
there is a good coordination between fiscal and monetary authorities.
SUMMARY
• Monetary policy refers to the use of monetary policy instruments which are at
the disposal of the central bank to regulate the availability, cost and use of
money and credit so as to promote economic growth, price stability, optimum
levels of output and employment, balance of payments equilibrium, stable
currency or any other goal of government's economic policy.
• The monetary policy framework which has three basic components, viz. the
objectives of monetary policy, the analytics of monetary policy which focus on
the transmission mechanism, and the operating procedure which focuses on
the operating targets and instruments.
• Though multiple objectives are pursued , the most commonly pursued
objectives of monetary policy of the central banks across the world has become
maintenance of price stability (or controlling inflation) and achievement of
economic growth.
• The process or channels through which the evolution of monetary aggregates
affects the level of production and price level is known as ‘monetary
transmission mechanism’ ie how they impact real variables such as aggregate
output and employment.

• There are mainly four different mechanisms, namely, the interest rate channel,
the exchange rate channel, the quantum channel, and the asset price channel.
• A contractionary monetary policy‐induced increase in interest rates increases
the cost of capital and the real cost of borrowing for firms and households
who respond by cut back on their investment and consumption respectively.
• The exchange rate channel works through expenditure switching between
domestic and foreign goods on account of appreciation / depreciation of the
domestic currency with its impact on net exports and consequently on
domestic output and employment.
• Two distinct credit channels- the bank lending channel and the balance sheet
channel- operate by altering access of firm and household to bank credit and
by the effect of monetary policy on the firm’s balance sheet respectively.
• Asset prices generate important wealth effects that impact, through spending,
• The operating framework of monetary policy relates to all aspects of
implementation namely, choosing the operating target, choosing the
intermediate target ,and choosing the policy instruments.
• The day-to-day implementation of monetary policy by central banks through
various instruments is referred to as ‘operating procedures’.
• Monetary policy instruments are the various tools that a central bank can use
to influence money market and credit conditions and pursue its monetary
policy objectives. There are direct instruments and indirect instruments.
• The Cash Reserve Ratio (CRR) refers to the fraction of the total net demand
and time liabilities (NDTL) of a scheduled commercial bank in India which it
should maintain as cash deposit with the Reserve Bank irrespective of its size
or financial position.
• The Statutory Liquidity Ratio (SLR) is what the scheduled commercial banks in
India are required to maintain as a stipulated percentage of their total Demand
and Time Liabilities (DTL) / Net DTL (NDTL) in Cash, Gold or approved
investments in securities.
• On the basis of the recommendations of Narsimham Committee on banking
sector reforms the RBI introduced Liquidity Adjustment Facility (LAF) under
which RBI provides financial accommodation to the commercial banks through
repos/reverse repos.

• Repurchase Options or in short Repo, is defined as ‘an instrument

for borrowing funds by selling securities with an agreement to repurchase the
securities on a mutually agreed future date at an agreed price which includes
interest for the funds borrowed’.
• In India, the fixed repo rate quoted for sovereign securities in the overnight
segment of Liquidity Adjustment Facility (LAF) is considered as the ‘policy rate’.
• Repo or repurchase option is a collaterised lending because banks borrow
money from Reserve bank of India to fulfill their short term monetary
requirements by selling securities to RBI with an explicit agreement to
repurchase the same at predetermined date and at a fixed rate. The rate
charged by RBI for this transaction is called the ‘repo rate’.
• Reverse Repo is defined as an instrument for lending funds by purchasing
securities with an agreement to resell the securities on a mutually agreed
future date at an agreed price which includes interest for the funds lent .
• The Marginal Standing Facility (MSF) refers to the facility under which
scheduled commercial banks can borrow additional amount of overnight
money from the central bank over and above what is available to them through
the LAF window by dipping into their Statutory Liquidity Ratio (SLR) portfolio
up to a limit
• Under the Market Stabilisation Scheme (MSS) the Government of India
requirements) and issues treasury-bills/dated securities
• Bank Rate refers to “the standard rate at which the Reserve Bank is prepared
to buy or re-discount bills of exchange or other commercial paper eligible for
purchase under the Act.
• OMOs is a general term used for market operations conducted by the Reserve
Bank of India by way of sale/ purchase of Government securities to/ from the
market with an objective to adjust the rupee liquidity conditions in the market
on a regular basis.
• The Monetary Policy Committee (MPC) consisting of six members shall
determine the policy rate to achieve the inflation target through debate and
majority vote by a panel of experts.
• The Monetary Policy Framework Agreement is an agreement reached between
the Government of India and the Reserve Bank of India (RBI) to keep the
Consumer Price Index CPI) inflation rate between 2 to 6 per cent.

• Choice of a monetary policy action is rather complex in view of the surrounding

uncertainties and the need for exercising trade-offs between growth and
inflation concerns. Additional complexities arise in the case of an emerging
market like India where inflation is influenced by factors such as international
petroleum prices and food prices.
TEST YOUR KNOWLEDGE

1. Which of the following is the function of monetary policy?
(a) regulate the exchange rate and keep it stable
(b) regulate the movement of credit to the corporate sector
(c) regulate the level of production and prices
(d) regulate the availability, cost and use of money and credit
2. The main objective of monetary policy in India is _______:
(e) reduce food shortages to achieve stability
(f) economic growth with price stability
(g) overall monetary stability in the banking system
(h) reduction of poverty and unemployment
3. The monetary transmission mechanism refers to
(a) how money gets circulated in different sectors of the economy post
monetary policy
(b) the ratio of nominal interest and real interest rates consequent on a
monetary policy
(c) the process or channels through which the evolution of monetary
aggregates affects the level of product and prices
4. A contractionary monetary policy‐induced increase in interest rates
(a) increases the cost of capital and the real cost of borrowing for firms
(b) increases the cost of capital and the real cost of borrowing for firms and
households
(c) decreases the cost of capital and the real cost of borrowing for firms

(d) has no interest rate effect on firms and households

5. During deflation
(a) the RBI reduces the CRR in order to enable the banks to expand credit and
increase the supply of money available in the economy
(b) the RBI increases the CRR in order to enable the banks to expand credit
and increase the supply of money available in the economy
(c) the RBI reduces the CRR in order to enable the banks to contract credit
and increase the supply of money available in the economy
(d) the RBI reduces the CRR but increase SLR in order to enable the banks to
contract credit and increase the supply of money available in the economy
6. Which of the following statements is correct?
(a) The governor of the RBI in consultation with the Ministry of Finance
decides the policy rate and implements the same
(b) While CRR has to be maintained by banks as cash with the RBI, the SLR
requires holding of approved assets by the bank itself
(c) When repo rates increase, it means that banks can now borrow money
through open market operations ( OMO)
7. RBI provides financial accommodation to the commercial banks through
repos/reverse repos under
(a) Market Stabilisation Scheme (MSS)
(b) The Marginal Standing Facility (MSF)
(c) Liquidity Adjustment Facility (LAF).
(d) Statutory Liquidity Ratio (SLR)
8. ---------------- is a money market instrument, which enables collateralised
short term borrowing and lending through sale/purchase operations in debt
instruments.
(a) OMO
(b) CRR
(c) SLR
(d) Repo

9. In India, the term ‘Policy rate’ refers to

(a) The bank rate prescribed by the RBI in its half yearly monetary policy
statement
(b) The CRR and SLR prescribed by RBI in its monetary policy statement
(c) the fixed repo rate quoted for sovereign securities in the overnight
segment of Liquidity Adjustment Facility (LAF)
(d) the fixed repo rate quoted for sovereign securities in the overnight
segment of Marginal Standing Facility(MSF)
10. Reverse repo operation takes place when
(a) RBI borrows money from banks by giving them securities
(b) banks borrow money from RBI by giving them securities
(c) banks borrow money in the overnight segment of the money market
(d) RBI borrows money from the central government
11. The Monetary Policy Framework Agreement is on
(a) the maximum repo rate that RBI can charge from government
(b) the maximum tolerable inflation rate that RBI should target to achieve
price stability.
(c) the maximum repo rate that RBI can charge from the commercial banks
(d) the maximum reverse repo rate that RBI can charge from the commercial
banks
12. An open market operation is an instrument of monetary policy which involves
buying or selling of ________from or to the public and banks
(a) bonds and bills of exchange
(b) debentures and shares
(c) government securities
(d) none of these
13. Which statement (s) is (are) true about Monetary Policy Committee?
I. The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016,
for giving a statutory backing to the Monetary Policy Framework
Agreement and for setting up a Monetary Policy Committee

II. The Monetary Policy Committee shall determine the policy rate through
debate and majority vote by a panel of experts required to achieve the
inflation target.
III. The Monetary Policy Committee shall determine the policy rate through
consensus from the governor of RBI
IV. The Monetary Policy Committee shall determine the policy rate through
debate and majority vote by a panel of bankers chosen for eth purpose
(a) I only
(b) I and II only
(c) III and IV
(d) III only
1. Define monetary policy.
2. Describe the objectives of monetary policy?
3. What is meant by the term monetary policy framework?
4. Define ‘monetary transmission mechanism’.
5. Explain the transmission of monetary policy outcomes through interest rate
channel?
6. Distinguish between the bank lending channel and the balance sheet channel
of monetary transmission?
7. How do asset prices asset prices respond to monetary policy?
8. What is meant by the term ‘monetary policy instruments’?
9. What is the distinction between direct and indirect instruments of monetary
policy?
10. Write notes on Cash Reserve Ratio (CRR) Explain the operation of CRR
11. Distinguish between CRR and Statutory Liquidity Ratio (SLR)
12. What are the eligible securities for SLR?
13. Explain the functioning of SLR?
14. What is the role of Liquidity Adjustment Facility (LAF)?
15. Define ‘repo’

16. What is meant by ‘policy rate’?

17. Define ‘Reverse Repo’
18. What role does Market Stabilisation Scheme (MSS) play in our economy?
19. Assess the role of Bank Rate as an instrument of monetary policy
20. Open Market Operations
21. Outline the role of Monetary Policy Committee (MPC)
1. Explain the objectives of monetary policy in an economy. Assess the
instruments and targets of monetary policy of the Reserve Bank of India.
2. Make a critical evaluation of the latest monetary policy statement of the
Reserve Bank of India.
3. Explain the operational procedure of the monetary policy in India.
4. A central bank is a ‘bankers’ bank.’ Elucidate the statement with illustrations
5. Describe the organisational structure for monetary policy decisions in India
6. Outline different components the monetary policy framework for India
7. Critically examine the different instruments of monetary policy.
1. What will be the nature of the monetary policy undertaken by RBI in the
following?
(i) Increases repo rate by 50 basis points
(ii) Reduces the cash reserve ratio
(iii) Increases the supply of currency and coins
(iv) Terminates marginal standing facility
(v) Increases the interest rates chargeable by commercial banks
(vi) Sells securities in the open market
(vii) Initiates reverse repo operation
(viii) Changes in the SLR

2. Write a brief note about the reasons why the policy rates were changed /not
changed in the recent monetary policy announcement by the RBI
ANSWERS/HINTS
1. (d) 2. (b) 3. (c) 4. (b) 5. (a) 6 (b)
7. (c) 8. (d) 9. (c) 10. (a) 11. (b) 12 (c)
13. (b)
1. Instruments which are at the disposal of the central bank to regulate the
availability, cost and use of money and credit so as to attain predetermined
objectives, mainly growth with stability
2. The most commonly pursued objectives of monetary policy: maintenance of
price stability (or controlling inflation) and achievement of economic growth.
Context-specific multiple objectives are pursued such as moderate long term
interest rates, exchange rate stability and external balance of payments
equilibrium etc.
3. The operating framework relates to all aspects of implementation of monetary
policy
4. Different mechanisms through which monetary policy is able to influence the
price level and the national income
5. A monetary policy‐induced change in interest rates generate corresponding
changes in the cost of capital and the real cost of borrowing for firms and
households who respond by changing on their investment and purchase
expenditures respectively affecting aggregate demand and employment.
6. Two distinct credit channels- the bank lending channel and the balance sheet
channel- operate by altering access of firms and households to bank credit and
by the effect of monetary policy on the firm’s balance sheet respectively.
7. Asset prices generate important wealth effects that impact, through spending,
8. Monetary policy instruments are the various tools that a central bank can use
to influence money market and credit conditions and pursue its monetary
policy objectives.

9. Direct instruments presuppose one-to-one correspondence between the

instrument (such as a credit ceiling) and the policy objective (such as a specific
amount of domestic credit outstanding) ,while indirect instruments act through
the market by adjusting the underlying demand for, and supply of, bank
reserves
10. Cash Reserve Ratio (CRR) refers to the fraction of the total net demand and
time liabilities (NDTL) of a scheduled commercial bank in India which it should
maintain as cash deposit with the Reserve Bank. Higher the CRR, lower the
credit creation capacity of banks. Reduce CRR during deflation- - banks to
expand credit and increase the supply of money available in the economy-
increase the CRR to contain credit expansion during – inflation.
11. While CRR has to be maintained by banks as cash with the RBI, the SLR requires
holding of assets in one of the above three categories by the bank itself.
12. Cash, Gold, or investments in un-encumbered Instruments that include:
treasury-bills, dated securities, State Development Loans (SDLs) issued by State
Governments under their market borrowings programme and other
instruments as notified by the RBI
13. Changes in SLR chiefly influence the availability of resources in the banking
system for lending. A rise in SLR -during periods of high liquidity - to lock up
a rising fraction of a bank’s assets in the form of eligible instruments - reduces
the credit creation capacity of banks. A reduction in SLR during periods of
economic downturn has the opposite effect.
14. The Liquidity Adjustment Facility(LAF) is a facility extended by the Reserve Bank
of India to the scheduled commercial banks (excluding RRBs) and primary
dealers to avail of liquidity in case of requirement (or park excess funds with
the RBI in case of excess liquidity) on an overnight basis against the collateral
of government securities including state government securities.
15. Repo, is defined as ‘an instrument for borrowing funds by selling
securities with an agreement to repurchase the securities on a mutually agreed
future date at an agreed price which includes interest for the funds borrowed’
16. The policy rate is the fixed repo rate quoted for sovereign securities in the
overnight segment of Liquidity Adjustment Facility (LAF).
17. Reverse Repo" is defined as an instrument for lending funds by purchasing
securities with an agreement to resell the securities on a mutually agreed
future date at an agreed price which includes interest for the funds lent .

18. Under the Market Stabilisation Scheme (MSS) the Government of India
requirements) and issues treasury-bills/dated securities that are utilized for
absorbing from the market excess liquidity of a more enduring nature arising
from large capital inflows.
19. The bank rate has been aligned to the Marginal Standing Facility (MSF) rate
and, therefore, as and when the MSF rate changes alongside policy repo rate
changes, the bank rate also changes automatically. Now bank rate is used only
for calculating penalty on default in the maintenance of Cash Reserve Ratio
(CRR) and the Statutory Liquidity Ratio (SLR).
20. Open Market Operations (OMO) is a general term used for market operations
conducted by the Reserve Bank of India by way of sale/ purchase of
Government securities to/ from the market with an objective to adjust the
rupee liquidity conditions in the market on a durable basis.
21. The Monetary Policy Committee (MPC) consisting of six members shall
determine the policy rate to achieve the inflation target through debate and
majority vote by a panel of experts.
IV Hints to Application Oriented Questions
(i) Contractionary monetary policy
(ii) Expansionary monetary policy
(iii) Expansionary monetary policy
(iv) Contractionary monetary policy
(v) Contractionary monetary policy
(vi) Contractionary monetary policy
(vii) Absorbs the liquidity in the system
(viii) Influence the availability of resources in the banking system for lending

CHAPTER 4
INTERNATIONAL
TRADE
UNIT I: THEORIES OF INTERNATIONAL
TRADE
LEARNING OUTCOMES

 Define international trade and describe how it differs from
internal trade
 Elucidate the arguments in favour of and against liberal trade
 Explain the mercantilists’ views on international trade

Illustrate how trade can be based on absolute advantage
 Describe the Ricardian theory of comparative advantage
 Explain the basis of trade according to modern theory of

trade

International Trade
Theories of International Trade
Important Theories of International Trade
1.1 INTRODUCTION
International trade is the exchange of goods and services as well as resources
between countries. It involves transactions between residents of different countries.
As distinguished from domestic trade or internal trade which involves exchange of
goods and services within the domestic territory of a country using domestic
currency, international trade involves transactions in multiple currencies.
Compared to internal trade, international trade has greater complexity as it involves
heterogeneity of customers and currencies, differences in legal systems, more
elaborate documentation, diverse restrictions in the form of taxes, regulations,
duties, tariffs, quotas, trade barriers, standards, restraints to movement of specified
goods and services and issues related to shipping and transportation. At present,
liberal international trade is an integral part of international relations and has
become an important engine of growth in developed as well as developing
countries.
While some economists and policy makers argue that there are net benefits from
keeping markets open to international trade and investments , others feel that

THEORIES OF INTERNATIONAL TRADE 4.3
trade generates a number of adverse consequences on the welfare of citizens. As

students of Economics, we need to have an objective understanding of the claims
put forth by both sections. We shall first examine the arguments in support of
international trade.
(i) International trade is a powerful stimulus to economic efficiency and
contributes to economic growth and rising incomes. The wider market made
possible owing to trade induces companies to reap the quantitative and
qualitative benefits of extended division of labour. As a result, they would
enlarge their manufacturing capabilities and benefit from economies of large
scale production. The gains from international trade are reinforced by the
increased competition that domestic producers are confronted with on
account of globalization of production and marketing requiring businesses to
compete against global businesses. Competition from foreign goods compels
manufacturers, especially in developing countries, to enhance efficiency and
profitability by adoption of cost reducing technology and business practices.
Efficient deployment of productive resources to their best uses is a direct
economic advantage of foreign trade. Greater efficiency in the use of natural,
human, industrial and financial resources ensures productivity gains. Since
international trade also tends to decrease the likelihood of domestic
monopolies, it is always beneficial to the community.
(ii) Trade provides access to new markets and new materials and enables sourcing
of inputs and components internationally at competitive prices. This reflects
in innovative products at lower prices and wider choice in products and
services for consumers. Also, international trade enables consumers to have
access to wider variety of goods and services that would not otherwise be
available. It also enables nations to acquire foreign exchange reserves
necessary for imports which are crucial for sustaining their economies.
(iii) International trade enhances the extent of market and augments the scope for
mechanization and specialisation. Trade necessitates increased use of
automation, supports technological change, stimulates innovations, and
facilitates greater investment in research and development and productivity
improvement in the economy.
(iv) Exports stimulate economic growth by creating jobs, which could potentially
reduce poverty and augmenting factor incomes and in so doing raising
standards of livelihood and overall demand for goods and services. Trade also

provides greater stimulus to innovative services in banking, insurance, logistics,

consultancy services etc.
(v) Employment generating investments, including foreign direct investment,
inevitably follow trade. For emerging economies, improvement in the quality
of output of goods and services, superior products, finer labour and
environmental standards etc. enhance the value of their products and enable
them to move up the global value chain.
(vi) Opening up of new markets results in broadening of productive base and
facilitates export diversification so that new production possibilities are
opened up. Countries can gainfully dispose off their surplus output and, thus,
prevent undue fall in domestic prices caused by overproduction. Trade also
allows nations to maintain stability in prices and supply of goods during
periods of natural calamities like famine, flood, epidemic etc.
(vii) Trade can also contribute to human resource development, by facilitating
fundamental and applied research and exchange of know-how and best
practices between trade partners.
(viii) Trade strengthens bonds between nations by bringing citizens of different
countries together in mutually beneficial exchanges and, thus, promotes
harmony and cooperation among nations.
Despite being a dynamic force which has enormous potential to generate economic
overall gains, liberal global trade and investments are often criticized as detrimental
to national interests. The major arguments put forth against trade openness are:
(i) Possible negative labour market outcomes in terms of labour-saving
technological change that depress demand for unskilled workers, loss of
labourers’ bargaining power, downward pressure on wages of semi skilled and
unskilled workers and forced work under unfair circumstances and unhealthy
occupational environments.
(ii) International trade is often not equally beneficial to all nations. Potential
unequal market access and disregard for the principles of fair trading system
may even amplify the differences between trading countries, especially if they
differ in their wealth. Economic exploitation is a likely outcome when
underprivileged countries become vulnerable to the growing political power
of corporations operating globally. The domestic entities can be easily
outperformed by financially stronger transnational companies.

(iii) International trade is often criticized for its excessive stress on exports and
profit-driven exhaustion of natural resources due to unsustainable production
and consumption. Substantial environmental damage and exhaustion of
natural resources in a shorter span of time could have serious negative
consequences on the society at large.
(iv) Probable shift towards a consumer culture and change in patterns of demand
in favour of foreign goods which are likely to occur in less developed countries
may have adverse effect on the development of domestic industries and may
even threaten the survival of infant industries. Trade cycles and the associated
economic crises occurring in different countries are also likely to get
transmitted rapidly to other countries.
(v) Risky dependence of underdeveloped countries on foreign nations impairs
economic autonomy and endangers their political sovereignty. Such reliance
often leads to widespread exploitation and loss of cultural identity. Substantial
dependence may also have severe adverse consequences in times of wars and
other political disturbances.
(vi) Welfare of people may be ignored or jeopardized for the sake of profit.
Excessive exports may cause shortages of many commodities in the exporting
countries and lead to high inflation (e.g. onion price rise in 2014). Also, import
of harmful products may cause health hazards and environmental damage.
(e.g. Chinese products).
(vii) Too much export orientation may distort actual investments away from the
genuine investment needs of a country.
(viii) Instead of cooperation among nations, trade may breed rivalry on account of
severe competition
(ix) Finally, there is often lack of transparency and predictability in respect of many
aspects related to trade policies of trading partners. There are also many risks
in trade which are associated with changes in governments’ policies of
participating countries, such as imposition of an import ban or trade
embargoes.
1.2 IMPORTANT THEORIES OF INTERNATIONAL TRADE

You might have noticed that many goods and services are imported by us because
they are simply not produced in our country for various reasons and therefore not
available domestically. However, we do import many things which can be produced

or are being produced within our country. Why do we do so? Is it beneficial to

engage in international trade? The theories of international trade which we discuss
in the following sections provide answers to these and other related questions.
1.2.1 The Mercantilists’ View of International Trade
Mercantilism, which was the policy of Europe’s great powers, was based on the
premise that national wealth and power are best served by increasing exports and
collecting precious metals in return. Mercantilists also believed that the more gold
and silver a country accumulates, the richer it becomes. Mercantilism advocated
maximizing exports in order to bring in more “specie” (precious metals) and
minimizing imports through the state imposing very high tariffs on foreign goods.
This view argues that trade is a ‘zero-sum game’, with winners who win does so
only at the expense of losers and one country’s gain is equal to another country’s
loss, so that the net change in wealth or benefits among the participants is zero.
The arguments put forth by mercantilists were later proved to have many
shortcomings by later economists. Although it is still very important theory which
explains policies followed by many big and fast growing economies in Asia.
1.2.2 The Theory of Absolute Advantage
Adam Smith was the first to put across the possibility that international trade is not
a zero-sum game. According to Adam Smith who supported unrestricted trade and
free international competition, absolute cost advantage is the determinant of
mutually beneficial international trade. The absolute cost advantage theory points
out that a country will specialize in the production and export of a commodity in
which it has an absolute cost advantage. In other words, exchange of goods
between two countries will take place only if each of the two countries can produce
one commodity at an absolutely lower production cost than the other country.
Smith’s thoughts on the principle of division of labour constitute the basis for his
theory of international trade and therefore, the value of goods is determined by
measuring the labour incorporated in them. The theory is generally presented with
an example of a hypothetical two countries and two commodities model (2x2
model). Absolute advantage exists between nations when they differ in their ability
to produce goods. Each nation can produce one good with less expenditure of
human labour or more cheaply than the other. As a result, each nation has an
absolute advantage in the production of one good. Absolute advantage can be
explained with a simple numerical example given in table 4.1.1:

Table 4.1.1
Output per Hour of Labour
Commodity Country A Country B

Wheat (bushels/hour) 6 1
Cloth (yards/hour) 4 5
As can be seen from the above table, one hour of labour time produces 6 bushels
and 1 bushel of wheat respectively in country A and country B. On the other hand,
one hour of labour time produces 4 yards of cloth in country A and 5 in country B.
Country A is more efficient than country B, or has an absolute advantage over
country B in production of wheat. Similarly, country B is more efficient than country
A, or has an absolute advantage over country A in the production of cloth. If both
nations can engage in trade with each other, each nation will specialize in the
production of the good it has an absolute advantage in and obtain the other
commodity through international trade. Therefore, country A would specialise
completely in production of wheat and country B in cloth.
If country A exchanges six bushels of wheat (6W) for six yards of country B’s cloth
(6C), then country A gains 2C or saves half an hour or 30 minutes of labour time
(since the country A can only exchange 6W for 4C domestically). Similarly, the 6W
that country B receives from country A is equivalent to or would require six hours
of labour time to produce in country B. These same six hours can produce 30C in
country B (6 hours x 5 yards of cloth per hour). By being able to exchange 6C
(requiring a little over one hour to produce in the country B) for 6W, country B
gains 24C, or saves nearly five hours of work.
This example shows trade is advantageous, although gains may not be distributed
equally, because their given resources are utilised more efficiently, and, therefore,
both countries can produce larger quantities of commodities which they specialize
in. By specialising and trading freely, global output is , thus, maximized and more
of both goods are available to the consumers in both the countries . If they
specialise but do not trade freely, country A’s consumers would have no wheat, and
country B’s consumers would have no rice. That is not desireable situation.
The theory discussed above gives us the impression that mutually gainful trade is
possible only when one country has absolute advantage and the other has absolute
disadvantage in the production of at least one commodity. What happens if a

country had higher productivity in both commodities compared to another

country? Let us now think of a situation where country A makes both wheat and
cloth with fewer resources than country B. In other words, country A has absolute
advantage in the production of both commodities and country B has absolute
disadvantage in the production of both commodities. This is the question that
Ricardo attempted to answer when he formalized the concept of ‘comparative
advantage’ to espouse the argument that even when one country is technologically
superior in both goods, it could still be advantageous for them to trade.
1.2.3 The Theory of Comparative Advantage
David Ricardo developed the classical theory of comparative advantage in his book
‘Principles of Political Economy and Taxation’ published in 1817. The law of
comparative advantage states that even if one nation is less efficient than (has an
absolute disadvantage with respect to) the other nation in the production of all
commodities, there is still scope for mutually beneficial trade. The first nation
should specialize in the production and export of the commodity in which its
absolute disadvantage is smaller (this is the commodity of its comparative
advantage) and import the commodity in which its absolute disadvantage is greater
(this is the commodity of its comparative disadvantage). Comparative advantage
differences between nations are explained by exogenous factors which could be
due to the differences in national characteristics. Labour differs in its productivity
internationally and different goods have different labour requirements, so
comparative labor productivity advantage was Ricardo’s predictor of trade.
The theory can be explained with a simple example given in table 4.1.2:
Table 4.1.2
Output per Hour of Labour
Commodity Country A Country B

Wheat (bushels/hour) 6 1
Cloth (yards/hour) 4 2
Table 4.1.2 differs from table 4.1.1 only in one respect; i.e, in this example, country
B can produce only two yards of cloth per hour of labour. Country B has now
absolute disadvantage in the production of both wheat and cloth. However, since
B’s labour is only half as productive in cloth but six times less productive in wheat

compared to country A, country B has a comparative advantage in cloth. On the

other hand, country A has an absolute advantage in both wheat and cloth with
respect to the country B, but since its absolute advantage is greater in wheat (6:1)
than in cloth (4:2), country A has a comparative advantage in production and
exporting wheat. In a two-nation, two-commodity world, once it is established that
one nation has a comparative advantage in one commodity, then the other nation
must necessarily have a comparative advantage in the other commodity. Put in
other words, country A’s absolute advantage is greater in wheat, and so country A
has a comparative advantage in producing and exporting wheat. Country B’s
absolute disadvantage is smaller in cloth, so its comparative advantage lies in cloth
production. According to the law of comparative advantage, both nations can gain
if country A specialises in the production of wheat and exports some of it in
exchange for country B’s cloth. Simultaneously, country B should specialise in the
production of cloth and export some of it in exchange for country A’s wheat.
How do these two countries gain from trade by each country specializing in the
production and export of the commodity of its comparative advantage? We need
to show that both nations can gain from trade even if one of them (in this case
country B) is less efficient than the other in the production of both commodities.
Assume that country A could exchange 6W for 6C with country B. Then, country A
would gain 2C (or save half an hour of labour time) since the country A could only
exchange 6W for 4C domestically. We need to show now that country B would also
gain from trade. We can observe from table 4.1.2 that the 6W that the country B
receives from the country A would require six hours of labour time to produce in
country B. With trade, country B can instead use these six hours to produce 12C
and give up only 6C for 6W from the country A. Thus, the country B would gain 6C
or save three hours of labour time and country A would gain 2C. However, the gains
of both countries are not likely to be equal.
However, we need to recognize that this is not the only rate of exchange at which
mutually beneficial trade can take place. Country A would gain if it could exchange
6W for more than 4C from country B; because 6W for 4 C is what it can exchange
domestically (both require the same one hour labour time). The more C it gets, the
greater would be the gain from trade. Conversely, in country B, 6W = 12C (in the
sense that both require 6 hours to produce). Anything less than 12C that country
B must give up to obtain 6W from country A represents a gain from trade for
country B. To summarize, country A gains to the extent that it can exchange 6W for
more than 4C from the country B. country B gains to the extent that it can give up

less than 12C for 6W from country A. Thus, the range for mutually advantageous
trade is 4C < 6W < 12C.
The spread between 12C and 4C (i.e., 8C) represents the total gains from trade
available to be shared by the two nations by trading 6W for 6C. The closer the rate
of exchange is to 4C = 6W (the domestic, or internal rate in country A), the smaller
is the share of the gain going to country A and the larger is the share of the gain
going to country B. Alternatively, the closer the rate of exchange is to 6W = 12C
(the domestic or internal rate in country B), the greater is the gain of country A
relative to that of country B. However, if the absolute disadvantage that one nation
has with respect to another nation is the same in both commodities, there will be
no comparative advantage and no trade.
Ricardo based his law of comparative advantage on the ‘labour theory of value’,
which assumes that the value or price of a commodity depends exclusively on the
amount of labour going into its production. This is quite unrealistic because labour
is not the only factor of production, nor is it used in the same fixed proportion in
the production of all commodities.
In 1936, Haberler resolved this issue when he introduced the opportunity cost
concept from Microeconomic theory to explain the theory of comparative
advantage in which no assumption is made in respect of labour as the source of
value. Opportunity cost is basically the value of the forgone option. It is the ’real’
cost in microeconomic terms, as opposed to cost given in monetary units.
According to the opportunity cost theory, the cost of a commodity is the amount
of a second commodity that must be given up to release just enough resources to
produce one extra unit of the first commodity. The opportunity cost of producing
one unit of good X in terms of good Y may be computed as the amount of labour
required to produce one unit of good X divided by the amount of labour required
to produce one unit of good Y. That is, how much Y do we have to give up in order
to produce one more unit of good X. Logically, the nation with a lower opportunity
cost in the production of a commodity has a comparative advantage in that
commodity (and a comparative disadvantage in the second commodity).
In the above example, we find that country A must give up two-thirds of a unit of
cloth to release just enough resources to produce one additional unit of wheat
domestically. Therefore, the opportunity cost of wheat is two-thirds of a unit of
cloth (i.e., 1W = 2/3C in country A). Similarly, in country B, we find that 1W = 2C,
and therefore, the opportunity cost of wheat (in terms of the amount of cloth that
must be given up) is lower in country A than in country B, and country A would

have a comparative (cost) advantage over country B in wheat. In a two-nation, two-

commodity world, if country A has a comparative advantage in wheat, then country
B will have a comparative advantage in cloth. Therefore, country A should consider
specializing in producing wheat and export some of it in exchange for cloth
produced in country B. By such specialization and trade, both nations will be able
to consume more of both commodities than what would have been possible
without trade.
In summary, international differences in relative factor-productivity are the cause
of comparative advantage and a country exports goods that it produces relatively
efficiently. This points to a tendency towards complete specialization in production.
Ricardo demonstrated that for two nations without input factor mobility,
specialization and trade could result in increased total output and lower costs than
if each nation tried to produce in isolation. Trade generates welfare gains and both
countries can potentially gain from trade. Therefore, international trade need not
be a zero-sum game.
However, the Ricardian theory of comparative advantage suffers from many
limitations. Its emphasis is on supply conditions and excludes demand patterns.
Moreover, the theory does not examine why countries have different costs. The
theory of comparative advantage also does not answer the important question:
Why does a nation have comparative advantage in the production of a commodity
and comparative disadvantage in the production of another? The answer to this
question is provided by the Heckscher-Ohlin theory.
1.2.4 The Heckscher-Ohlin Theory of Trade
The Heckscher-Ohlin theory of trade, (named after two Swedish economists, Eli
Heckscher and his student Bertil Ohlin), also referred to as Factor-Endowment
Theory of Trade or Modern Theory of Trade, is considered as a very important
theory of international trade. In view of the contributions made by P. A. Samuelson,
this theory is also sometimes referred to as Heckscher-Ohlin-Samuelson theorem.
The Heckscher-Ohlin (H-O) model studies the case that two countries have different
factor endowments under identical production function and identical preferences.
The difference in factor endowment results in two countries having different factor
prices in the beginning. Consequently, H-O model implies that the two countries
will have different cost functions. The Heckscher-Ohlin theory of trade states that
comparative advantage in cost of production is explained exclusively by the
differences in factor endowments of the nations. In a general sense of the term,
‘factor endowment’ refers to the overall availability of usable resources including

both natural and man-made means of production. Nevertheless, in the exposition

of the modern theory, only the two most important factors—labour and capital—
are taken into account.
According to this theory, international trade is but a special case of inter-regional
trade. Different regions have different factor endowments, that is, some regions
have abundance of labour, but scarcity of capital; whereas other regions have
abundance of capital, but scarcity of labour. Different goods have different
production functions, that is, factors of production are combined in different
proportions to produce different commodities. While some goods are produced by
employing a relatively larger proportion of labour and relatively small proportion
of capital, other goods are produced by employing a relatively small proportion of
labour and relatively large proportion of capital. Thus, each region is suitable for
the production of those goods for whose production it has relatively plentiful
supply of the requisite factors. A region is not suitable for production of those
goods for whose production it has relatively scarce or zero supply of essential
factors. Hence different regions have different capacity to produce different
commodities. Therefore, difference in factor endowments is the main cause of
international trade as well as inter-regional trade. According to Ohlin, the
immediate cause of inter-regional trade is that goods can be bought cheaper in
terms of money than they can be produced at home and this is the case of
international trade as well. The cause of difference in the relative prices of goods is
the difference the amount of factor endowments, like capital and labour, between
two countries.
The theory states that a country’s exports depend on its resources endowment i.e.
whether the country is capital-abundant or labour-abundant. If a country is a capital
abundant one, it will produce and export capital-intensive goods relatively more
cheaply than another country. Likewise, a labour-abundant country will produce
and export labour-intensive goods relatively more cheaply than another country.
The labour-abundant countries have comparative cost advantage in the production
of goods which require labour-intensive technology and by the same reasoning,
capital-abundant countries have comparative cost advantage in the production of
goods that need capital-intensive technology.
The Heckscher-Ohlin theory of foreign trade can be stated in the form of two
theorems namely, Heckscher-Ohlin Trade Theorem and Factor-Price Equalization
Theorem.

The Heckscher-Ohlin Trade Theorem establishes that a country tends to specialize

in the export of a commodity whose production requires intensive use of its
abundant resources and imports a commodity whose production requires intensive
use of its scarce resources.
The Factor-Price Equalization Theorem states that international trade tends to
equalize the factor prices between the trading nations. In the absence of foreign
trade, it is quite likely that factor prices are different in different countries.
International trade equalizes the absolute and relative returns to homogenous
factors of production and their prices. In other words, the wages of homogeneous
labour and returns to homogeneous capital will be the same in all those nations
which engage in trading. The factor price equalisation theorem says that if the
prices of the output of goods are equalised between countries engaged in free
trade, then the price of the input factors will also be equalised between countries.
This implies that the wages and rents will converge across the countries with free
trade, or in other words, trade in goods is a perfect substitute for trade in factors.
The Heckscher-Ohlin theorem, thus, postulates that foreign trade eliminates the
factor price differentials. The factor price equalization theorem is in fact a corollary
to the Heckscher-Ohlin trade theory. It holds only so long as Heckcher-Ohlin
Theorem holds.
The basic assumption of the Heckscher-Ohlin theorem is that the two countries
share the same production technology and that markets are perfectly competitive.
The opening up to trade for a labour-abundant country will increase the price of
labour-intensive goods, say clothes, and, thus, lead to an expansion of clothes
production. As there is demand for exports of clothes in foreign markets, the
demand for factors of production increases in the clothes sector. Because clothes
are labour-intensive goods, an increasing demand for labour in the factor market
will attract labour from the capital-intensive industry, say machine tools. The
expanding clothes industry absorbs relatively more labour than the amount
released by the contracting machine tools industry. The price of labour goes up,
and whilst its relative price increases, the relative price of capital declines. As a
result, the factors of production will become more capital-intensive in both sectors
leading to a decline in the marginal productivity of capital and an increase in that
of labour in both sectors. Similarly, when country B increases its specialization in
the production of capital-intensive commodity its demand for capital increases
causing capital returns to increase in relation to wage rate. This means that
specialization leads to change in relative factor prices.

When the prices of the output of goods are equalized between countries as they
move to free trade, then the prices of the factors (capital and labor) will also be
equalized between countries. It means that product mobility and factor mobility
become perfect substitutes. Whichever factor receives the lowest price before two
countries integrate economically and effectively become one market will therefore
tend to become more expensive relative to other factors in the economy, while
those with the highest price will tend to become cheaper.
The table 4.1.3 presents, though not exhaustive, a comparison of the theory of
comparative costs and modern theory.
Table 4.1.3
Comparison of Theory of Comparative Costs and Modern Theory
Theory of Comparative Costs Modern Theory

The basis is the difference between Explains the causes of differences in
countries is comparative costs comparative costs as differences in
factor endowments
Based on labour theory of value Based on money cost which is more
realistic.
Considered labour as the sole factor of Widened the scope to include labour
production and presents a one-factor and capital as important factors of
(labour) model production. This is 2-factor model and
cand be extended to more factors.
Treats international trade as quite International trade is only a special
distinct from domestic trade case of inter-regional trade.
Studies only comparative costs of the Considers the relative prices of the
goods concerned factors which influence the
comparative costs of the goods
Attributes the differences in Attributes the differences in
comparative advantage to differences comparative advantage to the
in productive efficiency of workers differences in factor endowments.

Does not take into account the factor Considers factor price differences as
price differences the main cause of commodity price
differences
Does not provide the cause of Explains the differences in comparative
differences in comparative advantage. advantage in terms of differences in
factor endowments.
Normative; tries to demonstrate the Positive; concentrates on the basis of
gains from international trade trade
1.2.5 New Trade Theory – An Introduction

New Trade Theory (NTT) is an economic theory that was developed in the 1970s
as a way to understand international trade patterns. NTT came about to help us
understand why developed and big countries are trade partners when they are
trading similar goods and services. These countries constitute more than 50% of
world trade.
This is particularly true in key economic sectors such as electronics, IT, food, and
automotive. We have cars made in the India, yet we purchase many cars made in
other countries.
These are usually products that come from large, global industries that directly
impact international economies. The mobile phones we use are a good example.
India produces them and also imports them. NTT argues that, because of
substantial economies of scale and network effects, it pays to export phones to sell
in another country. Those countries with the advantages will dominate the market,
and the market takes the form of monopolistic competition.
Monopolistic competition tells us that the firms are producing a similar product
that isn't exactly the same, but awfully close. According to NTT, two key concepts
give advantages to countries that import goods to compete with products from the
home country:
• Economies of Scale: As a firm produces more of a product its cost per unit
keeps going down. So if the firm serves domestic as well as foreign market
instead of just one, it can reap the benefit of large scale of production
consequently the profits are likely to be higher.

• Network effects are the way one person’s value of a good or service is
affected by the value of that good or service to others. The value of the product
or service is enhanced as the number of individuals using it increases. This is
also referred to as the ‘bandwagon effect’. Consumers like more choices, but
they also want products and services with high utility, and the network effect
offers increased utility from these products over others. A good example will
be Mobile App such as Whats App and software like Microsoft Windows.
SUMMARY
• International trade is the exchange of goods and services as well as
resources between countries and involves greater complexity compared to
internal trade
• Trade can be a powerful stimulus to economic efficiency, contributes to
economic growth and rising incomes, enlarges manufacturing capabilities,
ensures benefits from economies of large scale production, and enhances
competitiveness and profitability by adoption of cost reducing technology and
business practices.
• Efficient deployment of productive resources to their best uses, productivity
gains, decrease the likelihood of domestic monopolies, cost effective sourcing
of inputs and components internationally, innovative products at lower prices,
wider choice in products and services for consumers are also claimed as
benefits of trade
• Enhanced foreign exchange reserves, increased scope for mechanization and
specialisation, research and development, creation of jobs, reduction in
poverty ,augmenting factor incomes, raising standards of livelihood ,increase
in overall demand for goods and services and greater stimulus to innovative
services are other benefits
• There are also other possible positive outcomes in the form of prospects of
employment generating investments, improvement in the quality of output,
superior products, labour and environmental standards, broadening of
productive base, export diversification, stability in prices and supply of goods,
human resource development and strengthening of bonds between nations.
• The arguments against trade converge on negative labour market outcomes,
economic exploitation, profit-driven exhaustion of natural resources, shift
towards a consumer culture, risky dependence, shortages resulting in inflation,
disregard for welfare of people, quick transmission of trade cycles, rivalries and

risks in trade associated with changes in governments’ policies of participating

countries.
• Mercantilism advocated maximizing exports in order to bring in more precious
metals and minimizing imports through the state imposing very high tariffs on
foreign goods.
• According to Adam Smith’s Absolute Cost Advantage theory,a country will
specialize in the production and export of a commodity in which it has an
absolute cost advantage.
• Ricardo's theory of comparative advantage states that a nation should
specialize in the production and export of the commodity in which its absolute
disadvantage is smaller (this is the commodity of its comparative advantage)
and import the commodity in which its absolute disadvantage is greater (this
is the commodity of its comparative disadvantage).
• Haberler resolved the issue of dependence on labour alone in the case of
theory of comparative advantage when he introduced the opportunity cost
concept. Opportunity cost which is the value of the forgone option.
• The Heckscher-Ohlin theory of trade, also referred to as Factor-Endowment
Theory of Trade or Modern Theory of Trade, states that comparative advantage
in cost of production is explained exclusively by the differences in factor
endowments
• A country tends to specialize in the export of a commodity whose production
requires intensive use of its abundant resources and imports a commodity
whose production requires intensive use of its scarce resources.
• Accordingly, a capital abundant country will produce and export capital-
intensive goods relatively more cheaply and a labour-abundant country will
produce and export labour-intensive goods relatively more cheaply than
another country
• The Factor-Price Equalization Theorem states that international trade equalizes
the factor prices between the trading nations. Therefore, with free trade, wages
and returns on capital will converge across the countries.
• NTT is the latest entrant to explain the rising proportion of world trade in the
developed world and bigger developing economies (such as BRICS) which
trade in similar products. These countries constitute more than 50% of world
trade.

TEST YOUR KNOWLEDGE

1. The theory of absolute advantage states that
(a) national wealth and power are best served by increasing exports and
decreasing imports
(b) nations can increase their economic well-being by specializing in the
production of goods they produce more efficiently than anyone else
(c) that the value or price of a commodity depends exclusively on the amount
of labour going into its production and therefore factor prices will be the
same
(d) differences in absolute advantage explains differences in factor
endowments in different countries
2. Which of the following theories advocates that countries should produce
those goods for which it has the greatest relative advantage?
(a) Modern theory of international trade
(b) The factor endowment theory
(c) The Heckscher-Ohlin Theory
3. Which of the following does not represent a difference between internal trade
and international trade?
(e) transactions in multiple currencies
(f) homogeneity of customers and currencies
(g) differences in legal systems
(a) none of the above
4. Which of the following holds that a country can increase its wealth by
encouraging exports and discouraging imports
(a) Capitalism
(b) Socialism
(c) Mercantilism

(d) Laissez faire

5. Given the number of labour hours to produce cloth and grain in two countries,
which country should produce grain?
Labour cost (hours) for production of one unit
Country A Country B
Cloth 40 80
Grain 80 40
(a) Country A
(b) Country B
(c) Neither A nor B
(d) Both A and B
6. According to the theory of comparative advantage
(a) trade is a zero-sum game so that the net change in wealth or benefits
among the participants is zero.
(b) trade is not a zero-sum game so that the net change in wealth or benefits
among the participants is positive
(c) nothing definite can be said about the gains from trade
(d) gains from trade depends upon factor endowment and utilization
7. Given the number of labour hours to produce wheat and rice in two countries
and that these countries specialise and engage in trade at a relative price of
1:1 what will be the gain of country X ?
Wheat Rice
Country X 10 20
Country Y 20 10
(a) 20 labour hours

(b) 10 labour hours
(c) 30 labour hours

(d) Does not gain anything

8. Assume India and Bangladesh have the unit labour requirements for producing
tables and mats shown in the table below. It follows that:
India Bangladesh
Tables 3 8
Mats 2 1
(a) Bangladesh has a comparative advantage in mats

(b) India has a comparative advantage in tables
(c) Bangladesh has an absolute advantage in mats
(d) All the above are true
9. Comparative advantage refers to
(a) a country’s ability to produce some good or service at the lowest possible
cost compared to other countries
(b) a country’s ability to produce some good or service at a lower opportunity
cost than other countries.
(c) Choosing a productive method which uses minimum of the abundant
factor
10. Ricardo explained the law of comparative advantage on the basis of
(a) opportunity costs
(b) the law of diminishing returns
(c) economies of scale
(d) the labour theory of value
1. Define international trade?
2. What is meant by opportunity cost ?
3. How does trade increase economic efficiency?

4. What is meant by absolute advantage?

5. What is the major idea behind Mercantilist’s view of trade?
6. What is the essence of the theory of absolute advantage?
7. Mention the core principle of the theory of comparative advantage.
8. What is meant by ‘factor endowment ‘in the theory of international trade?
9. What is the crux of Heckscher-Ohlin theory of international trade?
10. What do you understand by ‘factor-price equalization’ in the context of
international trade?
1. Define international trade and describe how it differs from internal trade?
2. Critically examine the arguments for and against international trade?
3. Do you think international trade is always beneficial? Substantiate your
arguments?
4. What are the major arguments against liberal trade?
5. Do you think the developing countries will be disproportionately
disadvantaged if they engage in liberal trade?
6. What consequences do you foresee for the industrial sector if a nation has
greater openness of trade?
7. Using Ricardian model, explain how two countries can gain from trade? What
does the Ricardian model suggest regarding the effect of trade?
8. What are the underlying reasons that explain the differences among nations?
Explain the predictions from different theories in international trade.
9. Describe the reasons why international trade is opposed by many people?
10. “Specialization in production always increases the prosperity of a country” Do
you agree with the statement? Substantiate your answer.
11. Explain the Heckscher-Ohlin theory of international trade.
12. Compare the classical and modem theories of international trade.
13. What is the basis for international trade according to Ricardo?
14. What are the arguments put forth in the modem theory of international trade?

15. Describe the reasons for the superiority of Hecksher Ohlin theory of
international trade over the classical theory of international trade.
1. The price index for exports of Country A in year 2012 (2000 base-year), was
116.1 and the price index for Country A’s imports was 120.2 (2000 base-year)
(i) What do these figures mean?
(ii) Calculate the index of terms of trade for Country A
(iii) How do you interpret the index of terms of trade for Country A?
2. The table below shows the number of labour hours required to produce wheat
and cloth in two countries X and Y.
Commodity Country X Country Y
I unit of cloth 4 1.0

I unit of wheat 2 2.5
(i) Compare the productivity of labour in both countries in respect of both

commodities
(ii) Which country has absolute advantage in the production of wheat?
(iii) Which country has absolute advantage in the production of cloth?
(iv) If there is trade, which commodity should these countries produce?
(v) What are the opportunity costs of each commodity?
ANSWERS/HINTS
1. (b) 2. (d) 3. (b) 4. (c) 5. (b) 6 (b) 7. (b) 8. (d) 9. (b)
10. (d)


1. International trade is the exchange of goods and services as well as
resources between countries and involves transactions between residents of
different countries.
2. The value of the best foregone alternative that is given up when something is
chosen. In production, it is the amount of a second commodity that must be
given up to release just enough resources to produce one more unit of the first
commodity.
3. Economic efficiency increases due to quantitative and qualitative benefits of
extended division of labour, economies of large scale production, betterment
of manufacturing capabilities, increased competitiveness and profitability by
adoption of cost reducing technology and business practices and decrease in
the likelihood of domestic monopolies. Efficient deployment of productive
resources natural, human, industrial and financial resources ensures
productivity gains.
4. The ability of a country to produce a good at a lower cost, in terms of labour,
than another country.
5. Encourage exports and prevent imports and accumulate as much precious
metals as possible to become wealthy
6. A trade theory which holds that nations can increase their economic well-being
by specializing in goods that they can produce more efficiently than anyone
else.
7. A nation should specialize in the production and export of the commodity in
which its absolute disadvantage is smaller (this is the commodity of its
comparative advantage) and import the commodity in which it’s absolute
disadvantage is greater (this is the commodity of its comparative
disadvantage).
8. In a general sense of the term, ‘factor endowment’ which explains comparative
advantage in cost of production, refers to the overall availability of usable
resources including both natural and man-made means of production.
Differences between countries are explained exclusively by the differences in
factor endowments of the nations.

9. A country tends to specialize in the export of a commodity whose production

requires intensive use of its abundant resources and imports a commodity
whose production requires intensive use of its scarce resources.
10. International trade equalizes the factor prices between trading nations; implies
that the wages and rents will converge across the countries with free trade,
that if the prices of the output of goods are equalised between countries
engaged in free trade, then the price of the input factors will also be equalised
between countries.
1. (i) The price index for exports of Country A in year 2012 (2000 base-year), was
116.1 means that compared to year 2000, its export prices were 16.1
percent above the 2000 base year prices.
(ii) The price index for Country A’s imports was 120.2 in year 2012(2000 base-
year), means that compared to year 2000, its import prices were 20.2
percent above the 2000 base year prices.
(iii) The index of the terms of trade for Country A in 2012 would be calculated
as follows:
Price of a country's exports
Terms of Trade =
Price index of its imports
x 100
= (116.1/120.2) x 100 = 96.6

“Terms of trade” is ratio of the price of a country’s export commodity to
the price of its import commodity. The figure 96.6 means that each unit
of country A’s exports in 2012 exchanged for 3.4 percent (3.4 = 100 – 96.6)
fewer units of imports than in the base year.
2. (i) Productivity of labour in both countries in respect of both commodities
Productivity of Labour Country X Country Y
Units of cloth per hour 0.25 1.0

Units of wheat per hour 0.5 0.4
(ii) Country X has absolute advantage in the production of wheat because
productivity of wheat is higher in country X , or conversely, the number of
labour hours required to produce wheat in country X is less compared to
country Y

(iii) Country Y has absolute advantage in the production of cloth because

productivity of cloth is higher in country Y , or conversely, the number of
labour hours required to produce wheat in country Y is less compared to
country X
(iv) In country X, the opportunity cost is 0.25 units of cloth for 0.5 unit of wheat.
(v) In country Y the opportunity cost is 0.4 units of wheat for 1 unit of cloth.

UNIT II: THE INSTRUMENTS OF TRADE
POLICY
LEARNING OUTCOMES

 Define trade policy and describe its objectives
 Distinguish between different types of trade policy measures
 Evaluate the use of tariffs as a trade policy instrument
 Describe the ‘trigger price mechanisms’ for protection of

domestic industry
 Outline the different Non-Tariff Measures adopted by
countries
International Trade
The Instruments of
Trade Policy
Non-Tariff Measures Export-Related

Tariffs
(NTMs) Measures

THE INSTRUMENTS OF TRADE POLICY 4.27
2.1 INTRODUCTION
Before we go into the subject matter of this unit, we shall take a quick look into a
few recent developments in the international trade arena.
• On January 27 , 2017 The European Commission, after a detailed investigation

which confirmed dumping ,decided to impose anti-dumping measures on two
steel products (stainless steel tube and pipe butt-welding fittings) originating
in China and Taiwan.
• In April, 2017 India accuses that by deciding to test up to 50 per cent of India’s
shrimp consignments for antibiotic residues, European Union is using SPS
(Sanitary and Phytosanitary) restrictions in the case of seafood, and also on
fruits and vegetables) in an exaggerated way and that its specifications
sometimes exceed the norms prescribed in the Codex Alimentarius standards
of the FAO.
• In April, 2017, India decided to have a domestic purchase preference policy
applicable for five years for PSU oil companies. Targets of local contents (LC)
also are stipulated for certain oil and gas business activities.
• In view of the avian influenza threat, India has in recent years curbed the import
of frozen chicken legs from the US. The WTO upheld the objections raised by
the US to India’s move, that the curbs are beyond international norms and
therefore amounted to non-tariff barrier.
The above vignettes are just a few of the multitudes of episodes that arise almost
on a daily basis when countries engage in trade. A glance at similar newspaper
reports makes it obvious that governments do not conform to free trade despite
the potential efficiency and welfare outcomes it will promote; rather, they employ
different devices for restricting the free flow of goods and services across their
borders.
In unit 1, we have seen that there are clear efficiency benefits from trade in terms
of economic growth, job-creation and welfare. The persuasive academic arguments
for open trade presuppose that fair competition, without distortions, is maintained
between domestic and foreign producers. However, it is a fact that fair competition
does not always exist and unobstructed international trade also brings in severe
dislocation to many domestic firms and industries on account of difficult
adjustment problems. Therefore, individuals and organisations continue to
pressurize policy makers and regulatory authorities to restrict imports or to
artificially boost up the size of exports.

Historically, as part of their protectionist measures, governments of different

countries have applied many different types of policy instruments, not necessarily
based on their economic merit, for restricting free flow of goods and services across
national boundaries. While some such measures of government intervention are
simple, widespread, and relatively transparent, others are complex, less apparent
and frequently involve many types of distortions. In this unit, we shall describe
some of the most frequently used forms of interference with trade. Understanding
the uses and implications of the common trade policy instruments will enable
formulation of appropriate policy responses and more balanced dialogues on
trade policy issues and international trade agreements.
Trade policy encompasses all instruments that governments may use to promote
or restrict imports and exports. Trade policy also includes the approach taken by
countries in trade negotiations. While participating in the multilateral trading
system and/or while negotiating bilateral trade agreements, countries assume
obligations that shape their national trade policies. The instruments of trade policy
that countries typically use to restrict imports and/ or to encourage exports can be
broadly classified into price- related measures such as tariffs and non-price
measures or non-tariff measures (NTMs).
In the following sections, we shall briefly touch upon the different trade policy
measures adopted by countries to protect their domestic industries.
2.2 TARIFFS
Tariffs, also known as customs duties, are basically taxes or duties imposed on
goods and services which are imported or exported. It is defined as a financial
charge in the form of a tax, imposed at the border on goods going from one
customs territory to another. They are the most visible and universally used trade
measures that determine market access for goods. Import duties being pervasive
than export duties, tariffs are often identified with import duties and in this unit,
the term ‘tariff’ would refer to import duties.
Tariffs are aimed at altering the relative prices of goods and services imported, so
as to contract the domestic demand and thus regulate the volume of their imports.
Tariffs leave the world market price of the goods unaffected; while raising their
prices in the domestic market. The main goals of tariffs are to raise revenue for the
government, and more importantly to protect the domestic import-competing
industries.

2.2.1 Forms of Import Tariffs

(i) Specific Tariff: A specific tariff is an import duty that assigns a fixed monetary
tax per physical unit of the good imported. It is calculated on the basis of a
unit of measure, such as weight, volume, etc., of the imported good. Thus, a
specific tariff of `1000/ may be charged on each imported bicycle. The
disadvantage of specific tariff as an instrument for protection of domestic
producers is that its protective value varies inversely with the price of the
import. For example: if the price of the imported cycle is ` 5,000/,then the rate
of tariff is 20%; if due to inflation, the price of bicycle rises to ` 10,000 , the
specific tariff is only 10% of the value of the import. Since the calculation of
these duties does not involve the value of merchandise, customs valuation is
not applicable in this case.
(ii) Ad valorem tariff: An ad valorem tariff is levied as a constant percentage of
the monetary value of one unit of the imported good. A 20% ad valorem tariff
on any bicycle generates a `1000/ payment on each imported bicycle priced at
`5,000/ in the world market; and if the price rises to ` 10,000, it generates a
payment of `2,000/. While ad valorem tariff preserves the protective value of
tariff on home producer, it gives incentives to deliberately undervalue the
good’s price on invoices and bills of lading to reduce the tax burden.
Nevertheless, ad valorem tariffs are widely used the world over.
There are many other variations of the above tariffs, such as:
(a) Mixed Tariffs : Mixed tariffs are expressed either on the basis of the value of
the imported goods (an ad valorem rate) or on the basis of a unit of measure
of the imported goods (a specific duty) depending on which generates the
most income( or least income at times) for the nation. For example, duty on
cotton: 5 per cent ad valorem 0r ` 3000/per tonne, whichever is higher.
(b) Compound Tariff or a Compound Duty is a combination of an ad valorem
and a specific tariff. That is, the tariff is calculated on the basis of both the value
of the imported goods (an ad valorem duty) and a unit of measure of the
imported goods (a specific duty). It is generally calculated by adding up a
specific duty to an ad valorem duty. For example: duty on cheese at 5 per cent
ad valorem plus 100 per kilogram.
(c) Technical/Other Tariff: These are calculated on the basis of the specific
contents of the imported goods i.e the duties are payable by its components

or related items. For example: `3000/ on each solar panel plus ` 50/ per kg
on the battery.
(d) Tariff Rate Quotas : Tariff rate quotas (TRQs) combine two policy instruments:
quotas and tariffs. Imports entering under the specified quota portion are
usually subject to a lower (sometimes zero), tariff rate. Imports above the
quantitative threshold of the quota face a much higher tariff.
(e) Most-Favored Nation Tariffs: MFN tariffs are what countries promise to
impose on imports from other members of the WTO, unless the country is part
of a preferential trade agreement (such as a free trade area or customs union).
This means that, in practice, MFN rates are the highest (most restrictive) that
WTO members charge one another. Some countries impose higher tariffs on
countries that are not part of the WTO.
(f) Variable Tariff: A duty typically fixed to bring the price of an imported
commodity up to the domestic support price for the commodity.
(g) Preferential Tariff: Nearly all countries are part of at least one preferential
trade agreement, under which they promise to give another country's products
lower tariffs than their MFN rate. These agreements are reciprocal. A lower
tariff is charged from goods imported from a country which is given
preferential treatment. Examples are preferential duties in the EU region under
which a good coming into one EU country to another is charged zero tariffs.
Another example is North American Free Trade Agreement (NAFTA) among
Canada, Mexico and the USA where the preferential tariff rate is zero on
essentially all products. Countries, especially the affluent ones also grant
‘unilateral preferential treatment’ to select list of products from specified
developing countries .The Generalized System of Preferences (GSP) is one such
system which is currently prevailing.
(h) Bound Tariff : A bound tariff is a tariff which a WTO member binds itself with
a legal commitment not to raise it above a certain level. By binding a tariff,
often during negotiations, the members agree to limit their right to set tariff
levels beyond a certain level. The bound rates are specific to individual
products and represent the maximum level of import duty that can be levied
on a product imported by that member. A member is always free to impose a
tariff that is lower than the bound level. Once bound, a tariff rate becomes
permanent and a member can only increase its level after negotiating with its
trading partners and compensating them for possible losses of trade. A bound
tariff ensures transparency and predictability.

(i) Applied Tariffs: An 'applied tariff' is the duty that is actually charged on
imports on a most-favoured nation (MFN) basis. A WTO member can have an
applied tariff for a product that differs from the bound tariff for that product
as long as the applied level is not higher than the bound level.
(j) Escalated Tariff structure refers to the system wherein the nominal tariff rates
on imports of manufactured goods are higher than the nominal tariff rates on
intermediate inputs and raw materials, i.e the tariff on a product increases as
that product moves through the value-added chain. For example a four
percent tariff on iron ore or iron ingots and twelve percent tariff on steel pipes.
This type of tariff is discriminatory as it protects manufacturing industries in
importing countries and dampens the attempts of developing manufacturing
industries of exporting countries. This has special relevance to trade between
developed countries and developing countries. Developing countries are thus
forced to continue to be suppliers of raw materials without much value
addition.
(k) Prohibitive tariff : A prohibitive tariff is one that is set so high that no imports
will enter.
(l) Important subsidies : In some countries, import subsidies also exist. An import
subsidy is simply a payment per unit or as a percent of value for the
importation of a good (i.e., a negative import tariff).
(m) Tariffs as Response to Trade Distortions: Sometimes countries engage in
'unfair' foreign-trade practices which are trade distorting in nature and adverse
to the interests of the domestic firms. The affected importing countries, upon
confirmation of the distortion, respond quickly by measures in the form of tariff
responses to offset the distortion. These policies are often referred to as
"trigger-price" mechanisms. The following sections relate to such tariff
responses to distortions related to foreign dumping and export subsidies
(i) Anti-dumping Duties: Dumping occurs when manufacturers sell goods in a
foreign country below the sales prices in their domestic market or below their
full average cost of the product. Dumping may be persistent, seasonal, or
cyclical. Dumping may also be resorted to as a predatory pricing practice to
drive out established domestic producers from the market and to establish
monopoly position. Dumping is an international price discrimination favouring
buyers of exports, but in fact, the exporters deliberately forego money in order
to harm the domestic producers of the importing country. This is unfair and
constitutes a threat to domestic producers and therefore when dumping is

found, anti-dumping measures which are tariffs to offset the effects of

dumping may be initiated as a safeguard instrument by imposition of
additional import duties so as to offset the foreign firm's unfair price
advantage. This is justified only if the domestic industry is seriously injured by
import competition, and protection is in the national interest (that is, the
associated costs to consumers would be less than the benefits that would
accrue to producers). For example: In January 2017, India imposed anti-
dumping duties on colour-coated or pre-painted flat steel products imported
into the country from China and European nations for a period not exceeding
six months and for jute and jute products from Bangladesh and Nepal.
(ii) Countervailing Duties: Countervailing duties are tariffs that aim to offset the
artificially low prices charged by exporters who enjoy export subsidies and tax
concessions offered by the governments in their home country. If a foreign
country does not have a comparative advantage in a particular good and a
government subsidy allows the foreign firm to be an exporter of the product,
then the subsidy generates a distortion from the free-trade allocation of
resources. In such cases, CVD is charged in an importing country to negate
the advantage that exporters get from subsidies to ensure fair and market
oriented pricing of imported products and thereby protecting domestic
industries and firms. For example, in 2016, in order to protect its domestic
industry, India imposed 12.5% countervailing duty on Gold jewellery imports
from ASEAN.
2.2.2 Effects of Tariffs
A tariff levied on an imported product affects both the country exporting a product
and the country importing that product.
(i) Tariff barriers create obstacles to trade, decrease the volume of imports and
exports and therefore of international trade. The prospect of market access of
the exporting country is worsened when an importing country imposes a tariff.
(ii) By making imported goods more expensive, tariffs discourage domestic
consumers from consuming imported foreign goods. Domestic consumers
suffer a loss in consumer surplus because they must now pay a higher price for
the good and also because compared to free trade quantity, they now consume
lesser quantity of the good.
(iii) Tariffs encourage consumption and production of the domestically produced
import substitutes and thus protect domestic industries.

(iv) Producers in the importing country experience an increase in well-being as a

result of imposition of tariff. The price increase of their product in the domestic
market increases producer surplus in the industry. They can also charge higher
prices than would be possible in the case of free trade because foreign
competition has reduced.
(v) The price increase also induces an increase in the output of the existing firms
and possibly addition of new firms due to entry into the industry to take
advantage of the new high profits and consequently an increase in
employment in the industry.
(vi) Tariffs create trade distortions by disregarding comparative advantage and
prevent countries from enjoying gains from trade arising from comparative
advantage. Thus, tariffs discourage efficient production in the rest of the world
and encourage inefficient production in the home country.
(vii) Tariffs increase government revenues of the importing country by the value of
the total tariff it charges.
Trade liberalization in recent decades, either through government policy measures
or through negotiated reduction through the WTO or regional and bilateral free
trade agreements, has diminished the importance of tariff as a tool of protection.
Currently, trade policy is focusing increasingly on not so easily observable forms of
trade barriers usually called nontariff measures (NTMs). NTMs are thought to have
important restrictive and distortionary effects on international trade. They have
become so invasive that the benefits due to tariff reduction are practically offset by
them.
2.3 NON -TARIFF MEASURES (NTMS)

From the discussion above, we have learnt that tariffs constitute the visible barriers
to trade and have the effect of increasing the prices of imported merchandise. By
contrast, the non- tariff measures which have come into greater prominence than
the conventional tariff barriers, constitute the hidden or 'invisible' measures that
interfere with free trade.
Non-tariff measures (NTMs) are policy measures, other than ordinary customs
tariffs, that can potentially have an economic effect on international trade in goods,
changing quantities traded, or prices or both (UNCTAD, 2010). Non-tariff measures
comprise all types of measures which alter the conditions of international trade,
including policies and regulations that restrict trade and those that facilitate it. It
should be kept in mind that NTMs are not the same as non-tariff barriers (NTBs).

Compared to non-tariff barriers which are simply discriminatory non-tariff

measures imposed by governments to favour domestic over foreign suppliers, non-
tariff measures encompass a broader set of measures.
According to WTO agreements, the use of NTMs is allowed under certain
circumstances. Examples of this include the Technical Barriers to Trade (TBT)
Agreement and the Sanitary and Phytosanitary Measures (SPS) Agreement, both
negotiated during the Uruguay Round. However, NTMs are sometimes used as a
means to circumvent free-trade rules and favour domestic industries at the expense
of foreign competition. In this case they are called non-tariff measures (NTMs). It is
very difficult, and sometimes impossible, to distinguish legitimate NTMs from
protectionist NTMs, especially as the same measure may be used for several
reasons.
Depending on their scope and/or design NTMs are categorized as:
I. Technical Measures: Technical measures refer to product-specific properties
such as characteristics of the product, technical specifications and production
processes. These measures are intended for ensuring product quality, food safety,
environmental protection, national security and protection of animal and plant
health.
II. Non-technical Measures: Non-technical measures relate to trade
requirements; for example; shipping requirements, custom formalities, trade rules,
taxation policies, etc.
These are further distinguished as:
(a) Hard measures (e.g. Price and quantity control measures),
(b) Threat measures (e.g. Anti-dumping and safeguards) and
(c) Other measures such as trade-related finance and investment measures.
Furthermore, the categorization also distinguishes between:
(i) Import-related measures which relate to measures imposed by the importing
country, and
(ii) Export-related measures which relate to measures imposed by the exporting
country itself.
(iii) In addition, to these, there are procedural obstacles (PO) which are practical
problems in administration, transportation, delays in testing, certification etc
that may make it difficult for businesses to adhere to a given regulation.

2.3.1 Technical Measures

I Sanitary and Phytosanitary (SPS) Measures: SPS measures are applied to
protect human, animal or plant life from risks arising from additives, pests,
contaminants, toxins or disease-causing organisms and to protect biodiversity.
These include ban or prohibition of import of certain goods, all measures governing
quality and hygienic requirements, production processes, and associated
compliance assessments. For example; prohibition of import of poultry from
countries affected by avian flu, meat and poultry processing standards to reduce
pathogens, residue limits for pesticides in foods etc.
II Technical Barriers To Trade (TBT): Technical Barriers to Trade (TBT) which
cover both food and non-food traded products refer to mandatory ‘Standards and
Technical Regulations’ that define the specific characteristics that a product should
have, such as its size, shape, design, labelling / marking / packaging, functionality
or performance and production methods, excluding measures covered by the SPS
Agreement. The specific procedures used to check whether a product is really
conforming to these requirements (conformity assessment procedures e.g. testing,
inspection and certification) are also covered in TBT. This involves compulsory
quality, quantity and price control of goods before shipment from the exporting
country. Just as SPS, TBT measures are standards-based measures that countries
use to protect their consumers and preserve natural resources, but these can also
be used effectively as obstacles to imports or to discriminate against imports and
protect domestic products. Altering products and production processes to comply
with the diverse requirements in export markets may be either impossible for the
exporting country or would obviously raise costs hurting the competitiveness of
the exporting country. Some examples of TBT are: food laws, quality standards,
industrial standards, organic certification, eco-labeling, marketing and label
requirements.
2.3.2 Non-technical Measures
These include different types of trade protective measures which are put into
operation to neutralize the possible adverse effects of imports in the market of the
importing country. Following are the most commonly practiced measures in respect
of imports:
(i) Import Quotas: An import quota is a direct restriction which specifies that
only a certain physical amount of the good will be allowed into the country during
a given time period, usually one year. Import quotas are typically set below the free

trade level of imports and are usually enforced by issuing licenses. This is referred
to as a binding quota; a non-binding quota is a quota that is set at or above the
free trade level of imports, thus having little effect on trade.
Import quotas are mainly of two types: absolute quotas and tariff-rate quotas.
Absolute quotas or quotas of a permanent nature limit the quantity of imports to
a specified level during a specified period of time and the imports can take place
any time of the year. No condition is attached to the country of origin of the
product. For example: 1000 tonnes of fish import of which can take place any time
of the year from any country. When country allocation is specified, a fixed volume
or value of the product must originate in one or more countries. Example: A quota
of 1000 tonnes of fish that can be imported any time of the year, but where 750
tonnes must originate in country A and 250 tonnes in country B. In addition, there
are seasonal quotas and temporary quotas.
With a quota, the government, of course, receives no revenue. The profits received
by the holders of such import licenses are known as ‘quota rents’. While tariffs
directly interfere with prices that can be charged for an imported good in the
domestic market, import quota interferes with the market prices indirectly.
Obviously, an import quota at all times raises the domestic price of the imported
good. The license holders are able to buy imports and resell them at a higher price
in the domestic market and they will be able to earn a ‘rent’ on their operations
over and above the profit they would have made in a free market.
The welfare effects of quotas are similar to that of tariffs. If a quota is set below
free trade level, the amount of imports will be reduced. A reduction in imports will
lower the supply of the good in the domestic market and raise the domestic price.
Consumers of the product in the importing country will be worse-off because the
increase in the domestic price of both imported goods and the domestic
substitutes reduces consumer surplus in the market. Producers in the importing
country are better-off as a result of the quota. The increase in the price of their
product increases producer surplus in the industry. The price increase also induces
an increase in output of existing firms (and perhaps the addition of new firms), an
increase in employment, and an increase in profit.
(ii) Price Control Measures : Price control measures (including additional taxes
and charges) are steps taken to control or influence the prices of imported goods
in order to support the domestic price of certain products when the import prices
of these goods are lower. These are also known as 'para-tariff' measures and
include measures, other than tariff measures, that increase the cost of imports in a

similar manner, i.e. by a fixed percentage or by a fixed amount. Example: A

minimum import price established for sulphur.
(iii) Non-automatic Licensing and Prohibitions : These measures are normally
aimed at limiting the quantity of goods that can be imported, regardless of whether
they originate from different sources or from one particular supplier. These
measures may take the form of non-automatic licensing, or through complete
prohibitions. For example, textiles may be allowed only on a discretionary license
by the importing country. India prohibits import/export of arms and related
material from/to Iraq. Also, India prohibits many items (mostly of animal origin)
falling under 60 EXIM codes.
(iv) Financial Measures: The objective of financial measures is to increase import
costs by regulating the access to and cost of foreign exchange for imports and to
define the terms of payment. It includes measures such as advance payment
requirements and foreign exchange controls denying the use of foreign exchange
for certain types of imports or for goods imported from certain countries. For
example, an importer may be required to pay a certain percentage of the value of
goods imported three months before the arrival of goods or foreign exchange may
not be permitted for import of newsprint.
(v) Measures Affecting Competition: These measures are aimed at granting
exclusive or special preferences or privileges to one or a few limited group of
economic operators. It may include government imposed special import channels
or enterprises, and compulsory use of national services. For example, a statutory
marketing board may be granted exclusive rights to import wheat: or a canalizing
agency (like State Trading Corporation) may be given monopoly right to distribute
palm oil. When a state agency or a monopoly import agency sells on the domestic
market at prices above those on the world market, the effect will be similar to an
import tariff.
(vi) Government Procurement Policies: Government procurement policies may
interfere with trade if they involve mandates that the whole of a specified
percentage of government purchases should be from domestic firms rather than
foreign firms, despite higher prices than similar foreign suppliers. In accepting
public tenders, a government may give preference to the local tenders rather than
foreign tenders.
(vii) Trade-Related Investment Measures: These measures include rules on local
content requirements that mandate a specified fraction of a final good should be
produced domestically.

(a) requirement to use certain minimum levels of locally made components, ( 25

percent of components of automobiles to be sourced domestically)
(b) restricting the level of imported components , and
(c) limiting the purchase or use of imported products to an amount related to the
quantity or value of local products that it exports. ( A firm may import only up
to 75 % of its export earnings of the previous year)
(viii) Distribution Restrictions: Distribution restrictions are limitations imposed
on the distribution of goods in the importing country involving additional license
or certification requirements. These may relate to geographical restrictions or
restrictions as to the type of agents who may resell. For example: a restriction that
imported fruits may be sold only through outlets having refrigeration facilities
(ix) Restriction on Post-sales Services: Producers may be restricted from
providing after- sales services for exported goods in the importing country. Such
services may be reserved to local service companies of the importing country.
(x) Administrative Procedures : Another potential obstruction to free trade is the
costly and time consuming administrative procedures which are mandatory for
import of foreign goods. These will increase transaction costs and discourage
imports. The domestic import-competing industries gain by such non- tariff
measures. Examples include specifying particular procedures and formalities,
requiring licenses, administrative delay, red-tape and corruption in customs
clearing frustrating the potential importers , procedural obstacles linked to prove
compliance etc.
(xi) Rules of origin: Rules of origin are the criteria needed by governments of
importing countries to determine the national source of a product. Their
importance is derived from the fact that duties and restrictions in several cases
depend upon the source of imports. Important procedural obstacles occur in the
home countries for making available certifications regarding origin of goods,
especially when different components of the product originate in different
countries.
(xii) Safeguard Measures are initiated by countries to restrict imports of a product
temporarily if its domestic industry is injured or threatened with serious injury
caused by a surge in imports.
(xiii) Embargos : An embargo is a total ban imposed by government on import or
export of some or all commodities to particular country or regions for a specified

or indefinite period. This may be done due to political reasons or for other reasons
such as health, religious sentiments. This is the most extreme form of trade barrier
2.4. EXPORT-RELATED MEASURES

(i) Ban on exports : Export-related measures refer to all measures applied by the
government of the exporting country including both technical and non-technical
measures. For example ,during periods of shortages, export of agricultural
products such as onion , wheat etc may be prohibited to make them available for
domestic consumption. Export restrictions have an important effect on
international markets. By reducing international supply, export restrictions have
been shown to increase international prices.
(ii) Export Taxes: An export tax is a tax collected on exported goods and may be
either specific or ad valorem. The effect of an export tax is to raise the price of the
good and to decrease exports. Since an export tax reduces exports and increases
domestic supply, it also reduces domestic prices and leads to higher domestic
consumption.
(iii) Export Subsidies and Incentives : We have seen that tariffs on imports hurt
exports and therefore countries have developed compensatory measures of
different types for exporters like export subsidies ,duty drawback, duty-free access
to imported intermediates etc. Governments or government bodies also usually
provide financial contribution to domestic producers in the form of grants, loans,
equity infusions etc. or give some form of income or price support. If such policies
on the part of governments are directed at encouraging domestic industries to sell
specified products or services abroad, they can be considered as trade policy tools.
(iv) Voluntary Export Restraints : Voluntary Export Restraints (VERs) refer to a
type of informal quota administered by an exporting country voluntarily restraining
the quantity of goods that can be exported out of that country during a specified
period of time. Such restraints originate primarily from political considerations and
are imposed based on negotiations of the importer with the exporter. The
inducement for the exporter to agree to a VER is mostly to appease the importing
country and to avoid the effects of possible retaliatory trade restraints that may be
imposed by the importer. VERs may arise when the import-competing industries
seek protection from a surge of imports from particular exporting countries. VERs
cause, as do tariffs and quotas, domestic prices to rise and cause loss of domestic
consumer surplus.

Over the past few decades, significant transformations are happening in terms of
growth as well as trends of flows and patterns of global trade. The increasing
importance of developing countries has been a salient feature of the shifting global
trade patterns. Fundamental changes are taking place in the way countries
associate themselves for international trade and investments. Trading through
regional arrangements which foster closer trade and economic relations is shaping
the global trade landscape in an unprecedented way. Alongside, the trading
countries also have devised ingenious policies aimed at protecting their economic
interests. The discussions in this unit are in no way comprehensive considering the
faster pace of discovery of such protective strategies. Students are expected to get
themselves updated on such ongoing changes.
SUMMARY
• Trade policy encompasses all instruments that governments may use to
promote or restrict imports and exports.
• Trade policies are broadly classified into price- related measures such as tariffs
and non-price measures or non-tariff measures (NTMs)
• Tariff, also known as customs duty is defined as a financial charge in the form
of a tax, imposed at the border on goods going from one customs territory to
another. Tariffs are the most visible and universally used trade measures.
• A specific tariff is an import duty that assigns a fixed monetary tax per physical
unit of the good imported whereas an ad valorem tariff is levied as a constant
percentage of the monetary value of one unit of the imported good.
• Mixed tariffs are expressed either on the basis of the value of the imported
goods (an ad valorem rate) or on the basis of a unit of measure of the imported
goods (a specific duty),depending on desired yields.
• Compound Tariff or a compound duty is a combination of an ad valorem and
a specific tariff and is calculated on the basis of both the value of the imported
goods (an ad valorem duty) and a unit of measure of the imported goods
• Tariff rate quotas (TRQs) combine two policy instruments namely quotas and
tariffs.
• MFN tariffs are what countries promise to impose on imports from other
members of the WTO, unless the country is part of a preferential trade
agreement (such as a free trade area or customs union).

• Preferential tariff occurs when a country gives another country's products lower
tariffs than its MFN rate.
• The bound rate is specific to individual products and represents the maximum
level of import duty that can be levied on a product imported by that member.
• An 'applied tariff' is the duty that is actually charged on imports on a most-
favoured nation (MFN) basis.
• Escalated tariff structure refers to the system wherein the nominal tariff rates
that product moves through the value-added chain.
• A prohibitive tariff is one that is set so high that no imports will enter.
• Trigger-price mechanisms are quick responses of affected importing countries
upon confirmation of trade distortion to offset the distortion. Eg. Anti-
dumping duties.
• Dumping occurs when manufacturers sell goods in a foreign country below the
sales prices in their domestic market or below their full average cost of the
product. It hurts domestic producers.
• Anti-dumping measures are additional import duties so as to offset the foreign
firm's unfair price advantage.
• Countervailing duties are tariffs to offset the artificially low prices charged by
exporters who enjoy export subsidies and tax concessions offered by the
governments in their home country.
• Tariff barriers create obstacles to trade, reduce the prospect of market access,
make imported goods more expensive, increase consumption of domestic
goods, protect domestic industries and increase government revenues
• Non-tariff measures (NTMs) are policy measures, other than ordinary customs
tariffs, that can potentially have an economic effect on international trade in
goods, changing quantities traded or prices or both
• Technical Barriers to Trade (TBT) are ‘Standards and Technical Regulations’ that
define the specific characteristics that a product should have, such as its size,
shape, design, labelling / marking / packaging, functionality or performance
and production methods, excluding measures covered by the SPS Agreement.

• Non-technical measures relate to trade requirements; for example; shipping

requirements, custom formalities, trade rules, taxation policies, etc.
• SPS measures are applied to protect human, animal or plant life from risks
arising from additives, pests, contaminants, toxins or disease-causing
organisms and to protect biodiversity
• An import quota is a direct restriction which specifies that only a certain
physical amount of the good will be allowed into the country during a given
time period, usually one year.
• The objective of financial measures is to increase import costs by regulating
the access to and cost of foreign exchange for imports and to define the terms
of payment.
• Government procurement policies may interfere with trade if they involve
mandates that the whole of a specified percentage of purchases should be
from domestic firms rather than from foreign firms
• In the case of investments, local content requirements that mandate that a
specified fraction of a final good be produced domestically may act as a trade
barrier.
• Rules of origin are the criteria needed by governments of importing countries
to determine the national source of a product.
• Safeguard measures are initiated by countries to temporarily restrict imports
of a product if its domestic industry while an embargo is a total ban imposed
by government on import of export of some or all commodities to particular
country or regions for a specified or indefinite period.
• An export tax is a tax collected on exported goods and may be either specific
or ad valorem and an export subsidy includes financial contribution to
domestic producers in the form of grants, loans, equity infusions or some form
of income or price support. Both distort trade.
• Voluntary Export Restraints (VERs) refer to a type of informal quota
administered by an exporting country voluntarily restraining the quantity of
goods that can be exported out of that country during a specified period of
time, imposed based on negotiations to appease the importing country and to
avoid the effects of possible trade restraints

TEST YOUR KNOWLEDGE

1. A specific tariff is
(a) a tax on a set of specified imported good
(b) an import tax that is common to all goods imported during a given period
(c) a specified fraction of the economic value of an imported good
(d) a tax on imports defined as an amount of currency per unit of the good
2. A tariff on imports is beneficial to domestic producers of the imported good
because
(a) they get a part of the tariff revenue
(b) it raises the price for which they can sell their product on the domestic
market
(c) it determines the quantity that can be imported to the country
(d) it reduces their producer surplus, making them more efficient
3. A tax applied as a percentage of the value of an imported good is known as
(a) preferential tariff
(b) ad valorem tariff
(c) specific tariff
(d) mixed or compound tariff
4. Escalated tariff refers to
(a) nominal tariff rates on raw materials which are greater than tariffs on
manufactured products
(b) nominal tariff rates on manufactured products which are greater than
tariffs on raw materials
(c) a tariff which is escalated to prohibit imports of a particular good to
protect domestic industries

5. Voluntary export restraints involve:

(a) an importing country voluntarily restraining the quantity of goods that can
be exported into the country during a specified period of time
(b) domestic firms agreeing to limit the quantity foreign products sold in their
domestic markets
(c) an exporting country voluntarily restraining the quantity of goods that can
be exported out of a country during a specified period of time
(d) quantitative restrictions imposed by the importing country's government.
6. Anti-dumping duties are
(a) additional import duties so as to offset the effects of exporting firm's unfair
charging of prices in the foreign market which are lower than production
costs
(b) additional import duties so as to offset the effects of exporting firm's
increased competitiveness due to subsidies by government
(c) additional import duties so as to offset the effects of exporting firm's unfair
charging of lower prices in the foreign market
(d) and (c) above
7. A countervailing duty is
(a) a tariff that aim to offset artificially low prices charged by exporters who
enjoy export subsidies and tax concessions in their home country
(b) charged by importing countries to ensure fair and market oriented pricing
of imported products
(c) charged by importing countries to protect domestic industries and firms
from unfair price advantage arising from subsidies
(d) All the above
8. Which of the following is an outcome of tariff?
(a) create obstacles to trade and increase the volume of imports and exports
(b) domestic consumers enjoy consumer surplus because consumers must
now pay only a lower price for the good
(c) discourage domestic consumers from consuming imported foreign goods
and encourage consumption of domestically produced import substitutes

(d) increase government revenues of the importing country by more than

value of the total tariff it charges
9. SPS measures and TBTs are
(a) permissible under WTO to protect the interests of countries
(b) may result in loss of competitive advantage of developing countries
(c) increases the costs of compliance to the exporting countries
(d) All the above
10. Which of the following is not a non-tariff barrier.
(a) Complex documentation requirements
(b) Import quotas on specific goods
(c) Countervailing duties charged by importing country
(d) Pre shipment product inspection and certification requirements
11. Under tariff rate quota
(a) countries promise to impose tariffs on imports from members other than
those who are part of a preferential trade agreement
(b) a country permits an import of limited quantities at low rates of duty but
subjects an excess amount to a much higher rate
(c) lower tariff is charged from goods imported from a country which is given
preferential treatment
12. Non -tariff barriers (NTBs) include all of the following except:
(a) import quotas
(b) tariffs
(c) export subsidies
(d) technical standards of products
1. Define trade policy.
2. What is the purpose of trade policy?

3. What are the main types of trade policy instruments?

4. Define ‘tariff’.
5. Outline the main goals of tariffs?
6. What is meant by ‘specific tariff’?
7. Explain the term ‘ad valorem tariff’?
8. What is meant by mixed tariff?
9. Define ‘bound tariff’
10. What is the purpose of binding a tariff?
11. How does ‘escalated tariff structure’ work?
12. Define ‘dumping’?
13. What is meant by an ‘Anti-dumping’ measure?
14. Why are countervailing duties imposed?
15. Describe the term ‘Non-Tariff measure (NTM).
16. What is the purpose of SPS measures?
17. What do you understand by the term ‘import quota’?
18. Explain the concept of ‘local content requirements’ in the context of trade
policy
19. What is meant by ‘Voluntary Export Restraints’
20. Outline the meaning of ‘Trigger-price mechanism’
1. Define ‘trade policy’. What are the major objectives of trade policy?
2. Distinguish between different types of trade policy measures. What are the
effects of each?
3. Evaluate the use of tariffs as a trade policy instrument
4. Describe the ‘trigger price mechanisms’ for protection of domestic industry?
5. Outline the different non- tariff measures adopted by countries
6. ‘Governments do not conform to free trade despite the potential efficiency and
welfare outcomes it will promote’ Elucidate the statement .Give examples.

7. How do import tariffs influence international trade?

8. Distinguish between anti-dumping duties and countervailing duties. What
purpose do they serve?
9. Describe different technical barriers to trade (TBT) and their effects on trade
10. What are the effects of tariff on the importing and exporting countries?
11. How do import quotas affect domestic industries and consumers?
12. Explain the concept of ‘Voluntary Export Restraints’. What are the
circumstances under which exporters commit to voluntary export restraints?
1. (i) Which of the three exporters engage in anticompetitive act in the
international market while pricing its export of good X to country D?
(ii) What would be the effect of such pricing on the domestic producers of
good X? Advise remedy available for country D?
Goods X Country A Country B Country C
(in $) (in $) (in$)
Average Cost 30.5 29.4 30.9
Price per Unit for domestic 31.2 31.1 30.9
Sales
Price charged in country D 31.9 30.6 30.6
2. (i) What do you think the implications on trade will be if India pays an export
subsidy of ` 400 / on every pair of cotton trousers exported by it to
Germany
(ii) Suppose Germany charged an equivalent countervailing duty on every pair
of cotton trousers imported from India. Do you think world welfare will be
affected?
ANSWERS/HINTS
1. (d) 2. (b) 3. (b) 4. (b) 5. (c) 6 (d) 7. (d) 8. (c) 9. (d)
10. (c) 11. (b) 12. (b)


1. Trade policy encompasses all instruments that governments may use to
promote or restrict imports and exports.
2. The instruments of trade policy are typically used by countries to restrict
imports and/ or to encourage exports.
3. The instruments of trade policy are broadly classified into price- related
measures such as tariffs and non-price measures or non-tariff measures
(NTMs).
4. Tariffs, also known as customs duties, are basically taxes or duties imposed on
goods and services which are imported or exported.
5. The main goals of tariffs are to raise revenue for the government and more
importantly to protect the domestic import-competing industries.
6. A specific tariff is an import duty that assigns a fixed monetary tax per physical
unit of the good imported.
7. An ad valorem tariff is levied as a constant percentage of the monetary value
of one unit of the imported good. A 20% ad valorem tariff on imported car
8. Mixed tariff is a combination of an ad valorem and a specific tariff. That is, the
tariff is calculated on the basis of both the value of the imported goods (an ad
valorem duty) and a unit of measure of the imported goods (a specific duty)
9. A bound tariff is a tariff which a WTO member binds itself with a legal
commitment not to raise above a certain level.
10. By binding a tariff, often during negotiations, the members agree to limit their
right to set tariff levels beyond a certain level
11. Escalated tariff structure refers to the system wherein the nominal tariff rates
that product moves through the value-added chain.
12. Dumping occurs when manufacturers sell goods in a foreign country below the
sales prices in their domestic market or below their full average cost of the
product. It hurts domestic producers.
13. Anti-dumping measures are additional import duties so as to offset the foreign
firm's unfair price advantage.
14. Countervailing duties are tariffs which seek to offset artificially low prices
charged by exporters who enjoy export subsidies and tax concessions offered
by the Governments in their home country.

15. Non-tariff measures (NTMs) are policy measures, other than ordinary customs
tariffs, that can potentially have an economic effect on international trade in
goods, changing quantities traded, or prices or both
16. SPS measures are applied to protect human, animal or plant life from risks
arising from additives, pests, contaminants, toxins or disease-causing
organisms and to protect biodiversity
17. An import quota is a direct restriction which specifies that only a certain
18. Local content requirements mandate that a specified fraction of a final good
should be produced domestically
19. Voluntary Export Restraints (VERs) refer to a type of informal quota
administered by an exporting country voluntarily restraining the quantity of
goods that can be exported out of a country during a specified period of time
20. Trigger-price mechanisms are quick responses of affected importing countries
upon confirmation of trade distortion to offset the distortion. Eg. Anti-
dumping duties
1. (i) Dumping by Country B and Country C. B because it sells at a lower price
than that in domestic market; Country C because it is selling at a price
which is less than the average cost of production.
(ii) Adverse effects on domestic industry as they will lose competitiveness in
their markets due to unfair practice of dumping. Country D may prove
damage to domestic industries and charge anti dumping duties on goods
imported from Country B and Country C so as to raise the price and make
it at par which similar goods produced by domestic firms.
2. (i) Unfair and artificially created price advantage to trousers exporters of India
– price does not reflect costs- German trousers industry lose
competitiveness and market share as trousers from India are lower priced-
Loss of world welfare. German industry can ask for protection by
introducing countervailing duties.
(ii) An equivalent countervailing duty will push the prices of Indian trousers
and afford protection to domestic trousers industry. World welfare will be
the same as before India introduced export subsidy.

UNIT III: TRADE NEGOTIATIONS
LEARNING OUTCOMES

 Distinguish between different types of regional trade
agreements
 Outline the course of the history of trade negotiations
 Describe the structure and guiding principles of the WTO
 Give an overview of the WTO agreements
 List out the major concerns in respect of functioning of the

WTO
International Trade
Trade Negotiations
RTAs GATT WTO

TRADE NEGOTIATIONS 4.51
3.1 INTRODUCTION
The recent years have seen intense bilateral and multilateral negotiations among
different nations in the international arena. India, for example, has already become
part of 19 such concluded agreements and is currently negotiating more than two
dozens of such proposals. Events such as Britain planning an exit from the European
Union, the US deliberations on the impact of NAFTA, and many other unpredictable
developments in the trade front make trade negotiations a highly relevant topic in
Economics.
International trade negotiations, especially the ones aimed at formulation of
international trade rules, are complex interactive processes engaged in by countries
having competing objectives. Trade negotiations are not just face to face
discussions; rather they are multilevel or network games and involve intricate and
time consuming processes. They usually involve many parties who have conflicting
interests and objectives. It is not national governments alone who are the
stakeholders in a trade negotiation. Many interest groups, lobbying groups,
pressure groups and Non Governmental Organizations (NGO) exert their influence
on the process. As anyone can guess, the positions taken by each of the negotiating
parties would represent their underlying agenda of interests. For example, in trade
negotiations, when one of the parties seems to be bargaining for market access
through reduction in tariffs, the other (s) may be clamouring on the issue of
possible grant of protection to domestic industries.
Before we go into the discussion on multilateral trade negotiations and the related
institutions, it is relevant to understand the nature of regional as well as free trade
agreements which evolve through negotiations.
3.2 TAXONOMY OF REGIONAL TRADE AGREEMENTS (RTAS)

Regional Trade Agreements (RTAs) are defined as groupings of countries, (not
necessarily belonging to the same geographical region) which are formed with the
objective of reducing barriers to trade between member countries.
Trade negotiations result in different types of agreements namely;
1. Unilateral trade agreements under which an importing country offers trade
incentives in order to encourage the exporting country to engage in
international economic activities that will improve the exporting country’s
economy. E.g. Generalized System of Preferences.

2. Bilateral Agreements are agreements which set rules of trade between two
countries, two blocs or a bloc and a country. These may be limited to certain
goods and services or certain types of market entry barriers. E.g. EU-South
Africa Free Trade Agreement; ASEAN–India Free Trade Area
3. Regional Preferential Trade Agreements among a group of countries reduce
trade barriers on a reciprocal and preferential basis for only the members of
the group. E.g. Global System of Trade Preferences among Developing
Countries (GSTP)
4. Trading Bloc has a group of countries that have a free trade agreement
between themselves and may apply a common external tariff to other countries
Example: Arab League (AL), European Free Trade Association (EFTA)
5. Free-trade area is a group of countries that eliminate all tariff barriers on trade
with each other and retains independence in determining their tariffs with
nonmembers. Example: NAFTA
6. A customs union is a group of countries that eliminate all tariffs on trade
among themselves but maintain a common external tariff on trade with
countries outside the union (thus technically violating MFN). e.g. EC,
MERCOSUR.
7. Common Market: A Common Market deepens a customs union by providing
for the free flow of factors of production (labor and capital) in addition to the
free flow of outputs. The member countries attempt to harmonize some
institutional arrangements and commercial and financial laws and regulations
among themselves. There are also common barriers against non-members
(e.g., EU, ASEAN)
8. In an Economic and Monetary Union, members share a common currency and
macroeconomic policies. For example, the European Union countries
implement and adopt a single currency.
There has been significant growth in international trade since the end of the Second
World War, mostly due to multilateral trade system which is both a political process
and a set of political institutions. It is a political process because it is based on
negotiations and bargaining among sovereign governments based on which they
arrive at rules governing trade between or among themselves. The political
institutions that facilitate trade negotiations, and support international trade
cooperation by providing the rules of the game have been the former General
Agreements on Tariffs and Trade (GATT) and the World Trade Organization (WTO).

3.3 THE GENERAL AGREEMENT ON TARIFFS AND TRADE

(GATT)
Despite wide ranging benefits, a number of countries hinder the free flow of
international trade by imposing trade barriers. It was felt necessary that all
countries embark on cooperative economic relations for establishing mutual self-
interest. The General Agreement on Tariffs and Trade (GATT) provided the rules for
much of world trade for 47 years, from 1948 to 1994; but it was only a multilateral
instrument governing international trade or a provisional agreement along with the
two full-fledged “Bretton Woods” institutions, the World Bank and the International
Monetary Fund. The original intention to create an International Trade Organization
(ITO) as a third institution to handle the trade side of international economic
cooperation did not succeed for want of endorsement by some national
legislatures, especially the US. Eight rounds of multilateral negotiations known as
“trade rounds” held under the auspices GATT resulted in substantial international
trade liberalization. Though the GATT trade rounds in earlier years contemplated
tariff reduction as their core issue, later on the Kennedy Round in the mid-sixties,
and the Tokyo Round in the 1970s led to massive reductions in bilateral tariffs,
establishment of negotiation rules and procedures on dispute resolution, dumping
and licensing. The arrangements were informally referred to as ‘codes’ because
they were not acknowledged by the full GATT membership. A number of codes
were ultimately amended in the Uruguay Round and got converted into multilateral
commitments accepted by all WTO members. The eighth, the Uruguay Round of
1986-94, was the last and most consequential of all rounds and culminated in the
birth of WTO and a new set of agreements.
The GATT lost its relevance by 1980s because
• it was obsolete to the fast evolving contemporary complex world trade
scenario characterized by emerging globalisation
• international investments had expanded substantially
• intellectual property rights and trade in services were not covered by GATT
• world merchandise trade increased by leaps and bounds and was beyond its
scope
• the ambiguities in the multilateral system could be heavily exploited
• efforts at liberalizing agricultural trade were not successful

• there were inadequacies in institutional structure and dispute settlement

system
• it was not a treaty and therefore terms of GATT were binding only insofar as
they are not incoherent with a nation’s domestic rules.
3.4 THE URUGUAY ROUND AND THE ESTABLISHMENT OF

WTO
The need for a formal international organization which is more powerful and
comprehensive was felt by many countries by late 1980s. Having settled the most
ambitious negotiating agenda that covered virtually every outstanding trade policy
issue, the Uruguay Round brought about the biggest reform of the world’s trading
system. Members established 15 groups to work on limiting restrictions in the areas
of tariffs, non-tariff barriers, tropical products, natural resource products, textiles
and clothing, agriculture, safeguards against sudden ‘surges’ in imports, subsidies
and countervailing duties, trade related intellectual property restrictions, trade
related investment restrictions, services and four other areas dealing with GATT
itself, such as, the GATT system, dispute settlement procedures and implementation
of the NTB Codes of the Tokyo Round, especially on anti-dumping.
The Round started in Punta del Este in Uruguay in September 1986 and was
scheduled to be completed by December 1990. However, due to many differences
and especially due to heated controversies over agriculture, no consensus was
arrived at. Finally, in December 1993, the Uruguay Round, the eighth and the most
ambitious and largest ever round of multilateral trade negotiations in which 123
countries participated, was completed after seven years of elaborate negotiations.
The agreement was signed by most countries on April 15, 1994, and took effect on
July 1, 1995. It also marked the birth of the World Trade Organization (WTO) which
is a single institutional framework encompassing the GATT, as modified by the
Uruguay Round.
3.5 THE WORLD TRADE ORGANIZATION (WTO)

The most important outcome of the Uruguay Round agreement was the
replacement of the General Agreement on Tariffs and Trade (GATT) secretariat with
the World Trade Organization (WTO) in Geneva with authority not only in trade in
industrial products but also in agricultural products and services. The bulk of the
WTO's present operations come from the 1986-94 negotiations called the Uruguay
Round and earlier negotiations under the General Agreement on Tariffs and Trade

(GATT). Despite the fact that the WTO replaced GATT as an international
organization, the General Agreement still exists as the WTO’s umbrella treaty for
trade in goods, updated as a result of the Uruguay Round negotiations.
The objectives of the WTO Agreements as acknowledged in the preamble of the
Agreement creating the World Trade Organization, include “raising standards of
living, ensuring full employment and a large and steadily growing volume of real
income and effective demand, and expanding the production of and trade in goods
and services” The principal objective of the WTO is to facilitate the flow of
international trade smoothly, freely, fairly and predictably. The WTO does its
functions by acting as a forum for trade negotiations among member governments,
administering trade agreements, reviewing national trade policies, assisting
developing countries in trade policy issues, through technical assistance and
training programmes and cooperating with other international organizations
3.5.1 The Structure of the WTO
The WTO activities are supported by a Secretariat located in Geneva, headed by a
Director General. It has a three-tier system of decision making. The WTO’s top level
decision-making body is the Ministerial Conference which can take decisions on all
matters under any of the multilateral trade agreements. The Ministerial
Conference meets at least once every two years. The next level is the General
Council which meets several times a year at the Geneva headquarters. The General
Council also meets as the Trade Policy Review Body and the Dispute Settlement
Body. At the next level, the Goods Council, Services Council and Intellectual
Property (TRIPS) Council report to the General Council. These councils are
responsible for overseeing the implementation of the WTO agreements in their
respective areas of specialisation. Numerous specialized committees, working
groups and working parties deal with the individual agreements and other areas
such as the environment, development, membership applications and regional
trade agreements.
The WTO accounting for about 95% of world trade currently has 164 members, of
which 117 are developing countries or separate customs territories accounting for
about 95% of world trade. Around 25 others are negotiating membership. The
WTO’s agreements have been ratified in all members’ parliaments.

3.5.2 The Guiding Principles of World Trade Organization (WTO)

Right from its inception, the WTO has been driven by a number of fundamental
principles which are the foundations of the multilateral trading system. Following
are the major guiding principles:
1. Trade without discrimination: Most-favoured-nation (MFN): Originally
formulated as Article 1 of GATT, this principle states that any advantage, favour,
privilege or immunity granted by any contracting party to any product
originating in or destined for any other country shall be extended immediately
and unconditionally to the like product originating or destined for the
territories of all other contracting parties. Under the WTO agreements,
countries cannot normally discriminate between their trading partners. If a
country lowers a trade barrier or opens up a market, it has to do so for the
same goods or services from all other WTO members. Under strict conditions,
various permitted exceptions are allowed. For example; countries may enter
into free trade agreements and trading may be done within the group
discriminating against goods from outside; a country can raise barriers against
products that are considered to be traded unfairly from specific countries; or
they may give special market access to developing countries.
2. The National Treatment Principle (NTP): The National Treatment Principle is
complementary to the MFN principle. GATT Article III requires that with respect
to internal taxes, internal laws, etc. applied to imports, treatment not less
favourable than that which is accorded to like domestic products must be
accorded to all other members. In other words, a country should not
discriminate between its own and foreign products, services or nationals. For
instance, once imported apples reach Indian market, they cannot be
discriminated against and should be treated at par in respect of marketing
opportunities, product visibility or any other aspect with locally produced
apples.
3. Freer trade: Lowering trade barriers for opening up markets is one of the most
obvious means of encouraging trade. But by the 1980s, the negotiations had
expanded to cover non-tariff barriers on goods, and to the new areas such as
services and intellectual property. Since these require adjustments, the WTO
agreements permit countries to bring in changes gradually, through
“progressive liberalization”. Developing countries are generally given longer
time to conform to their obligations.

4. Predictability: Investments will be encouraged only if the business

environment is stable and predictable. The foreign companies, investors and
governments should be confident that the trade barriers will not be raised
arbitrarily. This is achieved through ‘binding’ tariff rates, discouraging the use
of quotas and other measures used to set limits on quantities of imports,
establishing market-opening commitments and other measures to ensure
transparency. A country can change its bindings, but only after negotiating
with its trading partners, which could mean compensating them for loss of
trade.
5. Principle of general prohibition of quantitative restrictions: One reason for
this prohibition is that quantitative restrictions are considered to have a greater
protective effect than tariff measures and are more likely to distort the free
flow of trade
6. Greater competitiveness: This is to be achieved by discouraging “unfair”
practices such as export subsidies, dumping etc. The rules try to establish what
is fair or unfair, and how governments can take action, especially by charging
additional import duties intended to compensate for injury caused by unfair
trade.
7. Tariffs as legitimate measures for the protection of domestic industries:
The imposition of tariffs should be the only method of protection, and tariff
rates for individual items should be gradually reduced through negotiations
‘on a reciprocal and mutually advantageous’ basis. Member countries bind
themselves to maximum rates and the imposition of tariffs beyond such
maximum rates (bound rates) or the unilateral raise in bound rates are banned.
8. Transparency in Decision Making: The WTO insists that any decisions by
members in the sphere of trade or in respect of matters affecting trade should
be transparent and verifiable. Such changes in matters of trade or of trade
related rules have to be invariability and without delay be notified to all the
trading partners. In case of any opposition to such changes, they should be
appropriately addressed and any loss occurring to the affected members
should be suitably compensated for.
9. Progressive Liberalization: Many trade issues of a controversial nature
similar to labour standards, non-agricultural market access, etc. on which there
was general disagreement among trading partners were left unsettled during
the Uruguay Round. These are to be liberalized during consecutive rounds of
discussion.

10. Market Access: The WTO aims to increase world trade by enhancing market
access by converting all non- tariff barriers into tariffs which are subject to
country specific limits. Further, in major multilateral agreements like the
Agreement on Agriculture (AOA), to specific targets have been specified for
ensuring market access.
11. Special privileges to less developed countries: With majority of WTO
members being developing countries and countries in transition to market
economies, the WTO deliberations favour less developed countries by giving
them greater flexibility, special privileges and permission to phase out the
transition period. Also, these countries are granted transition periods to make
adjustments to the not so familiar and intricate WTO provisions.
12. Protection of Health & Environment: The WTO’s agreements support
measures to protect not only the environment but also human, animal as well
as plant health with the stipulation that such measures should be non-
discriminatory and that members should not employ environmental
protection measures as a means of disguising protectionist policies.
13. A transparent, effective and verifiable dispute settlement mechanism:
Trade relations frequently involve conflicting interests. Any dispute arising out
of violation of trade rules leading to infringement of rights under the
agreements or misunderstanding arising as regards the interpretation of rules
are to be settled through consultation. In case of failures, the dispute can be
referred to the WTO and can pursue a carefully mapped out, stage-by-stage
procedure that includes the possibility of a judgment by a panel of experts,
and the opportunity to appeal the ruling on legal grounds. The decisions of
the dispute settlement body are final and binding.
3.5.3 Overview of the WTO agreements
The WTO agreements cover goods, services and intellectual property and the
permitted exceptions. These agreements are often called the WTO’s trade rules,
and the WTO is often described as “rules-based”, a system based on rules. (The
rules are actually agreements that the governments negotiated).
The WTO agreements are voluminous and multifaceted. The ‘Legal Texts’ consist of
a list of about 60 agreements, annexes, decisions and understandings covering a
wide range of activities. (The list of WTO agreements is given at the end of this
unit).

Following are the important agreements under WTO. Since a thorough discussion
on the features of each agreement is beyond the scope of this unit, only the major
provisions are given below.
1. Agreement on Agriculture aims at strengthening GATT disciplines and
improving agricultural trade. It includes specific and binding commitments
made by WTO Member governments in the three areas of market access,
domestic support and export subsidies.
2. Agreement on the Application of Sanitary and Phytosanitary (SPS) Measures
establishes multilateral frameworks for the planning, adoption and
implementation of sanitary and phytosanitary measures to prevent such
measures from being used for arbitrary or unjustifiable discrimination or for
camouflaged restraint on international trade and to minimize their adverse
effects on trade.
3. Agreement on Textiles and Clothing replaced the Multi-Fiber Arrangement
(MFA) which was prevalent since 1974 which entailed import protection
policies. ATC provides that textile trade should be deregulated by gradually
integrating it into GATT disciplines over a 10-year transition period.
4. Agreement on Technical Barriers to Trade (TBT) aims to prevent standards and
conformity assessment systems from becoming unnecessary trade barriers by
securing their transparency and harmonization with international standards.
Often excessive standards or misuse of standards in respect of manufactured
goods, and safety/environment regulations act as trade barriers.
5. Agreement on Trade-Related Investment Measures (TRIMs) expands disciplines
governing investment measures in relation to cross-border investments by
stipulating that countries receiving foreign investments shall not impose
investment measures such as requirements, conditions and restrictions
inconsistent with the provisions of the principle of national treatment and
general elimination of quantitative restrictions. For example: measures such as
local content requirements and trade balancing requirements should not be
applied on investing corporations.
6. Anti-Dumping Agreement seeks to tighten and codify disciplines for
calculating dumping margins and conducting dumping investigations, etc. in
order to prevent anti-dumping measures from being abused or misused to
protect domestic industries

7. Customs Valuation Agreement specifies rules for more consistent and reliable
customs valuation and aims to harmonize customs valuation systems on an
international basis by eliminating arbitrary valuation systems.
8. Agreement on Pre-shipment Inspection (PSI) intends to secure transparency of
pre-shipment inspection wherein a company designated by the importing
country conducts inspection of the quality, volume, price, tariff classification,
customs valuation, etc. of merchandise in the territory of the exporting country
on behalf of the importing country’s custom office and issues certificates. The
agreement also provides for a mechanism for the solution of disputes between
PSI agencies and exporters.
9. Agreement on Rules of Origin provides for the harmonization of rules of origin
for application to all non-preferential commercial policy instruments. It also
provides for dispute settlement procedures and creates the rules of origin
committee.
10. Agreement on Import Licensing Procedures relates to simplification of
administrative procedures and to ensure their fair operation so that import
licensing procedures of different countries may not act as trade barriers.
11. Agreement on Subsidies and Countervailing Measures aims to clarify
definitions of subsidies, strengthen disciplines by subsidy type and to
strengthen and clarify procedures for adopting countervailing tariffs
12. Agreement on Safeguards clarify disciplines for requirements and procedures
for imposing safeguards and related measures which are emergency measures
to restrict imports in the event of a sudden surge in imports.
13. General Agreement on Trade in Services (GATS): This agreement provides the
general obligations regarding trade in services, such as most- favored-nation
treatment and transparency. In addition, it enumerates service sectors and
stipulates that in the service sectors for which it has made commitments, a
member country cannot maintain or introduce market access restriction
measures and discriminatory measures that are severer than those that were
committed during the negotiations.
14. Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS):
This agreement stipulates most-favored-nation treatment and national
treatment for intellectual properties, such as copyright, trademarks,
geographical indications, industrial designs, patents, IC layout designs and
undisclosed information. In addition, it requires member countries to maintain

high levels of intellectual property protection and to administer a system of

enforcement of such rights. It also stipulates procedures for the settlement of
disputes related to the agreement.
15. Understanding on Rules and Procedures Governing the Settlement of Disputes
(DSU) provides the common rules and procedures for the settlement of
disputes related to the WTO agreements. It aims to strengthen dispute
settlement procedures by prohibiting unilateral measures, establishing dispute
settlement panels whose reports are automatically adopted, setting time
frames for dispute settlement, establishing the Appellate Body etc.
16. Trade Policy Review Mechanism (TPRM) provides the procedures for the trade
policy review mechanism to conduct periodical reviews of members’ trade
policies and practices conducted by the Trade Policy Review Body (TPRB).
17. Plurilateral Trade Agreements:
• Agreement on Trade in Civil Aircraft: Negotiations were ongoing alongside
the Uruguay Round to revise the Civil Aircraft Agreement (an agreement
from the Tokyo Round) and to strengthen disciplines on subsidies.
However, no agreement has yet been reached and the agreement reached
under the Tokyo Round continues.
• Agreement on Government Procurement: This agreement requires
national treatment and non-discriminatory treatment in the area of
government procurement and calls for fair and transparent procurement
procedures. The agreement covers the procurement of services (in
addition to goods) and the procurement by sub-central government
entities and government-related agencies (in addition to central
government).
All the above mentioned agreements entered into by the members are not
static; they are renegotiated from time to time and new agreements evolve
from negotiations. Many are now being negotiated under the Doha
Development Agenda, launched by WTO trade ministers in Doha, Qatar, in
November 2001.
3.6 THE DOHA ROUND

The Doha Round, formally the Doha Development Agenda, which is the ninth round
since the Second World War was officially launched at the WTO’s Fourth Ministerial
Conference in Doha, Qatar, in November 2001. The round seeks to accomplish

major modifications of the international trading system through lower trade

barriers and revised trade rules. The negotiations include 20 areas of trade,
including agriculture, services trade, market access for nonagricultural products,
and certain intellectual property issues. The most controversial topic in the yet to
conclude Doha Agenda has been agriculture trade.
3.7 THE WTO: A FEW CONCERNS

In recent years, apprehensions have been raised in respect of the WTO and its
ability to maintain and extend a system of liberal world trade. The major issues are:
(i) The progress of multilateral negotiations on trade liberalization is very slow
and the requirement of consensus among all members acts as a constraint and
creates rigidity in the system. As a result, countries find regionalism a plausible
alternative. Moreover, contemporary trade barriers are much more complex
and difficult to negotiate in a multilateral forum. Logically, these issues are
found easier to discuss on bilateral or regional level.
(ii) The complex network of regional agreements introduces uncertainties and
murkiness in the global trade system.
(iii) While multilateral efforts have effectively reduced tariffs on industrial goods,
the achievement in liberalizing trade in agriculture, textiles, and apparel, and
in many other areas of international commerce has been negligible.
(iv) The latest negotiations, such as the Doha Development Round, have run into
problems, and their definitive success is doubtful.
(v) Most countries, particularly developing countries are dissatisfied with the WTO
because, in practice, most of the promises of the Uruguay Round agreement
to expand global trade has not materialized.
(vi) The developing countries have raised a number of concerns and a few are
presented here:
• The developing countries contend that the real expansion of trade in the
three key areas of agriculture, textiles and services has been dismal.
• Protectionism and lack of willingness among developed countries to
provide market access on a multilateral basis has driven many developing
countries to seek regional alternatives.

• The developing countries have raised a number of issues in the Doha

Agenda in respect of the difficulties that they face in implementing the
present agreements.
• The North-South divide apparent in the WTO ministerial meets has fuelled
the apprehension of developing countries about the prospect of trade
expansion under the WTO regime.
• Developing countries complain that they face exceptionally high tariffs on
selected products in many markets and this obstructs their vital exports.
Examples are tariff peaks on textiles, clothing, and fish and fish products.
• Another major issue concerns ‘tariff escalation’ where an importing
country protects its processing or manufacturing industry by setting lower
duties on imports of raw materials and components, and higher duties on
finished products.
• There is also possible erosion of preferences i.e. the special tariff
concessions granted by developed countries on imports from certain
developing countries have become less meaningful because of the
narrowing of differences between the normal and preferential rates.
• The least-developed countries find themselves disproportionately
disadvantaged and vulnerable with regard to adjustments due to lack of
human as well as physical capital, poor infrastructure, inadequate
institutions, political instabilities etc.
A Summary of Agreements in the Final Act of the Uruguay Round
1. Agreement Establishing the WTO
2. General Agreement on Tariffs and Trade 1994
3. Uruguay Round Protocol GATT 1994
4. Agreement on Agriculture
5. Agreement on Sanitary and Phytosanitary Measures
6. Decision on Measures Concerning the Possible Negative Effects of the Reform
Programme on Least-Developed and Net Food-Importing Developing
Countries
7. Agreement on Textiles and Clothing (terminated on 1 January 2005)
8. Agreement on Technical Barriers to Trade

9. Agreement on Trade-Related Investment Measures

10. Agreement on Implementation of Article VI (Anti-dumping)
11. Agreement on Implementation of Article VII (Customs Valuation)
12. Agreement on Preshipment Inspection
13. Agreement on Rules of Origin
14. Agreement on Import Licensing Procedures
15. Agreement on Subsidies and Countervailing Measures
16. Agreement on Safeguards
17. General Agreement on Trade in Services
18. Agreement on Trade-Related Aspects of Intellectual Property Rights, Including
Trade in Counterfeit Goods
19. Understanding on Rules and Procedures Governing the Settlement of Disputes
20. Decision of Achieving Greater Coherence in Global Economic Policy-Making
SUMMARY
• International trade negotiations, especially the ones aimed at formulation of
international trade rules, are complex interactive processes engaged in by
countries having competing objectives.
• Regional Trade Agreements (RTAs) are defined as groupings of countries (not
necessarily belonging to the same geographical region) which are formed with
the objective of reducing barriers to trade between member countries.
• Trade negotiations result in different types of agreements, namely: unilateral
trade agreements, bilateral agreements, regional preferential trade
agreements, trading bloc, free-trade area, customs union, common market and
economic and monetary union
• The General Agreement on Tariffs and Trade (GATT) provided the rules for
much of world trade for 47 years, from 1948 to 1994
• Eight multilateral negotiations known as “trade rounds” held under the
auspices GATT resulted in substantial international trade liberalization.

• The eighth of the Uruguay Round of 1986-94, was the last and most
consequential of all rounds and culminated in the birth of WTO and a new set
of agreements replacing the General Agreement on Tariffs and Trade (GATT).
• The principal objective of the WTO is to facilitate the flow of international trade
smoothly, freely, fairly and predictably.
• The WTO does its functions by acting as a forum for trade negotiations among
member governments, administering trade agreements, reviewing national
trade policies, cooperating with other international organizations and assisting
developing countries in trade policy issues through technical assistance and
training programmes.
• The WTO activities are supported by the Secretariat located in Geneva, headed
by a Director General. It has a three-tier system of decision making. The top
level decision-making body is the Ministerial Conference, followed by councils
namely, the General Council and the Goods Council, Services Council and
Intellectual Property (TRIPS) Council.
• The WTO, accounting for about 95% of world trade, currently has 164
members, of which 117 are developing countries or separate customs
territories.
• The major guiding principles of the WTO are trade without discrimination,
most-favoured-nation treatment(MFN), the national treatment principle (NTP),
freer trade, predictability, general prohibition of quantitative restrictions,
greater competitiveness, tariffs as legitimate measures for protection,
transparency in decision making, progressive liberalization, market access and
a transparent, effective and verifiable dispute settlement mechanism.
• The important agreements under WTO are on agriculture, (SPS) measures,
textiles and clothing, technical barriers to trade (TBT), trade-related investment
measures (TRIMs), anti-dumping, customs valuation, pre-shipment inspection
(PSI) , rules of origin, import licensing procedures, subsidies and countervailing
measures , safeguards, trade in services (GATS), intellectual property rights
(TRIPS), settlement of disputes (DSU), trade policy review mechanism (TPRM)
and plurilateral trade agreements on trade in civil aircraft and government
procurement.
• The Doha Round, formally the Doha Development Agenda, which is the ninth
round since the Second World War was officially launched at the WTO’s Fourth
Ministerial Conference in Doha, Qatar, in November 2001.

• The major issues related to the WTO are in respect of slow progress of
multilateral negotiations, uncertainties resulting from regional trade
agreements, inadequate or negligible trade liberalisation, and those which are
specific to the developing countries, namely, protectionism and lack of
willingness among developed countries to provide market access, difficulties
that they face in implementing the present agreements ,apparent north-south
divide, exceptionally high tariffs, tariff escalation, erosion of preferences and
difficulties with regard to adjustments.
TEST YOUR KNOWLEDGE

1. Which of the following culminated in the establishment of the World Trade
Organization?
(a) The Doha Round
(b) The Tokyo Round
(c) The Uruguay Round
(d) The Kennedy Round
(a) The GATT was meant to prevent exploitation of poor countries by richer
countries
(b) The GATT dealt with trade in goods only, while, the WTO covers services
as well as intellectual property.
(c) All members of the World Trade Organization are required to avoid tariffs
of all types
(d) All the above
3. The ‘National treatment’ principle stands for
(a) the procedures within the WTO for resolving disagreements about trade
policy among countries
(b) the principle that imported products are to be treated no worse in the
domestic market than the local ones
(c) exported products are to be treated no worse in the domestic market than
the local ones

(d) imported products should have the same tariff , no matter where they are
imported from
4. ‘Bound tariff’ refers to
(a) clubbing of tariffs of different commodities into one common measure
(b) the lower limit of the tariff below which a nation cannot be taxing is
imports
(c) the upper limit on the tariff that a country can levy on a particular good,
according to its commitments under the GATT and WTO.
(d) the limit within which the country’s export duty should fall so that there
is cheaper exports
5. The essence of ‘MFN principle’ is
(a) equality of treatment of all member countries of WTO in respect of
matters related to trade
(b) favour one, country , you need to favour all in the same manner
(c) every WTO member will treat all its trading partners equally without any
prejudice and discrimination
(d) all the above
6. The World Trade Organization (WTO)
(a) has now been replaced by the GATT
(b) has an inbuilt mechanism to settle disputes among members
(c) was established to ensure free and fair trade internationally.
(d) b) and c) above
7. The Agreement on Agriculture includes explicit and binding commitments
made by WTO Member governments
(a) on increasing agricultural productivity and rural development
(b) market access and agricultural credit support
(c) market access, domestic support and export subsidies
(d) market access, import subsidies and export subsidies

8. The Agreement on Textiles and Clothing

(a) provides that textile trade should be deregulated by gradually and the
tariffs should be increased
(b) replaced the Multi-Fiber Arrangement (MFA) which was prevalent since
1974
(c) granted rights of textile exporting countries to increase tariffs to protect
their domestic textile industries
(d) stipulated that tariffs in all countries should be the same
9. The Agreement on Trade-Related Aspects of Intellectual Property Rights
(a) stipulates to administer a system of enforcement of intellectual property
rights.
(b) provides for most-favored-nation treatment and national treatment for
intellectual properties
(c) mandates to maintain high levels of intellectual property protection by all
members
(d) all the above
10 The most controversial topic in the yet to conclude Doha Agenda is
(a) trade in manufactured goods
(b) trade in intellectual property rights based goods
(c) trade in agricultural goods
(d) market access to goods from developed countries
11. The WTO commitments
(a) affect developed countries adversely because they have comparatively less
agricultural goods
(b) affect developing countries more because they need to make radical
adjustments
(c) affect both developed and developing countries equally
(d) affect none as they increase world trade and ensure prosperity to all


1. Define the term Regional Trade Agreements (RTAs). What is it’s major
advantage?
2. What is meant by ‘free trade area’?
3. What is the key feature of Monetary Union?
4. What are the peculiarities of the GATT?
5. What are the major functions of the WTO?
6. What do you understand by the term ‘Most-favoured-nation’ (MFN)?
7. What is meant by ‘National Treatment Principle’?
8. How does the WTO agreement ensure market access?
9. Describe the functioning of the dispute settlement mechanism?
10. What is the major aim of the agreement on the ‘Application of Sanitary and
Phytosanitary (SPS) Measures’?
11. What purpose does the Agreement on Technical Barriers to Trade (TBT) serve?
12. What does the agreement on Trade-Related Investment Measures (TRIMs)
stipulate?
13. What do you understand by agreement on Trade-Related Aspects of
Intellectual Property Rights (TRIPS)?
1. Distinguish between different types of regional trade agreements? How are
they different from the WTO agreements?
2. Summarize the course of the history of trade negotiations. What are the major
areas in which trade negotiations were undertaken?
3. Describe the structure and guiding principles of the World Trade Organization
4. Give an overview of the WTO agreements
5. List out the major concerns in respect of functioning of the WTO
6. Do you agree with the statement that the WTO disproportionately benefits
developed nations and impoverished developing nations?

7. What is the objective behind limiting protection by tariffs only? How does it
promote international trade?
IV Applications Oriented Question
Case Scenario
India aims to become a global leader in solar energy and for achieving this; the
Jawaharlal Nehru National Solar Mission (JNNSM) was launched in 2010. To
persuade and to promote producers to participate in the national solar programme,
the government planned long-term power purchase agreements with solar power
producers, thus effectively guaranteeing the sale of the energy produced as well as
the price that solar power producers could obtain. However, there was a stipulation
that the producers should use domestically sourced inputs, namely solar cells and
modules. India lost the case in DSB and WTO has ruled against the stipulation of
local content requirements by government of India.
Answer the following questions
(i) How does the ‘local content requirements’ clause violate the WTO agreements?
(ii) Do you think Indian domestic solar power industry will be affected when India
scraps the local-sourcing regulation as per the ruling of WTO?
ANSWERS/HINTS
1. (c) 2. (b) 3. (b) 4. (c) 5. (d) 6 (d) 7. (c) 8. (b) 9. (d)
10. (c) 11. (b)
1. Regional Trade Agreements (RTAs) are groupings of countries, which are
formed with the objective of reducing barriers to trade between member
countries.; not necessarily belonging to the same geographical region. They
reduce trade barriers on a reciprocal and preferential basis for only the
members of the group.
2. Free-trade area is a group of countries that eliminate all tariff barriers on trade
with each other and retains independence in determining their tariffs with non-
members. Example: NAFTA

3. In a Monetary Union, members share a common currency and macroeconomic

policies. For example, the euro zone countries implement and adopt a single
currency.
4. General Agreement on Tariffs and Trade (GATT) (1948 to 1994) provided the
rules for much of world trade; it was only multilateral instrument governing
international trade or a provisional agreement along with the two full fledged
“Bretton Woods” institutions, the World Bank and the International Monetary
Fund.
5. The principal objective of the WTO is to facilitate the flow of international trade
smoothly, freely, fairly and predictably. The WTO does its functions by acting
as a forum for trade negotiations among member governments, administering
trade agreements, reviewing national trade policies, assisting developing
countries in trade policy issues, through technical assistance and training
programmes and cooperating with other international organizations.
6. Under the WTO agreements, countries cannot normally discriminate between
their trading partners. If a country lowers a trade barrier or opens up a market,
it has to do so for the same goods or services from all other WTO members.
7. With respect to internal taxes, internal laws, etc. applied to imports, treatment
not less favourable than that which is accorded to like domestic products must
be accorded to all other members; i.e a country should not discriminate
between its own and foreign products, services or nationals.
8. The WTO aims to increase world trade by enhancing market access by
converting all non- tariff barriers into tariffs which are subject to country
specific limits. Further, in major multilateral agreements like the Agreement on
Agriculture (AOA), specific targets have been specified for ensuring market
access.
9. The disputes can be referred to the WTO and can pursue a carefully mapped
out, stage-by-stage procedure that includes the possibility of a judgment by a
panel of experts, and the opportunity to appeal the ruling on legal grounds.
The decisions of the dispute settlement body are final and binding.
10. To prevent sanitary and phytosanitary measures from being used for arbitrary
or unjustifiable discrimination or for camouflaged restraint on international
trade and to minimize their adverse effects on trade.

11. Agreement on Technical Barriers to Trade (TBT) aims to prevent standards and
conformity assessment systems from becoming unnecessary trade barriers by
securing their transparency and harmonization with international standards.
12. Establishes disciplines governing investment measures in relation to cross-
border investments by stipulating that countries receiving foreign investments
shall not impose investment measures such as requirements, conditions and
restrictions inconsistent with the provisions of the principle of national
treatment and general elimination of quantitative restrictions.
13. This agreement stipulates most-favored-nation treatment and national
treatment for intellectual properties.
(i) Local-sourcing regulation is considered as a protectionist measure inconsistent
with India’s international obligations under WTO agreement. Discrimination on
the basis of the national ‘origin’ of the cells and modules is a violation of its
trade commitment for ‘national treatment obligation’ under WTO. If the
objective is cost reduction and efficiency, then the solar power producers
should be free to choose energy-generation equipments and components on
the basis of price and quality, irrespective of whether they are manufactured
locally or not. By mandatorily requiring solar power producers to buy locally,
the government has, it is argued, tried to distort competition. This imposes
extra cost, and may possibly be passed on to the final consumers. Therefore,
the interests of the consumers will not be protected.
(ii) The market forces would prevail in respect of solar energy production -The
import competing domestic industry of solar panels and modules may face stiff
competition from imported items, especially those from China. Indian solar
industry is in its infancy. Possibility of subsidized imports and dumping from
different countries. India can evoke anti dumping duties, countervailing duties
and safe guards as provided for in WTO agreements. Need for innovation, cost
reduction and quality improvement of Indian solar industry to compete with
global manufacturers. Since clean energy is a merit good, government may
produce and supply it directly - economies of large scale production can be
reaped leading to cost and price reduction.

UNIT IV: EXCHANGE RATE AND ITS
ECONOMIC EFFECTS
LEARNING OUTCOMES

 Define exchange rate and describe how it is determined
 Appraise different types of exchange rate regimes
 Describe the functioning of the foreign exchange market
 Explain changes in exchange rates and their impact on the real

economy
The Exchange
Rate Regimes
Exchange Rate
International and its Changes in
Trade Economic Exchange Rates
Effects
Devaluation Vs
Depreciation
4.1 INTRODUCTION
Each day we get fascinating news about currency which fuel our curiosity, such as
Rupee gains 12 paise against US dollar, Dollar Spot/Forward Rates plummet, Rupee
down, Euro holds steady, Pound strengthens etc. Ever wondered what these and
other jargons mean? We shall try to understand a few fundamentals related to
currency transactions in this unit.

In chapter 3, we examined the demand for and supply of domestic currency. It is

not domestic currency alone that we need. Households, businesses and
governments in India, for example, buy different types of goods and services
produced in other countries. Similarly, residents of the rest of the world buy goods
and services from residents in India. Foreign investors, businesses, and
governments invest in our country, just as our nationals invest in other countries.
In the same way, lending, and borrowing also take place internationally. These and
similar other transactions give rise to an international dimension of money, which
involves exchange of one currency for another. Obviously, this entails market
transactions involving determination of price of one currency in terms of another.
4.2 THE EXCHANGE RATE

As all of us know, the term ‘Foreign Exchange’ refers to money denominated in a
currency other than the domestic currency. Similar to any other commodity, foreign
exchange has a price. The exchange rate, also known as a foreign exchange (FX)
rate, is the price of one currency expressed in terms of units of another currency
and represents the number of units of one currency that exchanges for a unit of
another. In other words, exchange rate is the rate at which the currency of one
country exchanges for the currency of another country. It is the minimum number
of units of one country’s currency required to purchase one unit of the other
countries currency. It is important to note that the value of a currency is relative as
it is always given in terms of another currency.
There are two ways to express nominal exchange rate between two currencies (e.g.
the US $ and Indian Rupee) namely direct quote and indirect quote. The direct
form of quotation is also called European Currency Quotation whereas indirect
form is known as American Currency Quotation. A direct quote is the number of
units of a local currency exchangeable for one unit of a foreign currency. The price
of 1 dollar may be quoted in terms of how much rupees it takes to buy one dollar.
For example, ` 66/US$ means that an amount of Rs 66 is needed to buy one US
dollar or ` 66 will be received while selling one US dollar. An indirect quote is the
number of units of a foreign currency exchangeable for one unit of local currency;
for example: $ 0.0151 per rupee. A quotation in direct form can easily be converted
into a quotation in indirect form and vice-versa. This is done by taking the
reciprocal of the given rate.
An exchange rate has two currency components; a ‘base currency’ and a ‘counter
currency’. In a direct quotation, the foreign currency is the base currency and the
domestic currency is the counter currency. In an indirect quotation, the domestic

EXCHANGE RATE AND ITS ECONOMIC EFFECTS 4.75
currency is the base currency and the foreign currency is the counter currency. As
the US dollar is the dominant currency in global foreign exchange markets, the
general convention is to apply direct quotes that have the US dollar as the base
currency and other currencies as the counter currency.
There may be two pairs of currencies with one currency being common between
the two pairs. For instance, exchange rates may be given between a pair, X and Y
and another pair, X and Z. The rate between Y and Z is derived from the given rates
of the two pairs (X and Y, and, X and Z) and is called ‘cross rate’. When there is no
difference between the buying and the selling rate, the rate is said to be ‘unique’
or ‘unified’. But, in practice, it is rarely so. . There are generally two rates – selling
rate and buying rate – for any currency when one goes to exchange it in the market.
Selling rate is generally higher than the buying rate for a currency. This is the
commission of the money exchanger (dealer) to run its operations.
4.3 THE EXCHANGE RATE REGIMES

An exchange rate regime is the system by which a country manages its currency in
respect to foreign currencies. It refers to the method by which the value of the
domestic currency in terms of foreign currencies is determined. There are two major
types of exchange rate regimes at the extreme ends; namely:
(i) floating exchange rate regime (also called a flexible exchange rate), and
(ii) fixed exchange rate regime
Under floating exchange rate regime, the equilibrium value of the exchange rate of
a country’s currency is market-determined i.e the demand for and supply of
currency relative to other currencies determine the exchange rate. There is no
predetermined target rate and the exchange rates are likely to change at every
moment in time depending on the changing demand for and supply of currency
in the market. There is no interference on the part of the government or the central
bank of the country in the determination of exchange rate. Any intervention by the
central banks in the foreign exchange market (through purchases or sales of foreign
currency in exchange for local currency) is intended for only moderating the rate
of change and preventing undue fluctuations in the exchange rate, rather than for
establishing a particular level for it. Nevertheless, in a few countries (for example,
New Zealand, Sweden, the United States), the central banks almost never interfere
to administer the exchange rates. Nearly all advanced economies follow floating
exchange rate regimes. Some large emerging market economies also follow the
system.

A fixed exchange rate, also referred to as pegged exchanged rate, is an exchange

rate regime under which a country’s Central Bank and/ or government announces
or decrees what its currency will be worth in terms of either another country’s
currency or a basket of currencies or another measure of value, such as gold. For
example: a certain amount of rupees per dollar. (When a government intervenes in
the foreign exchange market so that the exchange rate of its currency is different
from what the market would have produced, it is said to have established a “peg”
for its currency). In order to sustain a fixed exchange rate, it is not enough that a
country pronounces a fixed parity: it must also make concentrated efforts to defend
that parity by being willing to buy (or sell) foreign reserves whenever the market
demand for foreign currency is lesser (or greater) than the supply of foreign
currency. In other words, in order to maintain the exchange rate at the
predetermined level, the central bank intervenes in the foreign exchange market.
We are often misled to think that it is common for countries to adopt the flexible
exchange rate system. In the real world, there is a spectrum of ‘intermediate
exchange rate regimes’ which are either inflexible or have varying degrees of
flexibility that lie in between these two extremes (fixed and flexible). For example,
a central bank can implement soft peg and hard peg policies. A soft peg refers to
an exchange rate policy under which the exchange rate is generally determined by
the market, but in case the exchange rate tend to be move speedily in one
direction, the central bank will intervene in the market. With a hard peg exchange
rate policy, the central bank sets a fixed and unchanging value for the exchange
rate. Both soft peg and hard peg policy require that the central bank intervene in
the foreign exchange market. The tables 4.4.1 and 4.4.2 show respectively, the IMF
classifications and definitions of prevalent exchange rate systems and the latest
available data (as on April 30, 2016) on the distribution of the 189 IMF members
based on their exchange rate regimes.
Table No: 4.4.1
IMF Classifications and Definitions of Exchange Rate Regimes
Exchange Rate Regimes Description
Exchange arrangements with no Currency of another country circulates as
separate legal tender sole legal tender or member belongs to
a monetary or currency union in which
Dollarization same legal tender is shared by members
of the union.

Currency Board Arrangements Monetary regime based on implicit

national commitment to exchange
Hong Kong Dollar domestic currency for a specified foreign
currency at a fixed exchange rate.
Other conventional fixed peg Country pegs its currency (formal or de
arrangement facto) at a fixed rate to a major currency
or a basket of currencies where exchange
Chinese Yuan rate fluctuates within a narrow margin or
at most ± 1% around central rate
Pegged exchange rates within horizontal Value of the currency is maintained
bands within margins of fluctuation around a
formal or de facto fixed peg that are
wider than ± 1% around central rate.
Crawling Peg Currency is adjusted periodically in small
amounts at a fixed, preannounced rate in
response to changes in certain
quantitative indicators.
Crawling Bands Currency is maintained within certain
fluctuation margins say ( ±1-2 %)
around a central rate that is adjusted
periodically
Managed floating within no Monetary authority influences the
preannounced path for exchange rate: movements of the exchange rate
through active intervention in foreign
exchange markets without specifying a
Indian Rupee pre-announced path for the exchange
rate
Independent floating Exchange rate is market determined,
with any foreign exchange intervention
aimed at moderating the rate of change
US Dollar, Japanese Yen, New Zealand and preventing undue fluctuations in the
Dollar exchange rate, rather than at
establishing a level for it

Table No: 4.4.2

Distribution of IMF Members Based on Exchange Regime
Exchange Rate Arrangement % of IMF Members

Hard peg 13.0
No separate legal tender 7.3
Currency board 5.7
Soft peg 39.6
Conventional peg 22.9
Stabilized arrangement 9.4
Crawling peg 1.6
Crawl-like arrangement 5.2
Pegged exchange rate within horizontal bands 0.5
Floating 37.0
Floating 20.8
Free floating 16.1
Other managed Arrangements 10.4
Source: Annual Report on Exchange Arrangements and Exchange Restrictions, IMF
In an open economy, the main advantages of a fixed rate regime are:

I. A fixed exchange rate avoids currency fluctuations and eliminates exchange
rate risks and transaction costs that can impede international flow of trade and
investments. A fixed exchange rate can thus greatly enhance international
trade and investment.
II. A fixed exchange rate system imposes discipline on a country’s monetary
authority and therefore is more likely to generate lower levels of inflation.
III. The government can encourage greater trade and investment as stability
encourages investment.
IV. Exchange rate peg can also enhance the credibility of the country’s monetary-
policy

V. However, in the fixed or managed floating (where the market forces are
allowed to determine the exchange rate within a band) exchange rate regimes,
the central bank is required to stand ready to intervene in the foreign exchange
market and, also to maintain an adequate amount of foreign exchange reserves
for this purpose.
Basically, the free floating or flexible exchange rate regime is argued to be efficient
and highly transparent as the exchange rate is free to fluctuate in response to the
supply of and demand for foreign exchange in the market and clears the imbalances
in the foreign exchange market without any control of the central bank or the
monetary authority. A floating exchange rate has many advantages:
(i) A floating exchange rate has the great advantage of allowing a Central bank
and /or government to pursue its own independent monetary policy
(ii) Floating exchange rate regime allows exchange rate to be used as a policy tool:
for example, policy-makers can adjust the nominal exchange rate to influence
the competitiveness of the tradeable goods sector
(iii) As there is no obligation or necessity to intervene in the currency markets, the
central bank is not required to maintain a huge foreign exchange reserves.
However, the greatest disadvantage of a flexible exchange rate regime is that
volatile exchange rates generate a lot of uncertainties in relation to international
transactions, and add a risk premium to the costs of goods and assets traded across
borders. In short, a fixed rate brings in more currency and monetary stability and
credibility; but it lacks flexibility. On the contrary, a floating rate has greater policy
flexibility; but less stability.
4.4 NOMINAL VERSUS REAL EXCHANGE RATES

We have been discussing so far about nominal exchange rate which simply states
how much of one currency (i.e. money) can be traded for a unit of another currency
when prices are constant. When prices of goods and services change in either or
both countries, it would be difficult to know the change in relative prices of foreign
goods and services. Therefore, Real Exchange Rate (RER) which incorporates
changes in prices is a better measure. The ‘real exchange rate' describes ‘how
many’ of a good or service in one country can be traded for ‘one’ of that good or
service in a foreign country. It is calculated as :
Domestic Price Index

Real exchange rate = Nominal exchange rate X Foreign price Index

Another exchange rate concept, the Real Effective Exchange Rate (REER) is the
nominal effective exchange rate (a measure of the value of a domestic currency
against a weighted average of variouis foreign currencies) divided by a price
deflator or index of costs. An increase in REER implies that exports become more
expensive and imports become cheaper; therefore, an increase in REER indicates a
loss in trade competitiveness.
4.5 THE FOREIGN EXCHANGE MARKET

The wide-reaching collection of markets and institutions that handle the exchange
of foreign currencies is known as the foreign exchange market. In this market, the
participants use one currency to purchase another currency. The foreign exchange
market operates worldwide and is by far the largest market in the world in terms
of cash value traded. Being an over-the-counter market, it is not a physical place;
rather, it is an electronically linked network of big banks, dealers and foreign
exchange brokers who bring buyers and sellers together. With no central trading
location and no set hours of trading, the foreign exchange market involves
enormous volume of foreign exchange trading worldwide. The participants such as
firms, households, and investors who demand and supply currencies represent
themselves through their banks and key foreign exchange dealers who respond to
market signals transmitted instantly across the world. The foreign exchange
markets operate on very narrow spreads between buying and selling prices. But
since the volumes traded are very large, the traders in foreign exchange markets
stand to make huge profits or losses.
The major participants in the exchange market are central banks, commercial banks,
governments, foreign exchange Dealers, multinational corporations that engage in
international trade and investments, nonbank financial institutions such as asset-
management firms, insurance companies, brokers, arbitrageurs and speculators.
The central banks participate in the foreign exchange markets, not to make profit,
but essentially to contain the volatility of exchange rate to avoid sudden and large
appreciation or depreciation of domestic currency and to maintain stability in
exchange rate in keeping with the requirements of national economy. If the
domestic currency fluctuates excessively, it causes panic and uncertainty in the
business world. Commercial banks participate in the foreign exchange market
either on their own account or for their clients. When they trade on their own
account, banks may operate either as speculators or arbitrageurs/or both. The bulk
of currency transactions occur in the interbank market in which the banks trade
with each other. Foreign exchange brokers participate in the market as

intermediaries between different dealers or banks. Arbitrageurs profit by

discovering price differences between pairs of currencies with different dealers or
banks. Speculators, who are bulls or bears, are deliberate risk-takers who
participate in the market to make gains which result from unanticipated changes in
exchange rates. Other participants in the exchange market are individuals who form
only a very insignificant fraction in terms of volume and value of transactions.
Regardless of physical location, and given that the markets are highly integrated,
at any given moment, all markets tend to have the same exchange rate for a given
currency. This phenomenon occurs because of arbitrage. Arbitrage refers to the
practice of making risk-less profits by intelligently exploiting price differences of
an asset at different dealing locations. There is potential for arbitrage in the forex
market if exchange rates are not consistent between currencies. When price
differences occur in different markets, participants purchase foreign exchange in a
low-priced market for resale in a high-priced market and makes profit in this
process. Due to the operation of price mechanism, the price is driven up in the low-
priced market and pushed down in the high-priced market. This activity will
continue until the prices in the two markets are equalized, or until they differ only
by the amount of transaction costs involved in the operation. Since forex markets
are efficient, any profit spread on a given currency is quickly arbitraged away.
In the foreign exchange market, there are two types of transactions:
(i) current transactions which are carried out in the spot market and the exchange
involves immediate delivery, and
(ii) contracts to buy or sell currencies for future delivery which are carried out in
forward and/or futures markets
Exchange rates prevailing for spot trading (for which settlement by and large takes
two days) are called spot exchange rates. The exchange rates quoted in foreign
exchange transactions that specify a future date are called forward exchange rates.
The currency forward contracts are quoted just like spot rate; however, the actual
delivery of currencies takes place at the specified time in future. When a party
agrees to sell euro for dollars on a future date at a forward rate agreed upon, he
has ‘sold euros forward’ and ‘bought dollars forward’. A forward premium is said to
occur when the forward exchange rate is more than a spot trade rates. On the
contrary, if the forward trade is quoted at a lower rate than the spot trade, then
there is a forward discount. Currency futures, though conceptually similar to
currency forward and perform the same function, they are distinct in their nature
and details concerning settlement and delivery.

While a foreign exchange transaction can involve any two currencies, most
transactions involve exchanges of foreign currencies for the U.S. dollars even when
it is not the national currency of either the importer or the exporter. On account of
its critical role in the forex markets, the dollar is often called a ‘vehicle currency’.
4.6 DETERMINATION OF NOMINAL EXCHANGE RATE

As you already know, the key framework for analyzing prices is the operation of
supply and demand in markets. Usually, the supply of and demand for foreign
exchange in the domestic foreign exchange market determine the external value of
the domestic currency, or in other words, a country’s exchange rate.
Individuals, institutions and governments participate in the foreign exchange
market for a number of reasons. On the demand side, people desire foreign
currency to:
• purchase goods and services from another country
• for unilateral transfers such as gifts, awards, grants, donations or endowments
• to make investment income payments abroad
• to purchase financial assets, stocks or bonds abroad
• to open a foreign bank account
• to acquire direct ownership of real capital, and
• for speculation and hedging activities related to risk-taking or risk-avoidance
activity
The participants on the supply side operate for similar reasons. Thus, the supply of
foreign currency to the home country results from purchases of home exports,
unilateral transfers to home country, investment income payments, foreign direct
investments and portfolio investments, placement of bank deposits and
speculation.
We shall now look into how the foreign exchange markets work. Similar to any
standard market, the exchange market also faces a downward-sloping demand
curve and an upward-sloping supply curve.

Figure 4.4.1
Determination of Nominal Exchange Rate
The equilibrium rate of exchange is determined by the interaction of the supply and demand
for a particular foreign currency. In figure 4.4.1, the demand curve (D$) and supply curve
(S$ )of dollars intersect to determine equilibrium exchange rate eeq with Qe as the equilibrium
quantity of dollars exchanged.
4.7 CHANGES IN EXCHANGE RATES

Changes in exchange rates portray depreciation or appreciation of one currency.
The terms, ` currency appreciation’ and ‘currency depreciation’ describe the
movements of the exchange rate. Currency appreciates when its value increases
with respect to the value of another currency or a basket of other currencies. On
the contrary, currency depreciates when its value falls with respect to the value of
another currency or a basket of other currencies. We shall try to understand this
with the help of an example.
Now suppose, the Rupee dollar exchange rate in the month of January is $1 = ` 65.
And, we find that in the month of April it is $1 = ` 70. What does this indicate? In
April, you will have to exchange a greater amount of Indian Rupees (`70) to get the
same 1 US dollar. As such, the value of the Indian Rupee has gone down or Indian
Rupee has depreciated in its value. Rupee depreciation here means that the rupee
has become less valuable with respect to the U.S. dollar. Simultaneously, if you look
at the value of dollar in terms of Rupees, you find that the value of the US dollar
has increased in terms of the Indian Rupee. One dollar will now fetch ` 70 instead
of ` 65 earlier. This is called appreciation of the US dollar. You might have observed

that when one currency depreciates against another, the second currency must
simultaneously appreciate against the first.
To put it more clearly:
• Home-currency depreciation (which is the same as foreign-currency appre-
ciation) takes place when there is an increase in the home currency price of the
foreign currency (or, alternatively, a decrease in the foreign currency price of
the home currency). The home currency thus becomes relatively less valuable.
• Home-currency appreciation or foreign-currency depreciation takes place
when there is a decrease in the home currency price of foreign currency (or
alternatively, an increase in the foreign currency price of home currency). The
home currency thus becomes relatively more valuable.
Under a floating rate system, if for any reason, the demand curve for foreign
currency shifts to the right representing increased demand for foreign currency,
and supply curve remains unchanged, then the exchange value of foreign currency
rises and the domestic currency depreciates in value. This is illustrated in figure
4.4.2.
Figure 4.4.2
Home-Currency Depreciation under Floating Exchange Rates
The market reaches equilibrium at point E with equilibrium exchange rate e eq. An
increase in domestic demand for the foreign currency, with supply of dollars
remaining constant, is represented by a rightward shift of the demand curve to D1$.

The equilibrium exchange rate rises to e1. It means that more units of domestic
currency (here Indian Rupees) are required to buy a unit of foreign exchange
(dollar) and that the domestic currency (the Rupee) has depreciated.
We shall now examine what happens when there is an increase in the supply of
dollars in the Indian market. This is illustrated in figure 4.4.3.
Figure 4.4.3
Home-Currency Appreciation under Floating Exchange Rates
An increase in the supply of foreign exchange shifts the supply curve to the right
to S1 $ and as a consequence, the exchange rate declines to e1. It means, that lesser
units of domestic currency (here Indian Rupees) are required to buy a unit of
foreign exchange (dollar), and that the domestic currency (the Rupee) has
appreciated.
As we are aware, in an open economy, firms and households use exchange rates to
translate foreign prices into domestic currency terms. Exchange rates also permit
us to compare the prices of goods and services produced in different countries.
Furthermore, import or export prices could be expressed in terms of the same
currency in the trading contract. This is the reason why exchange rate movements
can affect intentional trade flows.

4.8 DEVALUATION (REVALUATION) VS DEPRECIATION

(APPRECIATION)
Devaluation is a deliberate downward adjustment in the value of a country's
currency relative to another currency, group of currencies or standard. It is
a monetary policy tool used by countries that have a fixed exchange rate or nearly
fixed exchange rate regime and involves a discrete official reduction in the
otherwise fixed par value of a currency. The monetary authority formally sets a new
fixed rate with respect to a foreign reference currency or currency basket. In
contrast, depreciation is a decrease in a currency's value (relative to other major
currency benchmarks) due to market forces under a floating exchange rate and not
due to any government or central bank policy actions.
Revaluation is the opposite of devaluation and the term refers to a discrete raising
of the otherwise fixed par value of a nation’s currency. Appreciation, on the other
hand, is a increase in a currency's value (relative to other major currencies) due
to market forces under a floating exchange rate and not due to any government
or central bank policy interventions.
4.9 IMPACTS OF EXCHANGE RATE FLUCTUATIONS ON

DOMESTIC ECONOMY
The fact that among the macroeconomic variables, exchange rates are perhaps the
most closely monitored, analyzed and manipulated economic measure highlights
the overwhelming importance of exchange rates in an economy. The
unpredictability of the markets caused by exchange rate changes can profoundly
influence the economy of countries. As a matter of fact, it is most likely that
exchange rate fluctuations may determine a country’s economic performance.
Knowledge about the possible effects of exchange rate fluctuations enables us to
have an understanding of the appropriateness of exchange rate policy, especially
in developing countries. In the discussion that follows, we shall examine the impact
of exchange rate fluctuations on the real economy.
The developments in the foreign exchange markets affect the domestic economy
both directly and indirectly. The direct impact of fluctuations in rates is initially felt
by economic agents who are directly involved in international trade or international
finance. In judging the impacts of exchange rate fluctuations, it becomes, therefore,
necessary to evaluate their effects on trade, investments, consumption output,
economic growth and inflation.

(i) Exchange rates have a very significant role in determining the nature and
extent of a country's trade. Changes in import and export prices will lead to
changes in import and export volumes, causing changes in import spending
and export revenue.
(ii) Fluctuations in the exchange rate affect the economy by changing the relative
prices of domestically-produced and foreign-produced goods and services. All
else equal (or other things remaining the same), an appreciation of a country’s
currency raises the relative price of its exports and lowers the relative price of
its imports. Conversely, a depreciation lowers the relative price of a country’s
exports and raises the relative price of its imports. When a country’s currency
depreciates, foreigners find that its exports are cheaper and domestic residents
find that imports from abroad are more expensive. An appreciation has
opposite effects i.e foreigners pay more for the country’s products and
domestic consumers pay less for foreign products. For example; assume that
there is devaluation or depreciation of Indian Rupee from $1=Rs 65/ to
$1=Rs 70/.A foreigner who spends ten dollars on buying Indian goods will,
post devaluation, get goods worth Rs.700/ instead of Rs 650/ prior to
depreciation. An importer has to pay for his purchases in foreign currency, and,
therefore, a resident of India, who wants to import goods worth $1 will have to
pay Rs 70/ instead of Rs 65/ prior to depreciation. Importers will be affected
most as they will have to pay more rupees on importing products. On the
contrary, exporters will be benefitted as goods exported abroad will fetch
dollars which can now be converted to more rupees.
(iii) Exchange rate changes affect economic activity in the domestic economy. A
depreciation of domestic currency primarily increases the price of foreign
goods relative to goods produced in the home country and diverts spending
from foreign goods to domestic goods. Increased demand, both for domestic
import-competing goods and for exports encourages economic activity and
creates output expansion. Overall, the outcome of exchange rate depreciation
is an expansionary impact on the economy at an aggregate level. The positive
effect of currency depreciation, however, largely depends on whether the
switching of demand has taken place in the right direction and in the right
amount, as well as on the capacity of the home economy to meet the additional
demand by supplying more goods to meet the increased domestic demand.
(iv) By lowering export prices, currency depreciation helps increase the
international competitiveness of domestic industries, increases the volume of
exports and promotes trade balance. However, a point to be noted is that the

price changes in exports and imports may counterbalance or offset each other
only if trade is in balance and terms of trade are not changed. In case the
country’s imports exceed exports, the net result is a reduction in real income
within the country.
(v) We have seen above that by changing the relative prices, depreciation may
increase windfall profits in export and import-competing industries. However,
depreciation may also cause contractionary effects. We shall see how it may
happen. In an under developed or semi industrialized country, where - inputs
(such as oil) and components for manufacturing are mostly imported and
cannot be domestically produced, increased import prices will increase firms’
cost of production , push domestic prices up and decrease real output.
(vi) For an economy where exports are significantly high, a depreciated currency
would mean a lot of gain. In addition, if exports originate from labour-intensive
industries, increased export prices will have positive effect employment
income and potentially on wages.
(vii) Depreciation is also likely to add to consumer price inflation in the short run,
directly through its effect on prices of imported consumer goods and also due
to increased demand for domestic goods. The impact will be greater if the
composition of domestic consumption baskets consists more of imported
goods. Indirectly, cost push inflation may result through possible escalation in
the cost of imported inputs. In such an inflationary situation, the central bank
of the country will have no incentive to cut policy rates as this is likely to
increase the burden of all types of borrowers including businesses.
(viii) When a country’s currency depreciates, production for exports and of import
substitutes become more profitable. Therefore, factors of production will be
induced to move into the tradable goods sectors and out of the non tradable
goods sectors. The reverse will be true when the currency appreciates. These
types of resource movements involve economic wastes.
(ix) A depreciation or devaluation is also likely to affect a country’s terms of trade.
(Terms of trade is the ratio of the price of a country’s export commodity to the
price of its import commodity) Since the prices of both exports and imports
rise in terms of the domestic currency as a result of depreciation or devaluation,
the terms of trade of the nation can rise , fall or remain unchanged, depending
on whether price of exports rises by more than , less than or same percentages
as price of imports.

(x) The fiscal health of a country whose currency depreciates is likely to be affected
with rising export earnings and import payments and consequent impact on
current account balance. A widening current account deficit is a danger signal
as far as growth prospects of the overall economy is concerned. If export
earnings rise faster than the imports spending then current account will
improve otherwise not.
(xi) Companies that have borrowed in foreign exchange through external
commercial borrowings (ECBs) but have been careless and did not sufficiently
hedge these loans against foreign exchange risks would also be negatively
impacted as they would require more domestic currency to repay their loans.
A depreciated domestic currency would also increase their debt burden and
lower their profits and impact their balance sheets adversely. These would
signal investors who will be discouraged from investing in such companies.
(xii) Countries with foreign currency denominated government debts, currency
depreciation will increase the interest burden and cause strain to the exchequer
for repaying and servicing foreign debt. Fortunately, India’s has small
proportion of public debt in foreign currency.
(xiii) Exchange rate fluctuations make financial forecasting more difficult for firms
and larger amounts will have to be earmarked for insuring against exchange
rate risks through hedging.
(xiv) With growth of investments across international boundaries, exchange rates
have assumed special significance. Investors who have purchased a foreign
asset, or the corporation which floats a foreign debt, will find themselves facing
foreign exchange risk. Exchange rate movements have become the single most
important factor affecting the value of investments on an international level.
They are critical to business volumes, profit forecasts, investment plans and
investment outcomes. Depreciating currency hits investor sentiments and has
radical impact on patterns of international capital flows.
(xv) Foreign investors are likely to be indecisive or highly cautious before investing
in a country which has high exchange rate volatility. Foreign capital inflows are
characteristically vulnerable when local currency weakens. Therefore foreign
portfolio investment flows into debt and equity as well as foreign direct
investment flows are likely to shrink. This shoots up capital account deficits
affecting the country’s fiscal health. If investor sentiments are such that they
anticipate further depreciation, there may be large scale withdrawal of
portfolio investments and huge redemptions through global exchange traded

funds leading to further depreciation of domestic currency. This may result in

a highly volatile domestic equity market affecting the confidence of domestic
investors. Reduced foreign investments also widen the gap between
investments required for growth and actual investments. Over a period of time,
unemployment is likely to mount in the economy.
With increasing dependence on imports, Indian economy has always felt the brunt
of higher international prices of fuel impacting domestic transportation and overall
cost of production which often triggered inflation, increase in oil and fertilizer
subsidy bills, costly foreign travel, escalated foreign debt service payments and
higher outstanding external commercial borrowings (or ECB) and government’s
foreign debt.
The other impacts of currency depreciation are:
(i) Windfall gains for export oriented sectors (such as IT sector, textile,
pharmaceuticals, gems and jewelry in the case of India) because depreciating
currency fetches more domestic currency per unit of foreign currency.
(ii) Remittances to homeland by non residents and businesses abroad fetches
more in terms of domestic currency
(iii) Depreciation would enhance government revenues from import related taxes,
especially if the country imports more of essential goods
(iv) Depreciation would result in higher amount of local currency for a given
amount of foreign currency borrowings of government.
(v) Depreciation also can have a positive impact on country’s trade deficit as it
makes imports more expensive for domestic consumers and exports cheaper
for foreigners.
(vi) Depreciation also can have a positive impact on controlling spiraling gold
imports (mostly wasteful) and thereby improve trade balance.
An appreciation of currency or a strong currency (or possibly an overvalued
currency) makes the domestic currency more valuable and, therefore, can be
exchanged for a larger amount of foreign currency. An appreciation will have the
following consequences on real economy:
(i) An appreciation of currency raises the price of exports and, therefore, the
quantity of exports would fall. Since imports become cheaper, we may expect
an increase in the quantity of imports. Combining these two effects together,

the domestic aggregate demand falls and, therefore, economic growth is likely
to be negatively impacted.
(ii) The outcome of appreciation also depends on the stage of the business cycle
as well. If appreciation sets in during the recessionary phase, the result would
be a further fall in aggregate demand and higher levels of unemployment. If
the economy is facing a boom, an appreciation of domestic currency would
trim down inflationary pressures and soften the rate of growth of the economy.
(iii) An appreciation may cause reduction in the levels of inflation because imports
are cheaper. Lower price of imported capital goods, components and raw
materials lead to decrease in cost of production which reflects on decrease in
prices. Additionally, decrease in aggregate demand tends to lower demand pull
inflation. Living standards of people are likely to improve due to availability of
cheaper consumer goods.
(iv) With increasing export prices, the competitiveness of domestic industry is
adversely affected and, therefore, firms have greater incentives to introduce
technological innovations and capital intensive production to cut costs to
remain competitive.
(v) Increasing imports and declining exports are liable to cause larger deficits and
worsen the current account. However, - the impact of appreciation on current
account depends upon the elasticity of demand for exports and imports.
Relatively inelastic demand for imports and exports may lead to an
improvement in the current account position. Higher the price elasticity of
demand for exports , greater would be the fall in demand and higher will be
the fall in the aggregate value of exports. This will adversely affect the current
account balance.
(vi) Loss of competitiveness will be insignificant if currency appreciation is because
of strong fundamentals of the economy.
From the discussions in this unit, we understand that all countries would desire to
have steady exchange rates to eliminate the risks and uncertainties associated with
international trade and investments. However, nations may sometimes go in for
tradeoffs with weaker exchange rate to stimulate exports and aggregate demand,
or a stronger exchange rate to fight inflation. Learners may keep themselves well-
informed on contemporary exchange rate developments and their implications on
the economic welfare of countries.

SUMMARY
• Exchange rate is the rate at which the currency of one country exchanges for
the currency of another country
• A direct quote (European Currency Quotation) is the number of units of a local
currency exchangeable for one unit of a foreign currency. For example, Rs
65/US$
• An indirect quote (American Currency Quotation).is the number of units of a
foreign currency exchangeable for one unit of local currency; for example: $
0.0151 per rupee.
• In a direct quotation, the foreign currency is the base currency and the
domestic currency is the counter currency. In an indirect quotation, the
domestic currency is the base currency and the foreign currency is the counter
currency
• The rate between Y and Z which is derived from the given rates of another set
of two pairs of currency (say, X and Y, and, X and Z) is called cross rate.
• An exchange rate regime is the system by which a country manages its currency
in respect to foreign currencies.
• There are two major types of exchange rate regimes at the extreme ends;
namely floating exchange rate regime, (also called a flexible exchange rate)
and fixed exchange rate regime
• Under floating exchange rate regime the equilibrium value of the exchange
rate of a country’s currency is market determined i.e the demand for and supply
of currency relative to other currencies determines the exchange rate.
• A fixed exchange rate, also referred to as pegged exchanged rate, is
an exchange rate regime under which a country’s government announces, or
decrees, what its currency will be worth in terms of either another country’s
currency or a basket of currencies or another measure of value, such as gold.
• A central bank may implement soft peg policy under which the exchange rate
is generally determined by the market, or a hard peg where the central bank
sets a fixed and unchanging value for the exchange rate
• A fixed exchange rate avoids currency fluctuations and eliminates exchange
rate risks and transaction costs, enhances international trade and investment
and lowers the levels of inflation. But, the central bank has to maintain an

adequate amount of reserves and be always ready to intervene in the foreign

exchange market.
• A floating exchange rate allows a government to pursue its own independent
monetary policy and there is no need of market intervention or maintenance
of reserves. But, volatile exchange rates generate a lot of uncertainties in
relation to international transactions,
• The ‘real exchange rate' incorporates changes in prices and describes ‘how
many’ of a good or service in one country can be traded for ‘one’ of that good
or service in a foreign country.
Domestic price Index
Real exchange rate = Nominal exchange rate X
Foreign price Index
• Real Effective Exchange Rate (REER) is the nominal effective exchange rate (a
measure of the value of a currency against a weighted average of various
foreign currencies) divided by a price deflator or index of costs.
• The wide-reaching collection of markets and institutions that handle the
exchange of foreign currencies is known as the foreign exchange market. Being
an over-the-counter market, it is not a physical place; rather, it is an
electronically linked network bringing buyers and sellers together and has only
very narrow spreads
• On account of arbitrage, regardless of physical location, at any given moment,
all markets tend to have the same exchange rate for a given currency. Arbitrage
refers to the practice of making risk-less profits by intelligently exploiting price
differences of an asset at different dealing places.
• There are two types of transactions in a forex market: current transactions
which are carried out in the spot market and contracts to buy or sell currencies
for future delivery which are carried out in forward and futures markets
• Usually, the supply of and demand for foreign exchange in the domestic
foreign exchange market determine the external value of the domestic
currency, or in other words, a country’s exchange rate.
• Changes in exchange rates portray depreciation or appreciation of one
currency. The terms, ‘currency appreciation’ and ‘currency
depreciation’ describe the movements of the exchange rate.
• Currency appreciates when its value increases with respect to the value of
another currency or a basketof other currencies. On the contrary, currency

depreciates when its value falls with respect to the value of another currency
or a basket of other currencies.
• Devaluation is a deliberate downward adjustment by central bank in the value
of a country's currency relative to another currency, group of currencies or
standard.
• An appreciation of a country’s currency cause changes in import and export
prices will lead to changes in import and export volumes, causing resulting in
import spending and export earnings
• Exchange rate depreciation lowers the relative price of a country’s exports,
raises the relative price of its imports, increases demand both for domestic
import-competing goods and for exports, leads to output expansion,
encourages economic activity, increases the international competitiveness of
domestic industries ,increases the volume of exports and improves trade
balance.
• Currency appreciation raises the price of exports, decrease exports; increase
imports, adversely affect the competitiveness of domestic industry, cause
larger deficits and worsens the trade balance.
TEST YOUR KNOWLEDGE

1. Based on the supply and demand model of determination of exchange rate,
which of the following ought to cause the domestic currency of Country X to
appreciate against dollar?
(a) The US decides not to import from Country X
(b) An increase in remittances from the employees who are employed abroad
to their families in the home country
(c) Increased imports by consumers of Country X
(d) Repayment of foreign debts by Country X
2. All else equal, which of the following is true if consumers of India develop taste
for imported commodities and decide to buy more from the US?
(a) The demand curve for dollars shifts to the right and Indian Rupee
appreciates
(b) The supply of US dollars shrink and, therefore, import prices decrease

(c) The demand curve for dollars shifts to the right and Indian Rupee
depreciates
(d) The demand curve for dollars shifts to the left and leads to an increase in
exchange rate
3. ‘The nominal exchange rate is expressed in units of one currency per unit of
the other currency. A real exchange rate adjusts this for changes in price levels’.
The statements are
(a) wholly correct
(b) partially correct
(c) wholly incorrect
4. Match the following by choosing the term which has the same meaning
i) floating exchange rate a. fixed exchange rate
ii) pegged exchange rate b. depreciation
iii) devaluation c. revaluation
iv) appreciation d. flexible exchange rate

(a) (i c ) ; ( ii d) ;( iii b); (iv a))
(b) (i b) ; ( ii a) ;( iii d); (iv c )
(c) (i a ) ; ( ii d ) ;( iii b); (iv c )
(d) (i d) ; ( ii a) ;( iii b); (iv c )
(a) An indirect quote is the number of units of a local currency exchangeable
for one unit of a foreign currency
(b) the fixed exchange rate regime is said to be efficient and highly
transparent
(c) A direct quote is the number of units of a local currency exchangeable for
one unit of a foreign currency
(d) Exchange rates are generally fixed by the central bank of the country

6. Which of the following statements is true?

(a) Home-currency appreciation or foreign-currency depreciation takes place
when there is a decrease in the home currency price of foreign currency
(b) Home-currency depreciation takes place when there is an increase in the
home currency price of the foreign currency
(c) Home-currency depreciation is the same as foreign-currency appreciation
and implies that the home currency has become relatively less valuable.
(d) All the above
7. An increase in the supply of foreign exchange
(a) shifts the supply curve to the right and as a consequence, the exchange
rate declines
(b) shifts the supply curve to the right and as a consequence, the exchange
rate increases
(c) more units of domestic currency are required to buy a unit of foreign
exchange
(d) the domestic currency depreciates and the foreign currency appreciates
8. Currency devaluation
(a) may increase the price of imported commodities and, therefore, reduce
the international competitiveness of domestic industries
(b) may reduce export prices and increase the international competitiveness
of domestic industries
(c) may cause a fall in the volume of exports and promote consumer welfare
through increased availability of goods and services
9. At any point of time , all markets tend to have the same exchange rate for a
given currency due to
(a) Hedging
(b) Speculation
(c) Arbitrage
(d) Currency futures

10. ‘Vehicle Currency’ refers to

(a) a currency that is widely used to denominate international contracts made
by parties because it is the national currency of either of the parties
(b) a currency that is traded internationally and, therefore, is in high demand
(c) a type of currency used in euro area for synchronization of exchange rates
(d) a currency that is widely used to denominate international contracts made
by parties even when it is not the national currency of either of the parties
1. Define exchange rate
2. Distinguish between direct quote and indirect quote?
3. What do you understand by the term ‘cross rate’?
4. What is an ‘exchange rate regime’?
5. Which are the major types of exchange rate regimes?
6. How is exchange rate determined under floating exchange rate regime?
7. Define fixed exchange rate?
8. What are the major merits of floating exchange rate?
9. Mention the main demerit of floating exchange rate?
10. Explain the term ‘real exchange rate’
11. Define Real Effective Exchange Rate (REER)
12. Describe the chief characteristics of foreign exchange market?
13. What is Arbitrage? What is the outcome of Arbitrage?
14. Mention the types of transactions in the forex market?
15. Describe the term currency appreciation?
16. What is meant by devaluation?
1. Distinguish between fixed exchange rate and floating exchange rate? What are
the merits and demerits of each?

2. Describe how exchange rate is determined under different exchange rate

regimes?
3. Evaluate the relative merits and demerits of different types of exchange rate
regimes?
4. What are the characteristic features of foreign exchange market? Who are the
participants in the foreign exchange market?
5. Describe the functioning of the foreign exchange market? What are the
different roles played by the participants in the foreign exchange market?
6. What do you understand by appreciation and depreciation of currency? How
do they affect real economy?
7. Explain the effects of currency depreciation? Do you consider a weak currency
is advantageous to a country?
8. Explain the nature of changes in exchange rates and their impact on real
economy?
9. ‘An overvalued currency is a bane for an economy’ Do you agree with the
statement? Give examples.
10. ‘Flexible exchange rates reflect the true fiscal health of the economy’ Elucidate.
I. Explain the implications of the following on the demand and supply of foreign
exchange and the exchange rate in spot foreign exchange market.
(i) Sherry Land’s exports remained more or less stagnant in the years 2005-
06 to 2016-17. However, due to heavy thrust on industrialization, import
of machinery, raw materials and components as well as associated services
of different types increased.
(ii) The investors of Merry Land find investments in financial assets in UK
highly attractive and the government of Merry Land which has a liberal
attitude on foreign investments permits such investments.
(iii) Many foreign investors who had previously acquired Roseland ’s financial
assets sell them
(iv) Effect on Country Y if Country X borrows $ 100 billion from country Y
II. Explain how the exchange value of Indian Rupee will be affected in each of the
following cases. What are the possible consequences on exports and imports?

(i) The spot exchange rate changes from Rs 61/ 1$ to Rs 64/1$

(ii) The spot exchange rate changes from Rs 66/ 1$ to Rs 63/1$
III. In 1983 Australia decided to float its dollar. Assuming free trade, explain the
effects of each of the following on the spot exchange rate between AUD and
USD.
(i) There is a substantial increase demand in Australia for US exports of
services. Since Australia manufactures were favoured over others, there is
a proportionate increase in exports of Australian products to the US
(ii) Investors in Australia perceive that the returns on investments in the US
would be much more lucrative than elsewhere. As a result there is a huge
increase in demand for investments in US dollar denominated financial
investments
(iii) Political uncertainties in the US due to presidential elections caused large
scale shift of Australian financial investments back in to Australia
(iv) An epidemic in some parts of Australia made the US evoke SPS measures
and ban the entry of a number of food items to the US
ANSWERS/HINTS
1. (b) 2. (c) 3. (a) 4. (d) 5. (c) 6 (d)
7. (a) 8. (b) 9. (c) 10. (d)
1. The price of one currency expressed in terms of units of another currency-
represents the number of units of one currency that exchanges for a unit of
another
2. A direct quote (European Currency Quotation) is the number of units of a local
currency exchangeable for one unit of a foreign currency. For example, Rs
66/US$. An indirect quote (American Currency Quotation).is the number of
units of a foreign currency exchangeable for one unit of local currency; for
example: $ 0.0151 per rupee.
3. The rate between Y and Z which is derived from the given rates of another set
of two pairs of currency (say, X and Y, and, X and Z) is called “cross rate”.

4. An exchange rate regime is the system by which a country manages its currency
in respect to foreign currencies.
5. There are two major types of exchange rate regimes at the extreme ends;
namely floating exchange rate regime, (also called a flexible exchange rate)
and fixed exchange rate regime
6. Under floating exchange rate regime the equilibrium value of the exchange
rate of a country’s currency is market determined i.e the demand for and supply
of currency relative to other currencies determines the exchange rate.
7. A fixed exchange rate, also referred to as pegged exchanged rate, is
an exchange rate regime under which a country’s government or central bank
announces, or decrees, what its currency will be worth in terms of either
another country’s currency or a basket of currencies or another measure of
value, such as gold.
8. A floating exchange rate allows a government to pursue its own independent
monetary policy and there is no need of market intervention or maintenance
of reserves.
9. The volatile exchange rates generate a lot of uncertainties in relation to
international transactions
10. The ‘real exchange rate' incorporates changes in prices and describes ‘how
many’ of a good or service in one country can be traded for ‘one’ of that good
or service in a foreign country.
Real exchange rate = Nominal exchange rate X
Foreign price Index
11. Real Effective Exchange Rate (REER) is the nominal effective exchange rate (a
measure of the value of a currency against a weighted average of various
foreign currencies) divided by a price deflator or index of costs.
12. The wide-reaching collection of markets and institutions that handle the
exchange of foreign currencies is known as the foreign exchange market. Being
an over-the-counter market, it is not a physical place; rather, it is an
electronically linked network bringing buyers and sellers together and has only
very narrow spreads.
13. Arbitrage refers to the practice of making risk-less profits by intelligently
exploiting price differences of an asset at different dealing places. On account
of arbitrage, regardless of physical location, at any given moment, all markets
tend to have the same exchange rate for a given currency.

14. There are two types of transactions in a forex market ; current transactions
which are carried out in the spot market and contracts to buy or sell currencies
for future delivery which are carried out in forward and futures markets
15. Currency appreciates when its value increases with respect to the value of
another currency or a basket of other currencies. On the contrary, currency
depreciates when its value falls with respect to the value of another currency
or a basket of other currencies.
16. Devaluation is a deliberate downward adjustment in the value of a country's
currency relative to another currency, group of currencies or standard.
I. (i) Higher demand in Sherry Land for foreign exchange (say $) to make
development imports for industrialization ; coupled with no proportionate
increase in supply on account of meager inflow of foreign exchange
consequent on stagnant exports for more than a decade, lead to rise in
exchange rate and depreciation in the value of domestic currency.
(ii) Increased demand for foreign exchange in Australia; the domestic currency
depreciates
(iii) Increased demand for foreign exchange ; Roseland’s domestic currency
depreciates
(iv) International capital outflow: demand for foreign currency-outflow of
foreign exchange , depreciation of domestic currency
II. (i) The spot exchange rate changes from Rs 61/ 1$ to Rs 64/1$. It implies
depreciation of Rupee and appreciation of Dollar. Exports become cheaper
and more attractive to foreigners; imports will be discouraged as they
become costlier to import.
(ii) The spot exchange rate changes from Rs 66/ 1$ to Rs 63/1$. This means
that Rupee has appreciated in value and dollar has depreciated. Exports
become costlier and so demand for Indian exports may fall; imports
become cheaper.
III. (i) The spot exchange rate between AUD and USD will not be affected as
increased demand for foreign currency in each country will be matched by
a proportionate increase in the supply of foreign exchange.
(ii) Investors in Australia would demand more USD for making dollar
denominated financial investments in the US. Supply of US dollars

remaining the same, being in floating rate, AUD will depreciate and USD
will appreciate.
(iii) Large scale shift of Australian financial investments back to home due to
political uncertainties in the US would result in large scale sale of financial
assets and capital outflow from the US. This will lead to more inflow of US
dollars to Australia and demand remaining the same, depreciation in the
value of USD viz a viz AUD.
(iv) Ban of exports to the US reduces USD inflows to Australia; demand for USD
remaining the same, AUD may depreciate.

UNIT V: INTERNATIONAL CAPITAL
MOVEMENTS
LEARNING OUTCOMES

 Describe the nature and types of foreign capital
 Distinguish between foreign direct investment and foreign

institutional investment
 Outline the factors influencing foreign investments
 Elucidate the potential costs and benefits of foreign direct

investment
 Explain the state-of-affairs of foreign direct investment in India
International Trade
International Capital Movements
FDI FPI
5.1 INTRODUCTION
In unit one, our focus was on international trade in goods and services. of late, we
find enormous increase in international movement of capital. This phenomenon has
received a great deal of attention from not just economists and policy-makers but
people in different walks of life including workers’ organisations and members of
the civil society. In this unit, we shall look into international capital movements;
more precisely into why do capital move across national boundaries and what are
the consequences of such capital movements. We shall also briefly touch upon the
FDI situation in India.

5.2 TYPES OF FOREIGN CAPITAL

The term 'foreign capital' is a comprehensive one and includes any inflow of capital
into the home country from abroad and therefore, we need to be clear about the
distinction between movement of capital and foreign investment. Foreign capital
may flow into an economy in different ways. Some of the important components
of foreign capital flows are:
1. Foreign aid or assistance which may be:
(a) Bilateral or direct inter government grants
(b) Multilateral aid from many governments who pool funds to international
organizations like the World Bank
(c) Tied aid with strict mandates regarding the use of money or untied aid
where there are no such stipulations
(d) Foreign grants which are voluntary transfer of resources by governments,
institutions, agencies or organizations
2. Borrowings which may take different forms such as:
(a) Direct inter government loans
(b) Loans from international institutions (e.g. world bank, IMF, ADB)
(c) Soft loans for e.g. from affiliates of World Bank such as IDA
(d) External commercial borrowing, and
(e) Trade credit facilities
3. Deposits from non-resident Indians (NRI)
4. Investments in the form of :
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and
(ii) Foreign direct investment(FDI) in industrial, commercial and similar other
enterprises
A detailed discussion about all types of capital movements is beyond the scope of this
unit and therefore, we shall concentrate only on foreign investments.

INTERNATIONAL CAPITAL MOVEMENTS 4.105
5.3 FOREIGN DIRECT INVESTMENT (FDI )

When we talk about international investments, we should first of all distinguish
between two types of investments namely, Foreign Direct Investment (FDI) and
Foreign Portfolio Investment (FPI). Foreign direct investment is defined as a
process whereby the resident of one country (i.e. home country) acquires ownership
of an asset in another country (i.e. the host country) and such movement of capital
involves ownership, control as well as management of the asset in the host country.
Foreign direct investment (FDI), according to IMF manual on 'Balance of payments'
is "all investments involving a long term relationship and reflecting a lasting interest
and control of a resident entity in one economy in an enterprise resident in an
economy other than that of the direct investor”. This typically occurs through
acquisition of more than 10 percent of the shares of the target asset. Direct
investment comprises not only the initial transaction establishing the relationship
between the investor and the enterprise, but also all subsequent transactions
between them and among affiliated enterprises, both incorporated and
unincorporated.
According to the IMF and OECD definitions, the acquisition of at least ten percent
of the ordinary shares or voting power in a public or private enterprise by non-
resident investors makes it eligible to be categorized as foreign direct investment
(FDI). India also follows the same pattern of classification. FDI has three
components, viz., equity capital, reinvested earnings and other direct capital in the
form of intra-company loans between direct investors (parent enterprises) and
affiliate enterprises.
Foreign direct investors may be individuals, incorporated or unincorporated private
or public enterprises, associated groups of individuals or enterprises, governments
or government agencies, estates, trusts, or other organizations or any combination
of the above mentioned entities. The main forms of direct investments are: the
opening of overseas companies, including the establishment of subsidiaries or
branches, creation of joint ventures on a contract basis, joint development of
natural resources and purchase or annexation of companies in the country
receiving foreign capital.
Direct investments are real investments in factories, assets, land, inventories etc.
and involve foreign ownership of production facilities. The investor retains control
over the use of the invested capital and also seeks the power to exercise control
over decision making to the extent of its equity participation. The lasting interest
implies the existence of a long-term relationship between the direct investor and

the enterprise and a significant degree of influence by the investor on the

management of the enterprise.
Based on the nature of foreign investments, FDI may be categorized as horizontal,
vertical or conglomerate.
i) A horizontal direct investment is said to take place when the investor
establishes the same type of business operation in a foreign country as it
operates in its home country, for example, a cell phone service provider based
in the United States moving to India to provide the same service.
ii) A vertical investment is one under which the investor establishes or acquires a
business activity in a foreign country which is different from the investor’s main
business activity yet in some way supplements its major activity. For example;
an automobile manufacturing company may acquire an interest in a foreign
company that supplies parts or raw materials required for the company.
iii) A conglomerate type of foreign direct investment is one where an investor
makes a foreign investment in a business that is unrelated to its existing
business in its home country. This is often in the form of a joint venture with a
foreign firm already operating in the industry as the investor has no previous
experience.
Yet another category of investments is ‘two- way direct foreign investments’
which are reciprocal investments between countries that occur when some
industries are more advanced in one nation (for example, the computer
industry in the United States), while other industries are more efficient in other
nations (such as the automobile industry in Japan).
5.4 FOREIGN PORTFOLIO INVESTMENT (FPI)

Foreign portfolio investment is the flow of what economists call ‘financial capital’
rather than ‘real capital’ and does not involve ownership or control on the part of
the investor. Examples of foreign portfolio investment are the deposit of funds in
an Indian or a British bank by an Italian company or the purchase of a bond (a
certificate of indebtedness) of a Swiss company or of the Swiss government by a
citizen or company based in France. Unlike FDI, portfolio capital, in general, moves
to investment in financial stocks, bonds and other financial instruments and is
effected largely by individuals and institutions through the mechanism of capital
market. These flows of financial capital have their immediate effects on balance of
payments or exchange rates rather than on production or income generation.

Foreign portfolio investment (FPI) is not concerned with either manufacture of

goods or with provision of services. Such investors also do not have any intention
of exercising voting power or controlling or managing the affairs of the company
in whose securities they invest. The singular intention of a foreign portfolio investor
is to earn a remunerative return through investment in foreign securities and is
primarily concerned about the safety of their capital, the likelihood of appreciation
in its value, and the return generated. Logically, portfolio capital moves to a
recipient country which has revealed its potential for higher returns and
profitability.
Following international standards, portfolio investments are characterised by lower
stake in companies with their total stake in a firm at below 10 percent. It is also
noteworthy that unlike the FDIs, these investments are typically of short term
nature, and therefore, are not intended to enhance the productive capacity of an
economy by the creation of capital assets.
Portfolio investors will evaluate, on a separate basis, the prospects of each
independent unit in which they might invest and may often shift their capital with
changes in these prospects. Therefore, portfolio investments are, to a large extent,
expected to be speculative. Once investor confidence is shaken, such capital has a
tendency to speedily shift from one country to another, occasionally creating
financial crisis for the host country.
Table 4.5.1
Foreign direct investment (FDI) VS Foreign portfolio investment (FPI)
Foreign direct investment (FDI) Foreign portfolio investment (FPI)

Investment involves creation of Investment is only in financial assets
physical assets
Has a long term interest and therefore Only short term interest and generally
remain invested for long remain invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by technology Not accompanied by technology transfer
transfer
Direct impact on employment of No direct impact on employment of labour
labour and wages and wages

Enduring interest in management and No abiding interest in management and

control control
Securities are held with significant Securities are held purely as a financial
degree of influence by the investor on investment and no significant degree of
the management of the enterprise influence on the management of the
enterprise
5.5 REASONS FOR FOREIGN DIRECT INVESTMENT

As we know, economic prosperity and the relative abundance of capital are
necessary prerequisites for export of capital to other countries. Many economies
and organisations have accumulation of huge mass of reserve capital seeking
profitable use. The primary aim of economic agents being maximisation of their
economic interests, the opportunity to generate profits available in other countries
often entices such entities to make investments in other countries. The chief motive
for shifting of capital between different regions or between different industries is
the expectation of higher rate of return than what is possible in the home country.
Investment in a host country may be found profitable by foreign firms because of
some firm-specific knowledge or assets (such as superior management skills or an
important patent) that enable the foreign firm to gainfully outperform the host
country's domestic firms. There are many other reasons (as listed below) for
international capital movements which have found adequate empirical support.
Investments move across borders on account of:
(i) the increasing interdependence of national economies and the consequent
trade relations and international industrial cooperation established among
them
(ii) internationalisation of production and investment of transnational
corporations in their subsidiaries and affiliates.
(iii) desire to reap economies of large-scale operation arising from technological
growth
(iv) lack of feasibility of licensing agreements with foreign producers in view of
the rapid rate of technological innovations
(v) necessity to retain direct control of production knowledge or managerial skill
(usually found in monopolistic or oligopolistic markets) that could easily and
profitably be utilized by corporations

(vi) desire to procure a promising foreign firm to avoid future competition and
the possible loss of export markets
(vii) risk diversification so that recessions or downturns may be experienced with
reduced severity
(viii) shared common language or common boundaries and possible saving in
time and transport costs because of geographical proximity
(ix) necessity to retain complete control over its trade patents and to ensure
consistent quality and service or for creating monopolies in a global context
(x) promoting optimal utilization of physical, human, financial and other
resources
(xi) desire to capture large and rapidly growing high potential emerging markets
with substantially high and growing population
(xii) ease of penetration into the markets of those countries that have established
import restrictions such as blanket bans, high customs duties or non-tariff
barriers which make it difficult for the foreign firm to sell in the host-country
market by ‘getting behind the tariff wall’.
(xiii) lower environmental standards in the host country and the consequent
relative savings in costs
(xiv) stable political environment and overall favourable investment climate in the
host country
(xv) higher degree of openness to foreign capital exhibited by the recipient
country and the prevalence of preferential investment systems such as
special economic zones to encourage direct foreign investments
(xvi) the strategy to obtain control of strategic raw material or resource so as to
ensure their uninterrupted supply at the lowest possible price; usually a form
of vertical integration
(xvii) desire to secure access to minerals or raw material deposits located
elsewhere and earn profits through processing them to finished form
(Eg.FDI in petroleum)
(xviii) the existence of low relative wages in the host country because of relative
labour abundance coupled with shortage and high cost of labour in capital
exporting countries, especially when the production process is labour
intensive.

(xix) lower level of economic efficiency in host countries and identifiable gaps in
development
(xx) tax differentials and tax policies of the host country which support direct
investment. However, a low tax burden cannot compensate for a generally
fragile and unattractive FDI environment
(xxi) inevitability of defensive investments in order to preserve a firm’s
competitive position
(xxii) high gross domestic product and high per capita income coupled with their
high rate of growth . There are also other philanthropic objectives such as
strengthening of socio-economic infrastructure, alleviation of poverty and
maintenance of ecological balance of the host country ,and
(xxiii) prevalence of high standards of social amenities and possibility of good
quality of life in the host country
Table 4.5.2
Host Country Determinants of Foreign Direct Investment
Economic Determinants Policy Framework

Market -seeking FDI: Economic, political, and social stability
Market size and per capita income Rules regarding entry and operations
Market growth Standards of treatment of foreign
Access to regional and global markets affiliates
Country-specific consumer preferences Policies on functioning and structure of

markets (e.g., regarding competition,
Structure of markets
mergers)
Resource - or asset-seeking FDI:
International agreements on FDI
Raw materials Privatization policy
Low -cost unskilled labour Trade policies and coherence of FDI and
Availability of skilled labour trade policies
Technological, innovative, and other Tax policy
created assets (e.g., brand names) Business Facilitation
Physical infrastructure Investment promotion (including image
building and investment-generating

Efficiency -seeking FDI: activities and investment-facilitation

Costs of above physical and human services)
resources and assets Investment incentives
(including an adjustment for "Hassle costs" (related to corruption and
productivity) administrative efficiency)
Other input costs (e.g., intermediate Social amenities (e.g., bilingual schools,
products, transport costs) quality of life)
Membership of country in a regional After-investment services
integration agreement, which could be
conducive to forming regional
corporate networks
Source :International economics (7th ed) International Economics, Dennis R. Appleyard; Alfred J. Field;
Steven L. Cobb(P237)
Factors in the host country discouraging inflow of foreign investments are

infrastructure lags, high rates of inflation, balance of payment deficits, poor literacy
and low labour skills, rigidity in the labour market, bureaucracy and corruption,
unfavourable tax regime, cumbersome legal formalities and delays, small size of
market and lack of potential for its growth, political instability, absence of well-
defined property rights, exchange rate volatility, poor track-record of investments,
prevalence of non-tariff barriers, stringent regulations, lack of openness, language
barriers, high rates of industrial disputes, lack of security to life and property, lack
of facilities for immigration and employment of foreign technical and
administrative personnel, double taxation and lack of a general spirit of friendliness
towards foreign investors.
5.6 MODES OF FOREIGN DIRECT INVESTMENT (FDI)

Foreign direct investments can be made in a variety of ways, such as:
(i) Opening of a subsidiary or associate company in a foreign country,
(ii) Equity injection into an overseas company,
(iii) Acquiring a controlling interest in an existing foreign company,
(iv) Mergers and acquisitions(M&A)
(v) Joint venture with a foreign company.
(vi) Green field investment (establishment of a new overseas affiliate for freshly
starting production by a parent company).

5.7 BENEFITS OF FOREIGN DIRECT INVESTMENT

The benefits from and concerns about FDI are widely discussed and well
documented. While recognizing the fact that there are also benefits and costs to
the home country from capital outflow, in this unit we focus only on host-country
effects of FDI with particular attention to the developing countries. Following are
the benefits ascribed to foreign investments:
1. Entry of foreign enterprises usually fosters competition and generates a
competitive environment in the host country. The domestic enterprises are
compelled to compete with the foreign enterprises operating in the domestic
market. This results in positive outcomes in the form of cost-reducing and
quality-improving innovations, higher efficiency and increasing variety of
better products and services at lower prices ensuring wider choice and welfare
for consumers
2. International capital allows countries to finance more investment than can be
supported by domestic savings. The provision of increased capital to work with
labour and other resources available in the host country can enhance the total
output (as well as output per unit of input) flowing from the factors of
production.
3. From the perspective of emerging and developing countries, FDI can accelerate
growth and foster economic development by providing the much needed
capital, technological know-how, management skills and marketing methods
and critical human capital skills in the form of managers and technicians. The
spill-over effects of the new technologies usually spread beyond the foreign
corporations. In addition, the new technology can clearly enhance the recipient
country's production possibilities.
4. Competition for FDI among national governments also has helped to promote
political reforms important to attract foreign investors, including legal systems
and macroeconomic policies.
5. Since FDI involves setting up of production base (in terms of factories, power
plants, etc.) it generates direct employment in the recipient country.
Subsequent FDI as well as domestic investments propelled in the downstream
and upstream projects that come up in multitude of other services generate
multiplier effects on employment and income.
6. FDI not only creates direct employment opportunities but also, through
backward and forward linkages, generate indirect employment opportunities.

This impact is particularly important if the recipient country is a developing

country with an excess supply of labour caused by population pressure.
7. Foreign direct investments also promote relatively higher wages for skilled
jobs. More indirect employment will be generated to persons in the lower-end
services sector occupations thereby catering to an extent even to the less
educated and unskilled persons engaged in those units.
8. Foreign corporations provide better access to foreign markets. Unlike portfolio
investments, FDI generally entails people-to-people relations and is usually
considered as a promoter of bilateral and international relations. Greater
openness to foreign capital leads to higher national dependence on
international investors, making the cost of discords higher.
9. There is also greater possibility for the promotion of ancillary units resulting in
job creation and skill development for workers.
10. Foreign enterprises possessing marketing information with their global
network of marketing are in a unique position to utilize these strengths to
promote the exports of developing countries. If the foreign capital produces
goods with export potential, the host country is in a position to secure scarce
foreign exchange which can be used to import needed capital equipments or
materials to assist the country's development plans or to ease its external debt
servicing.
11. If the host country is in a position to implement effective tax measures, the
foreign investment projects also would act as a source of new tax revenue
which can be used for development projects.
12. It is likely that foreign investments enter into industries in which scale
economies can be realized so that consumer prices might be lowered.
Domestic firms might not always be able to generate the necessary capital to
achieve the cost reductions associated with large-scale production.
13. Increased competition resulting from the inflow of foreign direct investments
facilitates weakening of the market power of domestic monopolies resulting in
a possible increase in output and fall in prices.
14. Since FDI has a distinct advantage over the external borrowings, it is considered
to have a favourable impact on the host country’s balance of payment position,
and

15. Better work culture and higher productivity standards brought in by foreign
firms may possibly induce productivity related awareness and may also
contribute to overall human resources development.
5.8 POTENTIAL PROBLEMS ASSOCIATED WITH FOREIGN

DIRECT INVESTMENT
In the above section, we have seen that a wide variety of benefits may result from
an inflow of foreign direct investment. These gains do not occur in all cases, nor do
they occur in the same magnitude. Despite the arguments which vehemently favour
direct investments in host countries, many are highly critical of the impact of
foreign capital, especially on developing economies. They argue that foreign
entities are highly focused on profits and have an eye on exploiting the natural
resources and are almost always not genuinely interested in the development
needs of host countries. Foreign capital is perceived by the critics as an
instrument of imperialism, or as a perpetrator of dependence and inequality both
between nations and within nations.
Following are the general arguments put forth against the entry of foreign capital.
1. FDIs are likely to concentrate on capital-intensive methods of production and
service so that they need to hire only relatively few workers. Such technology
is inappropriate for a labour-abundant country as it does not support
generation of jobs which is a crucial requirement to address poverty and
unemployment which are the two fundamental areas of concern for the less
developed countries.
2. The inherent tendency of FDI flows to move towards regions or states which
are well endowed in terms of natural resources and availability of infrastructure
has the potential to accentuate regional disparity. Foreign capital is also
criticized for accentuating the already existing income inequalities in the
host country.
3. In the context of developing countries, it is usually alleged that the inflow of
foreign capital may cause the domestic governments to slow down its efforts
to generate more domestic savings, especially when tax mechanisms are
difficult to implement. If the foreign corporations are able to secure incentives
in the form of tax holidays or similar provisions, the host country loses tax
revenues.

4. Often, the foreign firms may partly finance their domestic investments by
borrowing funds in the host country's capital market. This action can raise
interest rates in the host country and lead to a decline in domestic investments
through ‘crowding-out’ effect. Moreover, suppliers of funds in developing
economies would prefer foreign firms due to perceived lower risks and such
shifts of funds may divert capital away from investments which are crucial for
the development needs of the country.
5. The expected benefits from easing of the balance of payments situation might
remain unrealised or narrowed down due to the likely instability in the balance
of payments and the exchange rate. Obviously, FDI brings in more foreign
exchange, improves the balance of payments and raises the value of the host
country's currency in the exchange markets. However, when imported inputs
need to be obtained or when profits are repatriated, a strain is placed on the
host country's balance of payments and the home currency leading to its
depreciation. Such instabilities jeopardize long-term economic planning.
Foreign corporations also have a tendency to use their usual input suppliers
which can lead to increased imports. Also, large scale repatriation of profits
can be stressful on the balance of payments.
6. Jobs that require expertise and entrepreneurial skills for creative decision
making may generally be retained in the home country and therefore the host
country is left with routine management jobs that demand only lower levels of
skills and ability. The argument of possible human resource development and
acquisition of new innovative skills through FDI may not be realized in reality.
7. High profit orientation of foreign direct investors tend to promote a distorted
pattern of production and investment such that production could get
concentrated on items of elite and popular consumption and on non-essential
items.
8. Foreign entities are usually accused of being anti-ethical as they frequently
resort to methods like aggressive advertising and anticompetitive practices
which would induce market distortions.
9. A large foreign firm with deep pockets may undercut a competitive local
industry because of various advantages (such as in technology) possessed by
it and may even drive out domestic firms from the industry resulting in serious
problems of displacement of labour. The foreign firms may also exercise a
high degree of market power and exist as monopolists with all the
accompanying disadvantages of monopoly. The high growth of wages in

foreign corporations can influence a similar escalation in the domestic

corporations which are not able to cover this increase with growth of
productivity. The result is decreasing competitiveness of domestic companies
which might prove detrimental to the long term interests of industrial
development of the host country.
10. FDI usually involves domestic companies ‘off –shoring’, or shifting jobs and
operations abroad in pursuit of lower operating costs and consequent higher
profits. This has deleterious effects on employment potential of home country.
11. The continuance of lower labour or environmental standards in host countries
is highly appreciated by the profit seeking foreign enterprises. This is of great
concern because efforts to converge such standards often fail to receive
support from interested parties.
12. At times, there is potential national security considerations involved when
foreign firms function in the territory of the host country, especially when acute
hostilities prevail.
13. FDI may have adverse impact on the host country's commodity terms of trade
(defined as the price of a country's exports divided by the price of its imports).
This could occur if the investments go into production of export goods and the
country is a large country in the sale of its exports. Thus, increased exports
drive down the price of exports relative to the price of imports.
14. FDI is also held responsible by many for ruthless exploitation of natural
resources and the possible environmental damage.
15. With substantial FDI in developing countries there is a strong possibility of
emergence of a dual economy with a developed foreign sector and an
underdeveloped domestic sector.
16. Perhaps the most disturbing of the various charges levied against foreign direct
investment is that a large foreign investment sector can exert excessive amount
of power in a variety of ways so that there is potential loss of control by host
country over domestic policies and therefore the less developed host country’s
sovereignty is put at risk. Mighty multinational firms are often criticized of
corruption issues, unduly influencing policy making and evasion of corporate
social responsibility.
No general assessment can be made regarding whether the benefits of FDI
outweigh the costs. Each country's situation and each firm's investment must be

examined in the light of various considerations and a judgment about the

desirability or otherwise of the investment should be arrived at.
Many safeguards and performance requirements are put in place by developed and
developing countries to improve the ratio of benefits to costs associated with
foreign capital. A few examples are: domestic content requirements on inputs,
reservation of certain key sectors to domestic firms, requirement of a minimum
percent of local employees, ceiling on repatriation of profits, local sourcing
requirements and stipulations for full or partial export of output to earn scarce
foreign exchange.
5.9 FOREIGN DIRECT INVESTMENT IN INDIA (FDI)

The import-substitution strategy of industrialisation followed by India post
independence stressed on an extremely careful and selective approach while
formulating FDI policy. Extensive controls imposed by the government severely
restricted the inflow of foreign capital to India. The enactment of the Foreign
Exchange Regulation Act (FERA), 1973 consolidated the regulatory framework with
stipulations of upto 40 per cent of foreign equity holding in a joint venture. The
Industrial Policy announcements of 1980 and 1982 and the Technology Policy
Statement (1983) provided for a moderately lenient attitude towards foreign
investments by endorsement of manufacturing exports as well as modernisation of
industries through liberalised imports of capital goods and technology. This was
supplemented by trade liberalisation measures in the form of tariff reduction and
shifting of large number of items from import licensing to Open General Licensing
(OGL).
The most important shift in investment policy occurred when India embarked upon
economic liberalisation and reforms programme in 1991 to raise its growth
potential and to integrate it with the world economy. Further reforms in
subsequent years put in place a series of measures directed towards liberalizing
foreign investments and for ensuring access to foreign technology and funding.
The government’s strategy favouring foreign investments and the prevalent robust
business environment have ensured that foreign capital keeps flowing into the
country. The government initiatives such as automatic approval of FDI,
simplification of procedures, setting up of Foreign Investment Promotion Board
(FIPB abolished wef May 2017), signing of the Multilateral Investment Guarantee
Agency Protocol for protection of foreign investments, permitting use of foreign
trade marks and brand names, 100% FDI in multitude of sectors , enactment of
Foreign Exchange Management Act (FEMA), passing of the SEZ Act in 2005, Special

Economic Zones (SEZ), support to mergers ,acquisitions and green field

investments, and encouragement to foreign technology collaboration agreements
are a few such measures.
Apart from being a critical driver of economic growth, foreign direct investment
(FDI) is a major source of non-debt financial resource for the economic
development of India. According to United Nations Conference on Trade and
Development (UNCTAD)’s World Investment Report 2016, India ranks as the tenth
highest recipient of foreign direct investment globally in 2015 receiving $44 billion
of investment that year compared to $35 billion in 2014. India has also moved up
by one rank to become the sixth most preferred investment destination.
According to the Department of Industrial Policy and Promotion (DIPP), the total
FDI investments India received during April - September 2016 rose 30 per cent
year-on-year to US$ 21.6 billion. During the period, the services sector attracted
the highest FDI equity inflow (US$ 5.29 billion), followed by telecommunications
(US$ 2.79 billion), and trading (US$ 1.48 billion). Also, India received the maximum
FDI equity inflows from Mauritius (US$ 5.85 billion) followed by Singapore,
Netherlands, Japan and the USA.
With the government taking steps to improve the ease of doing business and to
relax regulations, foreign direct investment into the country surged by 60 per cent
to $4.68 billion in November 2016 from $2.93 billion in November 2015.
Currently, an Indian company may receive foreign direct investment either through
‘automatic route’ without any prior approval either of the Government or the
Reserve Bank of India or through ‘government route’ with prior approval of the
Government.
An Indian Company can receive foreign investment by issue of ‘FDI compliant
instruments’ namely: equity shares, fully and mandatorily convertible preference
shares and debentures, partly paid equity shares and warrants. These have to be
issued in accordance with the provisions of the Companies Act, 2013 and the SEBI
guidelines, as applicable.
All foreign investments are repatriable (net of applicable taxes) except in cases
where the investment is made or held on non-repatriation basis or where the
sectoral condition specifically mentions non-repatriation. Further, dividends/
profits (net of applicable taxes), on foreign investments, being current income can
be remitted outside India through an Authorised Dealer bank. Only NRIs are
allowed to set up partnership/ proprietorship concerns in India on non-repatriation
basis.

In India, foreign investment is prohibited in the following sectors:

(i) Lottery business including Government / private lottery, online lotteries, etc.
(ii) Gambling and betting including casinos etc.
(iii) Chit funds
(iv) Nidhi company
(v) Trading in Transferable Development Rights (TDRs)
(vi) Real Estate Business or Construction of Farm Houses
(vii) Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of
tobacco substitutes
(viii) Activities / sectors not open to private sector investment e.g. atomic energy
and railway operations (other than permitted activities).
Foreign technology collaboration in any form including licensing for franchise,
trademark, brand name, management contract is also prohibited for lottery
business and gambling and betting activities.
With the objective of making India the most open economy in the world for FDI and
for providing major impetus to employment and job creation, the FDI regime was
radically liberalized on 20-June-2016. Changes introduced in the FDI policy include
increase in sectoral caps, bringing more activities under automatic route and easing
of conditions for foreign investment. These include easing of FDI in defence sector,
e-commerce, in respect of food products manufactured or produced in India,
pharmaceuticals (Greenfield and Brownfield), airports (both Greenfield and
Brownfield),airport transport services, private security agencies, animal husbandry,
establishment of branch offices, liaison office or project office, teleports, direct to
home cable networks, mobile TV and headend-in-the sky broadcasting service and
single brand retail trading.
5.10 OVERSEAS DIRECT INVESTMENT BY INDIAN COMPANIES

Integration of the Indian economy with the rest of the world is evident not only in
terms of higher level of FDI inflows but also in terms of increasing level of FDI
outflows as overseas investments by the Indian entrepreneurs in joint ventures (JV)
and wholly owned subsidiaries (WOS). Outbound investments from India have
undergone substantial changes not only in terms of size but also in terms of
geographical spread and sectoral composition. Outward Foreign Direct Investment
(OFDI) from India stood at US$ 1.86 billion in the month of June, 2016.

The overseas investments have been primarily driven by resource seeking, market
seeking or technology seeking motives. Many Indian IT firms like Tata Consultancy
Services, Infosys, WIPRO, and Satyam acquired global contracts and established
overseas offices in developed economies to be close to their key clients. Of late,
there has been a surge in resource seeking overseas investments by Indian
companies, especially to acquire energy resources in Australia, Indonesia and
Africa. Indian entrepreneurs are also choosing investment destinations in countries
such as Mauritius, Singapore, British Virgin Islands, and the Netherlands on account
of higher tax benefits they provide.
At present, any Indian investor can make overseas direct investment in any bona-
fide activity except in certain real estate activities. This has been made possible by
progressive relaxation of the capital controls and simplification of procedures for
outbound investments from India. For example, the annual overseas investment
ceiling to establish joint ventures (JV) and wholly owned subsidiaries has been
raised to US$ 125,000 from US$ 75,000. The RBI has also relaxed norms for foreign
investment by Indian corporates by raising the borrowing limit.
Policies in respect of foreign investments undergo far reaching changes from time
to time. (Learners are expected to keep pace with the modifications in government
policy in respect of inbound and outbound foreign investments).
SUMMARY
• Foreign capital may flow into an economy in different ways, such as foreign
aid, grants, borrowings, deposits from non-resident Indians, investments in the
form of foreign portfolio investment (FPI) and foreign direct investment (FDI)
• Foreign direct investment is defined as a process whereby the resident of one
country (i.e. home country) acquires ownership of an asset in another country
(i.e. the host country) and such movement of capital involves ownership,
control as well as management of the asset in the host country.
• Direct investments are real investments in factories, assets, land, inventories
etc. and have three components, viz., equity capital, reinvested earnings and
other direct capital in the form of intra-company loans. FDI may be categorized
as horizontal, vertical or conglomerate.
• Foreign portfolio investment is the flow of ‘financial capital’ with stake in a firm at
below 10 percent, and does not involve manufacture of goods or provision of
services, ownership management or control of the asset on the part of the investor.
• The main reasons for foreign direct investment are profits, higher rate of return,

possible economies of large-scale operation, risk diversification, retention of

trade patents, capture of emerging markets, lower host country environmental
and labour standards, bypassing of non tariff and tariff barriers, cost–effective
availability of needed inputs and tax and investment incentives.
• Foreign direct investment takes place through opening of a subsidiary or
associate company, equity injection, acquiring a controlling interest, mergers
and acquisitions (M&A), joint venture and green field investment.
• Benefits of foreign direct investment include positive outcomes of competition
such as cost- reducing and quality-improving innovations, higher efficiency,
huge variety of better products and services at lower prices, welfare for
consumers, multiplier effects on employment, output and income, relatively
higher wages, better access to foreign markets, control of domestic
monopolies and betterment of balance of payments position.
• Potential problems of foreign direct investment include use of inappropriate
capital- intensive methods in a labour-abundant country, increase in regional
disparity, crowding-out of domestic investments, diversion of capital resulting
in distorted pattern of production and investment, instability in the balance of
payments and exchange rate and indiscriminate repatriation of the profits.
• FDIs are also likely to indulge in anti-ethical market distortions, off–shoring or
shifting of jobs, overexploitation of natural resources causing environmental
damage, exercising monopoly power, decrease competitiveness of domestic
companies, potentially jeopardize national security and sovereignty, worsen
commodity terms of trade and cause emergence of a dual economy
• FDI in India, mostly a post reform phenomenon, is a major source of non-debt
financial resource for economic development. The government has, at different
stages, liberalized FDI by increasing sectoral caps, bringing in more activities
under automatic route and easing of conditions for foreign investment.
• Overseas direct investments by Indian companies, made possible by
progressive relaxation of capital controls and simplification of procedures for
outbound investments from India, have undergone substantial changes in
terms of size, geographical spread and sectoral composition. Outward Foreign
Direct Investment (OFDI) from India stood at US$ 1.86 billion in the month of
June 2016.

TEST YOUR KNOWLEDGE

1. Which of the following statements is incorrect?
(a) Direct investments are real investments in factories, assets, land,
inventories etc. and involve foreign ownership of production facilities.
(b) Foreign portfolio investments involve flow of ‘financial capital’
(c) Foreign direct investment (FDI) is not concerned with either manufacture
of goods or with provision of services.
(d) Portfolio capital moves to a recipient country which has revealed its
potential for higher returns and profitability.
2. Which of the following is a component of foreign capital?
(a) Direct inter government loans
(b) Loans from international institutions (e.g. World Bank, IMF, ADB)
(c) Soft loans for e.g. from affiliates of World Bank such as IDA
(d) All the above
3. Which of the following would be an example of foreign direct investment from
Country X?
(a) A firm in Country X buys bonds issued by a Chinese computer
manufacturer.
(b) A computer firm in Country X enters into a contract with a Malaysian firm
for the latter to make and sell to it processors
(c) Mr. Z a citizen of Country X buys a controlling share in an Italian
electronics firm
4. Which of the following types of FDI includes creation of fresh assets and
production facilities in the host country?
(a) Brownfield investment
(b) Merger and acquisition
(c) Greenfield investment

(d) Strategic alliances

5. Which is the leading country in respect of inflow of FDI to India?
(a) Mauritius
(b) USA
(c) Japan
(d) USA
6. An argument in favour of direct foreign investment is that it tends to
(a) promote rural development
(b) increase access to modern technology
(c) protect domestic industries
(d) keep inflation under control
7. Which of the following is a reason for foreign direct investment?
(a) secure access to minerals or raw materials
(b) desire to capture of large and rapidly growing emerging markets
(c) desire to influence home country industries
8. A foreign direct investor
(a) May enter India only through automatic route
(b) May enter India only through government route
(c) May enter India only through equity in domestic enterprises
(d) Any of the above
9. Foreign investments are prohibited in
(a) Power generation and distribution
(b) Highways and waterways
(c) Chit funds and Nidhi company
(d) Airports and air transport

10. Which of the following statement is false in respect of FPI?

(a) portfolio capital in general, moves to investment in financial stocks, bonds
and other financial instruments about foreign portfolio investment?
(b) is effected largely by individuals and institutions through the mechanism
of capital market
(c) is difficult to recover as it involves purely long term investments and the
investors have controlling interest
(d) investors also do not have any intention of exercising voting power or
controlling or managing the affairs of the company
1. What are the different types of foreign capital?
2. Define foreign direct investment?
3. Enumerate the components of foreign direct investment?
4. Distinguish between horizontal and vertical foreign direct investment
5. What is meant by foreign portfolio investment?
6. What are the different routes for securing FDI?
7. What is meant by automatic route?
8. Mention the effects of FDI on host country labour?
9. What are the reasons for the speculative nature of foreign portfolio
investments?
10. What impact does FDI have on host country employment?
11. Outline the effect of FDI on technology of host country?
12. Enumerate the effect of FDI on domestic industries?
13. Do you think FDI would help prevent formation of monopolies?
14. Do you agree with the argument that FDI is likely to reduce employment?
15. What implications do FDI have on domestic resource use?
16. Why did India discourage FDIs in its early stages?
1. What are the different types of foreign capital?

2. Define foreign direct investment (FDI). What are the features of FDI?
3. What are the characteristics of foreign portfolio investments (FPI)?
4. Describe the factors influencing foreign direct investments?
5. Enumerate the host country determinants of foreign direct investment?
6. What are the factors in the host country that discourage inflow of foreign
investments?
7. Explain the different modes of effecting foreign direct investment (FDI)?
8. What are the benefits of foreign direct investments to the host country?
9. Critically examine the general arguments put forth against entry of foreign
capital
10. Write a note on foreign direct investment in India
11. Give an account of overseas direct investments by Indian companies?
12. Distinguish between foreign direct investment and foreign institutional
investment?
13. Elucidate the potential costs and benefits of foreign direct investment?
14. Explain the state of affairs of foreign direct investment in India
15. What are the grounds on which the opponents of foreign investments criticise
the flow of FDI to developing countries?
16. Mention two arguments made in favour of FDI to developing economies like
India? Illustrate your answer
17. Which are the sectors in India where FDI is prohibited? Why?
18. “Foreign capital is not a bag of unmixed blessings as far as its impact on the
host country is concerned”. Comment on this statement.
1. Which of the following is a FDI?
(i) Claram Joe, a German investor buys 5000 shares of Ford, a US Automobile
company.
(ii) Annette D, the US Company acquires all the equity shares of Emeline & Co
in Alice Land which makes computer components.

(iii) A Bulgarian investor Boryana Gergiev pays cash and buys 0.2 % of all
outstanding equity shares of Mariette company which makes computer
peripherals
(iv) Maansi Tech solutions purchase 52% stake in a Sarra, a Jamaican
technology firm
(v) Kora extends a loan to Christa Victorine, a power producing firm in which
it holds 60 percent of equity
(vi) Augusta Corp lends pounds 10 million to Lee Sud, a Dutch parts making
firm in which it holds 79 percent of equity
(vii) Labour group in your country oppose the flow of FDI into the country on
grounds of perceived inequities consequent on FDI. What are their
arguments?
(viii) Beth & Sushil are members of the committee for resolution of the issue
cited under What arguments would they put forth to convince the labour
groups of the welfare implications for labour that may arise from FDI?
ANSWERS/HINTS
1. (c) 2. (d) 3. (c) 4. (c) 5. (a) 6 (b) 7. (d) 8. (d) 9. (c)
10. (c)
1. Foreign aid or assistance, multilateral aid from international organizations like
the World Bank, borrowings of all types; such as, soft loans, external
commercial borrowings, deposits from NRIs, and investments both FPI and FDI.
2. All investments involving a long term relationship and reflecting a lasting
interest and control of a resident entity in one economy in an enterprise
resident in an economy other than that of the direct investor and occur through
acquisition of more than 10 percent of the shares of the target asset.
3. FDI has three components, viz., equity capital, reinvested earnings and other
direct capital in the form of intra-company loans.
4. A horizontal direct investment is said to take place when the investor
establishes the same type of business operation in a foreign country as it
operates in its home country, whereas a vertical investment is one under
which the investor establishes or acquires a business activity in a foreign

country which is different from the investor’s main business activity, yet in
some way supplements its major activity.
5. Foreign portfolio investment is the flow of ‘financial capital’ rather than ‘real
capital’ and does not involve ownership, control, or management on the part
of the investor.
6. The main forms of direct investments are: the opening of overseas companies,
including the establishment of subsidiaries or branches, creation of joint
ventures on a contract basis, joint development of natural resources and
purchase or annexation of companies in the country receiving foreign capital.
7. Direct investments through ‘automatic route’ do not need any prior approval
either of the Government or of the Reserve Bank of India.
8. Benefits of higher wages, better opportunities for employment and skill
enhancement, increased productivity, adverse effects of displacement due to
use of capital intensive methods, crowding in jobs requiring low skills,
perpetuation of low labour standards and differential treatment.
9. Typically of short term nature with no intention to create capital assets;
tendency to often speedily shift the capital from one country to another with
changes in prospects of returns.
10. Better opportunities for employment, likely to concentrate in less skill requiring
jobs, possible displacement due to use of capital intensive methods
11. Possible state-of-the-art technology transfer, improvement in host country
technology (may be inappropriate for a labour abundant nation). Often
criticized of transferring outdated technology
12. Unequal competition, gainfully outperforms the host country's domestic firms,
tendency to undercut a competitive local industry, may even drive out
domestic firms from the industry, exercise a high degree of market power and
exist as monopolists, high growth of wages in foreign corporations can
influence a similar escalation in the domestic corporations, decreasing
competitiveness, detrimental to the long term interests.
13. Increased competition decreases market power and the chance of formation
of monopolies. However, foreign firms may also act as monopolists.
14. Possible due to capital intensive technology which is inappropriate for a labour
abundant country; displacement of labour if industries fail or are forced to close down

15. Better and more efficient utilization of available resources, but resources are
likely to be unsustainably overexploited causing environmental damage.
16. Policy of import substitution, extensive controls, selective policy
(i) Not FDI because less than 10 percent (which is the globally accepted criterion)
(ii) FDI since 100 percent shares are bought
(iii) Not FDI because an insignificant part of the total stake is acquired
(iv) FDI because it involves more than 10 percent of the company’s shares.
(v) FDI; lending to a company in which Kora has majority stake
(vi) FDI refer (e)above
(vii) Foreign corporates concentrate on capital-intensive methods of production -
so they need to hire only relatively few workers, technology inappropriate for
a labour-abundant country - does not support generation of jobs or address
poverty and unemployment- help accentuate the already existing income
inequalities- jobs that require expertise and entrepreneurial skills for creative
decision making may generally be retained in the home country and therefore
the host country is left with routine management jobs that demand only lower
levels of skills and ability. The argument of possible human resource
development and acquisition of new innovative skills through FDI may not be
realized in reality- may resort to anti-ethical, and anticompetitive practices-
‘off –shoring’, or shifting jobs – negative effects on employment potential of
home country- continuance of lower labour or environmental standards and
ruthless labour and natural resources exploitation.
(viii) FDI will - accelerate growth and foster economic development – bring in
technological know-how, management skills and marketing methods-
generate direct employment in the recipient country- Subsequent FDI as well
as domestic investments propelled in the downstream and upstream projects
that come up in multitude of other services generate multiplier effects on
employment and income - generate indirect employment opportunities--
promote relatively higher wages for skilled jobs- more indirect employment
will be generated to persons in the lower-end services sector occupations
thereby catering to an extent even to the less educated and unskilled engaged
in those units. Better work culture and higher productivity standards- induce
productivity related awareness and may also contribute to overall human
resources development.

GLOSSARY
1. Absolute advantage: The advantage of greater efficiency that one nation

may have over another/others to produce a good or service using fewer
resources. Considered as basis for international trade by Adam Smith.
2. Ad valorem tariff: A tariff expressed as a constant percentage of the
monetary value of one unit of the value of the imported good.
3. Administered interest rates: The deposit and lending rates are not market
determined; these are prescribed by the central bank.
4. Adverse selection: Opportunism characterized by an informed person’s
benefiting from trading or otherwise contracting with a less-informed
person who does not know about an unobserved characteristic of the
informed person. Eg. A disproportionately large share of unhealthy people
tends to buy insurance policy.
5. Aggregate demand: The total demand for goods and services in an
economy which is equal to the total spending on goods and services. The
four components of Aggregate Demand (AD) are Consumption (C), Investment (I),
Government Spending (G) and Net Exports (X-M).
6. Agreement on Subsidies and Countervailing Measures: A WTO
agreement that aims to clarify definitions of subsidies, strengthen
disciplines by subsidy type and to strengthen and clarify procedures for
adopting countervailing tariffs
7. Agreement on Technical Barriers to Trade (TBT): A WTO agreement that
aims to prevent the standards and conformity assessment systems from
becoming unnecessary trade barriers by securing their transparency and
harmonization with international standards
8. Agreement on Textiles and Clothing: A WTO agreement which replaced
the Multi-Fiber Arrangement (MFA) provides that textile trade should be
deregulated by gradually integrating it into GATT disciplines over a 10-year
transition period.
9. Agreement on Trade-Related Investment Measures (TRIMs): A WTO
agreement that expands disciplines governing investment measures in
relation to cross-border investments.
10. Allocation function: Government role to ensure optimal or efficient
allocation of scarce resources to correct the sources of inefficiency in the
economic system.

I.2 ECONOMICS FOR FINANCE
11. American currency quotation: An indirect quote showing the number of

units of a foreign currency exchangeable for one unit of local currency; for
example: $ 0.0151 per rupee
12. Anti-dumping Duties: Additional import duties so as to offset the foreign
firm's unfair price advantage. ( see dumping)
13. Antitrust laws: Also referred to as ‘competition laws’, regulate the conduct
and organization of business corporations, generally to promote fair
competition for the benefit of consumers.
14. Arbitrage: The purchase of a currency or good where it is lower priced for
immediate resale in a market where it is higher priced in order to make a
profit.
15. Asymmetric information: A situation where one party to an economic
transaction possesses greater material knowledge than the other party.
16. Autonomous consumption spending: The part of consumption spending
that is independent of income; also the vertical intercept of the
consumption function.
17. Balance of payments: A summary statement of all the international
transactions of the residents of a nation with the rest of the world during a
particular period of time, usually a year.
18. Bank Rate: The standard rate at which the Reserve Bank of India is prepared
to buy or re-discount bills of exchange or other commercial papers eligible
for purchase under the RBI Act.
19. Base money see Reserve Money
20. Bilateral agreements : Agreements between two nations regarding
quantities and terms of specific trade transactions.
21. Bond: A debt investment in which an investor lends money to an entity
(corporate or governmental) which borrows the funds for the purpose of
raising capital for a defined period of time at a variable or fixed interest rate.
22. Bound Tariff: A tariff which a WTO member binds itself with a legal
commitment not to raise above a certain level
23. Bretton Woods institutions: The World Bank and the International
Monetary Fund.

GLOSSARY I.3
24. Brownfield investment: The purchase or lease of an existing production

facility in order to use it for a new activity.
25. Budget deficit: The amount by which spending exceeds the income of an
entity over a particular period of time.
26. Budget surplus: The amount by which income exceeds the spending of an
entity over a particular period of time.
27. Cambridge approach: The Neo classical Approach or cash balance
approach to quantity theory of money put forth by Cambridge economists
28. Capital consumption: Depreciation of a fixed asset
29. Capital-intensive commodity: The commodity with the higher capital-
labour ratio at all relative factor prices.
30. Cash Reserve Ratio (CRR): The fraction of the total net demand and time
liabilities (NDTL) of a scheduled commercial bank in India which it should
maintain as cash deposit with the Reserve Bank of India irrespective of its
size or financial position.
31. Circular flow of income: The continuous interlinked phases in circulation
of production, income generation and expenditure involving different
sectors of the economy; a simple model that shows how goods, resources,
and money payments flow between households and firms.
32. Club goods: Impure public goods which are replicable and therefore
individuals who are excluded from one facility may get similar services from
an equivalent provider.
33. Common market: A free trade area with no barriers on trade among
members who harmonize trade policies toward the rest of the world, and
also allow the free movement of labour and capital among member nations.
Eg. the European Union (EU).
34. Common resource: A non-excludable and rival good, generally available
free of charge.
35. Comparative advantage: The advantage conferred on an individual or
country in producing a good or service if the opportunity cost of producing
the good or service is lower for that individual or country than for other
producers.

36. Compensatory spending: Government spending carried out with the

obvious intention to compensate the deficiency in private investment.
37. Compound Tariff: A combination of an ad valorem and a specific tariff.
38. Consumer Price Index (CPI): Measures changes in the price level of market
basket of consumer goods and services purchased by households;
constructed using the prices of a sample of representative items whose
prices are collected periodically.
39. Consumer surplus: The difference between what consumers are willing to
pay for a specific amount of a commodity and what they actually pay for it.
40. Consumption function: The functional relationship between aggregate
consumption expenditure and aggregate disposable income, expressed as
C = f (Y). The specific form consumption function, proposed by
Keynes C = a + bY
41. Contractionary fiscal policy: Government policy designed to restrain levels
of economic activity of the economy during an inflationary phase by
decreasing the aggregate expenditures and aggregate demand through a
decrease in all types of government spending and/ or an increase in taxes.
42. Contractionary monetary policy: Type of monetary policy to combat
inflation; implemented by central banks by decreasing the money supply of
an economy and thus making money and credit more costly and less
accessible to individuals and businesses.
43. Copyright: The exclusive legal right of the creator of a literary or artistic
work to profit from that work; it is a temporary monopoly like a patent.
44. Countervailing duties (CVDs): Tariffs imposed on imports to offset
artificially low prices charged by exporters who enjoy export subsidies and
tax concessions offered by the Governments in their home country.
45. Crawling bands: The value of currency is maintained within certain
fluctuation margins say (±1-2 %) around a central rate that is adjusted
periodically.
46. Crawling peg: The system under which the par value or exchange rates are
changed by very small preannounced amounts at frequent and clearly
specified intervals until the equilibrium exchange rate is reached.
47. Credit money: Part of total money supply created by commercial by banks

GLOSSARY I.5
48. Credit multiplier: Also referred to as the ‘deposit multiplier’ or the ‘deposit
expansion multiplier’, describes the amount of additional money created
by commercial bank through the process of lending the available money it
has in excess of the central bank's reserve requirements.
49. Cross rate: The rate between Y currency and Z currency derived from the
given rates of the two pairs of currencies (X and Y, and, X and Z).
50. Crowding Out: A decline in one sector’s spending caused by an increase in
some other sector’s spending.
51. Crowding-out effect: the negative effect fiscal policy may generate when
money from the private sector is ‘crowded out’ to the public sector.
52. Currency appreciation: A decrease in the domestic currency price of the
foreign currency in a floating-rate system, which is the same as an increase
in the value of a currency.
53. Currency convertibility: The ability to exchange one national currency for
another without any restriction or limitation.
54. Customs union: A group of countries that eliminate all tariffs on trade
among themselves but maintain a common external tariff on trade with
countries outside the union. Example the European Union (EU).
55. Customs Valuation Agreement: A WTO agreement that specifies rules for
more consistent and reliable customs valuation. It aims to harmonize
customs valuation systems on an international basis by eliminating arbitrary
valuation systems.
56. Deadweight loss: The loss in total surplus that occurs whenever an action
or a policy reduces the quantity transacted below the efficient market
equilibrium quantity.
57. Deficit in the balance of payments: The excess of debits over credits in
the current and capital accounts, or autonomous transactions.
58. Deflation: A state of sustained decrease in prices and increase in
purchasing power of money.
59. Demerit goods: Goods which impose significant negative externalities on
the society as a whole and therefore believed to be socially undesirable.
60. Desired or planned investment: The level of investment expenditures that
business would like to undertake.

61. Devaluation: A deliberate downward adjustment in the value of a country's

currency relative to another currency, group of currencies or standard.
62. Disposable Personal Income (DI): A measure of the amount of the money
in the hands of the individuals that is available for their consumption or
savings. DI = Personal Income - Personal Income Taxes.
63. Doha Round: The multilateral trade negotiations launched in November
2001 in Doha (Qatar) which was scheduled to be completed in 2004, to
address, among other things greater trade access by developing countries
in developed countries.
64. Dollarization: The situation whereby a nation adopts another nation's
currency as its legal tender.
65. Domestic content requirements: Mandate that a specified fraction of a
final good should be produced domestically. See Local Content
Requirements.
66. Dumping: The export of a commodity at below their full average cost or at
a lower price than the sales prices in their domestic market.
67. Duty-free zones or Free Economic Zones: Areas set up to attract foreign
investments by allowing raw materials and intermediate products duty free.
68. Economic integration: The commercial policy of discriminatively reducing
or eliminating trade barriers only among the nations joining together.
69. Effective exchange rate: A weighted average of the exchange rates
between the domestic currency and the nation's most important trade
partners, with weights given by the relative importance of the nation's trade
with each of these trade partners.
70. Efficiency costs: see deadweight loss
71. Embargo : A total ban imposed by government on import or export of some
or all commodities to particular country or regions for a specified or
indefinite period.
72. Emissions standard: Legal limit on the amount of pollutants that a firm can
emit.
73. Environmental standards: Rules established by a government to protect
the environment by specifying possible and prohibited actions.

GLOSSARY I.7
74. Escalated tariff structure: The system wherein the nominal tariff rates on
imports of manufactured goods are higher than the nominal tariff rates on
intermediate inputs and raw materials, i.e the tariff on a product increases
as that product moves through the value-added chain.
75. European currency quotation: A direct quote which shows the number of
units of a local currency exchangeable for one unit of a foreign currency. Eg.
$ 1 = Rs.66.12
76. Exchange rate: The rate at which the currency of one country exchanges for
the currency of another country.
77. Expansionary fiscal policy: Policy designed to stimulate the economy
during the contractionary phase of a business cycle; accomplished by
increasing aggregate expenditures and aggregate demand through an
increase in all types of government spending and / or a decrease in taxes.
78. Expansionary monetary policy: Monetary policy that raises aggregate
demand, real income and employment.
79. Expenditure Method: Also called ‘Expenditure Approach’, or ‘Income
Disposal Approach’ a method of estimating national income, measures the
aggregate final expenditure in an economy during an accounting year
composed of final consumption expenditure, gross domestic capital
formation and net exports.
80. Export Subsidies: The granting of tax relief and subsidized inputs to
exporters
81. Export tariff : A tax or duty on exports.
82. External balance: The state of equilibrium in a nation's balance of
payments.
83. Externality: A by-product of consuming or producing a good that affects
someone other than the buyer or seller. These can be external benefits and
external costs.
84. Factor Income Method: Also called ‘Factor Payment Method’ or
‘Distributed Share Method’, under which national income is calculated by
summation of factor incomes paid out by all production units within the
domestic territory of a country as wages and salaries, rent, interest, and
profit.
85. Factor-endowment theory: See Heckscher-Ohlin theory.

86. Factor-price equalization theorem: The part of the H-O theory that
predicts, under highly restrictive assumptions, that international trade will
bring about equalization in relative and absolute returns to homogeneous
factors across nations.
87. Fiat money: Money which has no intrinsic value, but is used as a medium
of exchange because the government has, by law, made it ‘legal tender.’
88. Fiscal multiplier: The response of gross domestic product to an exogenous
change in government expenditures.
89. Fiscal policy: The use of government spending, taxation and borrowing to
influence both the pattern of economic activity and level of growth of
aggregate demand, output and employment.
90. Fixed exchange rate: Also referred to as ‘pegged exchange rate’, is an
exchange rate regime under which a country’s government announces, or
decrees, what its currency will be worth in terms of either another country’s
currency or a basket of currencies or another measure of value, such as
gold.
91. Floating exchange rate: The flexible exchange rate system under which the
exchange rate is always determined by the forces of demand and supply
without any government intervention in foreign exchange markets.
92. Foreign Direct Investment (FDI): The process whereby the resident of one
country (i.e. home country) acquires ownership of an asset in another
country (i.e. the host country) and such movement of capital involves
ownership, control as well as management of the asset in the host country.
93. Foreign exchange futures: A forward contract for standardized currency
amounts and selected calendar dates traded on an organized market
(exchange).
94. Foreign exchange market: The framework for the exchange of one national
currency for another.
95. Foreign exchange options: A contract specifying the right to buy or sell a
standard amount of a traded currency at or before a stated date.
96. Foreign exchange risk: Also called an ‘open position’. The risk resulting
from changes in exchange rates over time and faced by anyone who expects
to make or to receive a payment in a foreign currency at a future date.

GLOSSARY I.9
97. Foreign portfolio investment: The flow of ‘financial capital’ rather than
‘real capital’ and does not involve manufacture of goods or provision of
services or ownership management or control of the asset on the part of
the investor.
98. Forward rate: The exchange rate quoted in foreign exchange transactions
involving delivery of the foreign exchange on a future date as per the
contract agreed upon.
99. Free rider problem: A problem that results when individuals who have no
incentive to pay for their own consumption of a good take a “free ride” on
anyone who does pay; a problem with goods that are nonexcludable
100. Free trade area: Free-trade area is a group of countries that eliminate all tariff
barriers on trade with each other and retains independence in determining
their tariffs with nonmembers. Examples EFTA, NAFTA, and MERCOSUR.
101. General Agreement on Trade in Services (GATS): A WTO agreement that
provides the general obligations regarding trade in services, such as most-
favoured-nation treatment and transparency.
102. Global public goods: Public goods, with benefits and/or costs that
potentially extend to all countries, people, and generations.
103. Globalization: The increasing integration of economies around the world,
particularly through trade and financial flows and also through the
movement of ideas and people, facilitated by the revolution in
telecommunication and transportation.
104. Government Failure : An outcome that occurs when government’s
intervention is ineffective causing wastage of resources expended for the
intervention and/or when government intervention in the economy to
correct a market failure creates inefficiency and leads to misallocation of
scarce resources.
105. Gross Domestic Product (GDP): The total income earned domestically,
including the income earned by foreign-owned factors of production. May
be expressed at constant prices or at current prices.
106. Gross National Product (GNP): The total income of all residents of a
nation, including the income from factors of production used abroad; ie the
total expenditure on the nation’s output of goods and services.

107. Hard peg: An exchange rate policy where the central bank sets a fixed and
unchanging value for the exchange rate.
108. Heckscher-Ohlin (H-O) theorem: The theory that postulates that a nation
will export the commodity intensive in its relatively abundant and cheap
factor and import the commodity intensive in its relatively scarce and
expensive factor.
109. Hedging: The avoidance of a foreign exchange risk (or the covering of an
open position).
110. High powered money see Reserve Money ,Base money
111. Home-currency appreciation or foreign-currency depreciation: Takes
place when there is a decrease in the home currency price of foreign
currency (or alternatively, an increase in the foreign currency price of home
currency). The home currency thus becomes relatively more valuable.
112. Home-currency depreciation or foreign-currency appreciation: Takes
place when there is an increase in the home currency price of the foreign
currency (or, alternatively, a decrease in the foreign currency price of the
home currency). The home currency thus becomes relatively less valuable.
113. Import Quota: A direct restriction which specifies that only a certain
114. Import tariff: A tax or duty on imports.
115. Income Method: The national income is calculated by summation of factor
incomes paid out by all production units within the domestic territory of a
country as wages and salaries, rent, interest, and profit. Transfer incomes
are excluded.
116. Inflation targeting: A monetary policy under which the central bank
announces a specific target, or target range, for the inflation rate.
117. Inflation: A general increase in prices and fall in the value or purchasing
power of money.
118. Intellectual property rights: The exclusive rights granted to the creators
of intellectual property, and include trademarks, copyright, patents,
industrial design rights etc.

GLOSSARY I.11
119. Inter-bank money market: A very short-term money market, which allows
financial institutions such as banks, to borrow and lend money at interbank
rates.
120. Investment function: The relationship between investment expenditures
and income.
121. Investment multiplier (k): The ratio of change in national income (∆Y)
due to change in investment (∆I)
122. Kennedy Round: The multilateral trade negotiations that were completed
in 1967 under which agreement was reached to reduce average tariff duties
on industrial products by 35 percent.
123. Keynesian cross: A simple model of income determination, based on the
ideas in Keynes’s ‘General Theory’, which shows how changes in spending
can have a multiplied effect on aggregate income.
124. Keynesian model: A model derived from the ideas of Keynes’s ‘General
Theory’; a model based on the assumptions that wages and prices do not
adjust to clear markets and that aggregate demand determines the
economy’s output and employment.
125. Laissez-faire: The policy of minimum government interference in or
regulation of economic activity, advocated by Adam Smith and other
classical economists.
126. Liquidity Adjustment Facility (LAF): Facility under which the RBI
provides financial accommodation to the commercial banks through
repos/reverse repos. Instituted on the basis of the recommendations of
Narsimham committee on banking sector reforms.
127. Local content requirements: The mandate that a specified fraction of a
final good should be produced domestically.
128. M1: Also called ‘Narrow Money’ is a measure of money supply =Currency
and coins with the people + demand deposits of banks (Current and
Saving accounts) + other deposits of the RBI.
129. M2 = M1 + savings deposits with post office savings banks.
130. M3 = Also called ‘Broad Money’ =M1 + net time deposits with the banking
system.

131. M4 = M3 + total deposits with the Post Office Savings Organization

(excluding National Savings Certificates).
132. Managed floating exchange rate system: The policy of intervention in
foreign exchange markets by monetary authorities to smooth out short-run
fluctuations without attempting to affect the long-run trend in exchange
rates.
133. Marginal propensity to consume (MPC): The ratio of change in
consumption expenditures to change in income, or ∆C /∆Y.
134. Marginal propensity to save (MPS): The ratio of change in saving to
change in income, or ∆S/∆Y.
135. Marginal social benefit: The full benefit provided by another unit of a good,
including the benefit to the consumer and any benefits enjoyed by third
parties i.e the sum of marginal private benefit plus marginal external
benefit.
136. Marginal social cost: The full cost of producing another unit of a good,
including the marginal cost to the producer and any harm caused to third
parties, i.e the sum of marginal cost of production and marginal external
cost.
137. Marginal Standing Facility (MSF): The facility under which the scheduled
commercial banks in India can borrow additional amount of overnight
money from the central bank over and above what is available to them
through the LAF window by dipping into their Statutory Liquidity Ratio (SLR)
portfolio up to a limit ( a fixed per cent of their net demand and time
liabilities deposits (NDTL) liable to change ) at a penal rate of interest.
138. Market failure: A market that operates inefficiently and fails to achieve
efficient allocation of resources.
139. Market Stabilisation Scheme (MSS): Under this scheme, the Government
of India borrows from the RBI (such borrowing being additional to its normal
borrowing requirements) and issues treasury-bills/dated securities for
absorbing excess liquidity from the market arising from large capital inflows.
140. Mercantilism: The body of thought that postulated that the way for a
nation to become richer was to restrict imports and stimulate exports. Thus,
one nation could gain only at the expense of other nations.

GLOSSARY I.13
141. MERCOSUR: The South American Common Market that was formed by
Argentina, Brazil, Paraguay, and Uruguay in 1991
142. Merit goods: Goods which are socially desirable and have substantial
positive externalities. They are rival, excludable, limited in supply, rejectable
by those unwilling to pay, and involve positive marginal cost for supplying
to extra users Eg. Education, health care etc.
143. Minimum Support Price (MSP): Guaranteed minimum price as well as
procurement by government agencies at the set support prices to ensure
steady and assured incomes to producers.
144. Mixed tariff: A combination of an ad valorem and a specific tariff.
145. Monetary base: The sum of currency and bank reserves; also called High-
powered money.
146. Monetary Policy Committee (MPC): An empowered six-member panel of
experts in India to determine through debate and majority vote, the
benchmark policy interest rate (repo rate) required to achieve the inflation
target.
147. Monetary Policy Department (MPD): Assists the MPC in formulating the
monetary policy.
148. Monetary Policy Framework Agreement: An agreement reached between
the Government of India and the Reserve Bank of India (RBI) on the
maximum tolerable inflation rate that the RBI should target to achieve price
stability.
149. Monetary policy instruments: The various direct and indirect instruments
that a central bank can use to influence money market and credit conditions
and pursue its monetary policy objectives.
150. Monetary policy: The use of monetary policy instruments which are at the
disposal of the central bank to regulate the availability, cost and use of
money and credit so as to promote goals of government's economic policy.
151. Monetary transmission mechanism: The process or channels through
which the evolution of monetary aggregates affects real variables such as
aggregate output and employment.
152. Monetary union: A group of economies that have decided to share a
common currency and thus a common monetary policy.

153. Money demand function: A function showing the determinants of demand

for real money balance.
154. Money multiplier: The ratio that relates the change in money supply to a
given change in the monetary base i.e what multiple of the monetary base
is transformed into money supply.
155. Money supply: The amount of money in an economy available to the Public
at any particular point of time; usually determined by the Central bank and
the banking system
156. Money: Assets which are commonly used and accepted as a means of
payment or as a medium of exchange or of transferring purchasing power.
157. Moral hazard: The situation that can exist when someone is protected from
paying the full costs of their harmful actions and acts irresponsibly, making
the harmful consequences more likely.
158. Most Favoured Nation: The extension to all trade partners of any reciprocal
tariff reduction negotiated by a WTO member with any other nation.
159. Multilateral trade negotiations: Trade negotiations among many nations.
160. Multiplier: The ratio of the change in income to change in investment
in a closed economy.
161. Narrow money : The sum of currency held by the public, demand deposits
of the banks and other deposits of RBI.
162. National Income Equilibrium: The level of income at which the desired or
planned expenditures equal the value of output, and desired saving equals
desired investment.
163. Net exports: The difference between a country's total value of exports and
total value of imports.
164. Net Factor Income from Abroad (NFIA): The difference between the total
factor income received from abroad and the total factor income paid
to abroad.
165. Net Indirect Taxes: Indirect taxes - Subsidies.
166. Nominal exchange rate : The rate at which one country’s currency trades
for another country’s currency

GLOSSARY I.15
167. Nominal GDP: Gross Domestic Product (GDP) evaluated at current market
prices and is not inflation adjusted. Therefore nominal values of GDP for
different time periods can differ due to changes in quantities of goods and
services and/or changes in general price levels.
168. Nominal tariff: (such as an ad valorem one) calculated on the price of a
final commodity.
169. Non tariff Measures: Policy measures for restricting trade, other than
ordinary customs tariffs, that can potentially have an economic effect on
international trade in goods, changing quantities traded, or prices or both.
170. Non-excludable goods: Goods in the case of which the supplier cannot
prevent those who do not pay from consuming the good.
171. Non-Profit Institutions Serving Households: Non-profit institutions
which provide goods or services to households for free or at prices that are
not economically significant. Examples include churches and religious
societies, sports and other clubs, trade unions and political parties.
172. Non-rival goods: The same unit of good can be consumed by more
than one person at the same time.
173. North American Free Trade Agreement (NAFTA): The agreement to
establish a free trade area among the United States, Canada, and Mexico
that came into existence on January 1, 1994.
174. Open-market operations: A general term used for market operations
conducted by the Reserve Bank of India by way of sale/ purchase of
Government securities to/ from the market with an objective to adjust the
rupee liquidity conditions in the market on a durable basis.
175. Opportunity cost: The value of the next-highest-valued alternative use of
that resource that is given up when a decision is made.
176. Over-the-counter market: A decentralized market, without a central
physical location, where market participants trade with one another through
various communication modes.
177. Own account production: Production performed by a business or
government for its own use.
178. Per Capita Income: Income per head; ie total national income divided by
total population.

179. Personal Income : A measure of the actual current income receipt of

persons from all sources.
180. Pigouvian taxes: Named after A.C. Pigou , is a tax on pollution. These
taxes, by ‘making the polluter pay’, seek to internalize external costs into
the price of a product or activity.
181. Plurilateral Trade Agreements: Four agreements, originally negotiated in
the Tokyo Round, which have a narrower group of signatories.
182. Policy rate: In India, the fixed repo rate quoted for sovereign securities in
the overnight segment of Liquidity Adjustment Facility (LAF) is considered
as the ‘policy rate’.
183. Precautionary motive: A desire to hold cash in order to be able to deal
effectively with unforeseen, unexpected contingencies that require cash
outlay.
184. Preferential tariff: A tariff system under which the parties levy lower rates
of duty on imports from one another than they do on imports from third
countries.
185. Price Ceiling: When prices of certain essential commodities rise excessively,
government may resort to controls in the form of price ceilings (also called
maximum price) for making a resource or commodity available to all at
reasonable prices.
186. Price intervention: Intervention by governments to influence the
outcomes of a market; generally takes the form of price controls which may
be either a price floor (a minimum price buyers are required to pay) or a
price ceiling (a maximum price sellers are allowed to charge for a good or
service).
187. Private cost: A producer's or supplier's cost of providing goods or services.
These do not always equate with the total cost to the society.
188. Private goods: A good that is both excludable and rival in consumption.
189. Product Method: Also known as ‘Value Added Method’ or ‘Industrial Origin
Method’ or ‘Net Output Method’. A method of measuring national income
that entails the aggregation of production of each industry less intermediate
purchases from all other industries.
190. Progressive tax: A tax in which the tax rate increases as the taxable amount
increases.

GLOSSARY I.17
191. Prohibitive tariff: A tariff sufficiently high to stop all international trade
192. Public borrowing: Borrowing by governments.
193. Public goods: Nonexclusive and nonrival good; the marginal cost of
provision to an additional consumer is zero and people cannot be excluded
from consuming it.
194. Pump priming: When private spending becomes deficient, certain volumes
of public spending will help revive the economy
195. Pure private good: A good that is both rivalrous and excludable.
196. Pure public good: A good that is both nonrival and non excludable.
197. Quantitative Restrictions (QRs): A trade restriction ( also called trade
quota) which places limits on the volume or value of a good or service that
can be improved into a country; frequently resorted to for protecting the
price of domestically produced goods or to decrease or eliminate a trade
deficit.
198. Quantity theory of money: A theory which postulates that the nation's
money supply times the velocity of circulation of money is equal to the
nation's general price index times physical output at full employment.
199. Quasi public goods: Also called ‘near public good’ possess nearly all of the
qualities of private goods and some of the benefits of public good. It is easy
to keep people away from them by charging a price or fee. (for e.g.
education, health services).
200. Real effective exchange rate (REER): The nominal effective exchange
rate (a measure of the value of a currency against a weighted average of
several foreign currencies) divided by a price deflator or index of costs.
201. Real exchange rate = Nominal exchange rate X Foreign price Index
202. Real GDP: An inflation-adjusted measure that reflects the value of all goods
and services produced by an economy in a given year, expressed in base-
year prices, and is often referred to as GDP at constant-price, or inflation-
corrected GDP.
203. Recession: Stage of contraction in a business cycle which results in a
general slowdown in economic activity.

204. Recessionary gap: Also known as ‘contractionary gap’, is said to exist if the
existing levels of aggregate production is less than what would be produced
with full employment of resources.
205. Redistribution function: The state’s function to ensure equity and fairness
to promote the wellbeing of all sections of people and achieved through
taxation, public expenditure, regulation and preferential treatment of target
populations.
206. Regional Trade Agreements (RTAs): Groupings of countries (not
necessarily belonging to the same geographical region) which are formed
with the objective of reducing barriers to trade among member countries.
207. Repos: Repurchase Options or ‘Repo’, is an instrument for borrowing funds
by selling securities with an agreement to repurchase the securities on a
mutually agreed future date at an agreed price which includes interest for
the funds borrowed. It is a money market instrument, which enables
collateralised short term borrowing and lending through sale/purchase
operations in debt instruments.
208. Reserve money: Reserve money is comprised of currency held by the
public, cash reserves of banks and other deposits of RBI.
209. Reverse Repo: An instrument for lending funds by purchasing securities
with an agreement to resell the securities on a mutually agreed future date
at an agreed price which includes interest for the funds lent.
210. Rivalrous: Referring to a good, describes the case in which one unit cannot
be consumed by more than one person at the same time.
211. Rules of origin: Criteria used by governments of importing countries to
determine the national source of a product. Their importance is derived
from the fact that duties and restrictions in several cases depend upon the
country of origin of imports.
212. Safeguard Measures: Measures initiated by countries to restrict imports
of a product temporarily if its domestic industry is injured or threatened
with serious injury caused by a surge in imports.
213. Sanitary and Phytosanitary Measures (SPS): Measures provided for in
WTO agreements which can be applied to protect human, animal or plant
life from risks arising from additives, pests, contaminants, toxins or disease-
causing organisms and to protect biodiversity.

GLOSSARY I.19
214. Saving function: The relationship between saving and income. In general,
saving is negative when income is zero and rises as income rises, in such a
way that the increase in consumption plus the increase in saving equals the
increase in income.
215. Social costs: The total costs to the society on account of a production or
consumption activity. Social costs are private costs borne by individuals
directly involved in a transaction together with the external costs borne by
third parties not directly involved in the transaction. Social Cost = Private
Cost + External Cost.
216. Soft peg: An exchange rate policy under which the exchange rate is
generally determined by the market, but in case the exchange rate tend to
be move speedily in one direction, the central bank will intervene in the
market.
217. Special Drawing Rights (SDRs): International reserves created by the IMF
to supplement other international reserves and distributed to member
nations according to their quotas in the Fund.
218. Specific tariff: An import duty that assigns a fixed sum per physical unit
of the good imported.
219. Speculative motive: People’s desire to hold cash in order to be equipped
to exploit any attractive investment opportunity requiring cash expenditure.
220. Spot exchange rates: The exchange rate in foreign exchange transactions
which are carried out in the spot market and the exchange involves
immediate delivery.
221. Stabilization function: One of the key functions of fiscal policy which aims to eliminate
macroeconomic fluctuations arising from suboptimal allocation.
222. Stabilization policy: Public policy aimed at reducing the severity of short-
run economic fluctuations.
223. Stagflation: The combination of recession or stagnation and increasing
prices or inflation.
224. Statutory Liquidity Ratio (SLR): A stipulated percentage of the total
demand and time liabilities (DTL) / Net DTL (NDTL) of a scheduled
commercial bank in India which it is are required to maintain with RBI in
cash, gold or approved investments in securities.

225. Supply of money: The nation's total money supply which is equal to the
nation's monetary base times the money multiplier.
226. Tariff rate quotas (TRQs): Combine two policy instruments namely, quotas
and tariffs. Imports entering under the specified quota portion are usually
subject to a lower (sometimes zero), tariff rate. Imports above the
quantitative threshold of the quota face a much higher tariff.
227. Tariffs: Also known as customs duties, are taxes or duties imposed on
goods and services which are imported or exported.
228. Theory of liquidity preference: A simple model of the interest rate, based
on the ideas in Keynes’s General Theory, which says that the interest rate
adjusts to equilibrate the supply and demand for real money balances.
229. Tradable emissions permits: The system of marketable permits allocated
among firms, to emit limited quantities of pollutants which can be bought
and sold by polluters. The high polluters have to buy more permits and the
low polluters receive extra revenue from selling their surplus permits.
230. Trade policy: The regulations governing a nation’s commerce or
international trade and encompass all instruments that governments may
use to promote or restrict imports and exports.
231. Trade-Related Aspects of Intellectual Property Rights (TRIPS): A WTO
agreement that stipulates most-favored-nation treatment and national
treatment for intellectual properties, such as copyright, trademarks,
geographical indications, industrial designs, patents etc.
232. Trading bloc: A group of countries that have a free trade agreement among
themselves and may apply a common external tariff to other countries.
233. Tragedy of the commons: The problem of overuse when a good is
rivalrous but non excludable.
234. Transaction demand for money: The demand for active money balances
to carry on business transactions; it varies directly with the level of national
income and the volume of business transactions.
235. Transfer payment: Any Payment from the government to individuals that
are not in exchange for goods and services. Eg. Social Security payments.
236. Trigger price mechanisms: The quick responses of affected importing
countries upon confirmation of trade distortion to offset the distortion.

GLOSSARY I.21
237. Unilateral transfers: One-way economic transactions between the

residents of two nations over a stipulated period of time. These include gifts,
donations, personal remittances and other 'one-way' transactions.
238. Uruguay round: The multilateral trade negotiations 1986-94, the last and
most consequential of all rounds culminated in the birth of WTO and a new
set of agreements replacing the General Agreement on Tariffs and Trade
(GATT).
239. Value Added: The value of a firm’s output minus the value of the
intermediate goods the firm purchased.
240. Value-added approach: Measuring GDP by summing up the values added
by all firms in the economy.
241. Vehicle currency: A currency, such as the U.S. dollar used to denominate
international contracts and for international transactions.
242. Voluntary Export Restraints (VER): A type of informal quota administered
by an exporting country voluntarily restraining the quantity of goods that
can be exported out of a country during a specified period of time.
243. World trade organization (WTO): The organization set up at the Uruguay
Round with the objective of facilitating the flow of international trade
smoothly, freely, fairly and predictably. It has authority over trade in
industrial goods, agricultural commodities, and services, and to settle trade
disputes.

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Evolving Role of a CA - Shift Towards Strategic Decision Making

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Skill Requirements at Intermediate Level