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Macroeconomic Environment of
Business
Module - 2
Semester- III
July – 2010
Introduction to Macroeconomics
Definitions:
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In the words of Boulding, " Macroeconomics is that
part of economics which studies the overall averages
and aggregates of the system."
According to Shapiro, "Macroeconomics deals with the
functioning of the economy as a whole."
Scope & Importance of Macroeconomics
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To understand the working of the Economy
Framing Economic Policies
Study of Unemployment
National Income
Economic Growth
Monetary Problems
Business Cycles
Objectives of Macroeconomic Policy
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High level of output (GDP)
Full employment
Price stability
Sustainable balance of Payments
Rapid Economic Growth
Instruments of Macroeconomic
Policy
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Fiscal Policy
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Monetary Policy
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Exchange Rate Policy
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Trade Policy
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Price and Income Policies
Objectives
Instruments/Tools
High output level
Monetary Policy
Low unemployment rate Fiscal Policy
Stable price level
Exchange rate Policy
Maintenance of Balance International Trade Policy
of Payments
Steady economic growth Price and Income Policy
Basic Concepts in Macroeconomics
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Stock and Flow Concepts:
 A stock variable is measured at a specific point in time –it
signifies the level of a variable at a point in time
 Money supply, consumer price index, unemployment level
and foreign exchange reserves are examples
 A flow variable is measured over a specific period of
time- it represents the change in the level of a variable
over a period of time
 GDP, inflation, exports, imports, consumption and
investments are examples
Economic Environment
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Economic stages that exists at a given time in a country
Economic system that is adopted by a country for example.
Capitalistic, Socialistic or Mixed Economy
Economic planning, such as five year plans, budgets, etc.
Economic Indices such as National Income, Per Capital Income,
Disposable Income, Rate of growth of GNP, Distribution of Income,
Rate of savings, Balance of Payments etc.
Economic policies for example, monetary, industrial and fiscal
policies
Phases of business cycle
Structure of economy
Economic System
Types of Economic System
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Capitalism
Communism/Socialism
Mixed Economy
What is Capitalism?
"Capitalism is a system of economic organization
featured by private ownership and its use for
private profit of man-made and nature-made
capital."
Features of Capitalism
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Right to Private Property
Freedom of Enterprise
Freedom of Choice by Consumer
Profit Motive
Competition
Importance of Price System
Socialism
"the important essentials of socialism are that all
the great industries and the land should be public
or collectively owned, and that they should be
conducted (in conformity with a national economic
plan) for the common good instead of private
profit."
Features of Socialism
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Social Ownership of Means of Production
No Private Enterprise
Economic Planning
Classless Society
Consumer is not sovereign
Mixed Economy
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Co- Existence of Public and Private Property
Price System and Government Directives
Government Regulates and Controls the Private
Sector
Consumers' sovereignty is protected
Government Protects Labor Interest
Economic Planning & Budget
Objectives of Five Year Plans
1st Plan (1951-56)
It gave importance to agriculture, irrigation and power projects to
decrease the countries reliance on food grain imports, resolve the
food crisis The focus was to maximize the output from agriculture,
which would then provide the impetus for industrial growth.
2nd Plan (1956-61)
The second five year plan mainly focused on hydroelectric projects,
steel Mills, production of coal, railway tracks.
Contd..
8th Plan (1992-97)-Post Economic Reforms
The eighth plan was initiated just after a severe balance of payment
crisis, which was intensified by the Gulf war in 1990.several structural
modification policies were brought in to put the country in a path of
high growth rate. They were devaluation of rupees, dismantling of
license prerequisite and decrease trade barriers.
The plan targeted an annual growth rate of 5.6% in GDP and at the
same time keeping inflation under control.
Contd..
9th Plan (1997-2002)
It was observed in the eighth plan that, even though the economy
performed well, the gains did not percolate to the weaker
sections of the society. The ninth plans therefore laid greater
impetus on increasing agricultural and rural incomes and alleviate
the conditions of the marginal farmer and landless laborers.
The main objectives of the ninth five year plan were agriculture
and rural development, food and nutritional security,
empowerment of women, accelerating growth rates, providing
the basic requirements such as health, drinking water, sanitation
etc.
Contd..
10th Plan (2002-2007)
The aim of the tenth plan was to make the Indian economy the
fastest growing economy in the world, with a growth target of
10%.It wanted to bring in investor friendly market reforms and
create a friendly environment for growth. It sought active
participation by the private sector and increased FDI's in the
financial sector. Emphasis was also on improving the infrastructure.
Eleventh Five-Year Plan- (2007-12)
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The major objectives of the eleventh five year plan are
income generation, poverty alleviation, education, health,
infrastructure, environment , agriculture etc.
The chief thrust of the plan, that will run from 2007-08 to
2011-12, will be agriculture, education and infrastructure -all areas that remain a concern in a rapidly growing
economy.
‘Towards Faster and More Inclusive Growth’ is the central
theme of the plan that seeks to lower poverty by 10%,
generate 70 million new jobs, and reduce unemployment to
less than 5%.
What is Union Budget?
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The Union Budget gives the details of income and expenditure
planned by the government of India.
Income are those that will be generated by taxation and
expenditure is which that the government is going to make.
Government's expenditure includes money spent on running
various government services, subsidies, interest charges etc..
The union budget also announces policies and it tells about the
government's economic thinking. It also determines activities such
as exports and foreign direct investment. The Union Budget has
both short and long term effect.
Economic Indicators
What is an Economic Indicator???
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An economic indicator is a statistic about the economy.
Economic indicators allow analysis of economic
performance and predictions of future performance.
Nature of Economic indicators can be described in two
ways:
Relation with the economy
 Timing
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Nature of Economic indicators
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Relation to the Business cycle or Economy
Procyclic: A procyclic economic indicator is one that moves in the
same direction as the economy. So if the economy is doing well,
this number is usually increasing, whereas if we're in a recession
this indicator is decreasing. The Gross Domestic Product (GDP) is
an example of a procyclic economic indicator.
 Countercyclic: A countercyclic economic indicator is one that
moves in the opposite direction as the economy. The
unemployment rate gets larger as the economy gets worse so it
is a countercyclic economic indicator.
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Nature of Economic indicators
Timing: Economic Indicators can be leading, lagging, or coincident which indicates the
timing of their changes relative to how the economy as a whole changes.
 Leading: Leading economic indicators are indicators which change before the
economy changes. Stock market returns are a leading indicator, as the stock
market usually begins to decline before the economy declines and they improve
before the economy begins to pull out of a recession. Leading economic indicators
are the most important type for investors as they help predict what the economy
will be like in the future.
Examples
 Stock price
 Housing Markets
 Inflation
 Interest rates
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Contd…
 Lagged:
trail behind the general economic
activity. Example: Unemployment rate GDP
(sometimes)
 Coincident:
A coincident economic indicator is one
that simply moves at the same time the economy
does. The Gross Domestic Product is a coincident
indicator.
General Economic Indicators
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Total Output, Income, and Spending (GDP, Consumer
Spending)
Employment, Unemployment, and Wages
Production and Business Activity (Index of Industrial
production)
Prices (Inflation rate)
Money, Credit, and Security Markets (Interest rates)
Federal Finance (Fiscal deficit)
International Statistics (BOP status, Exchange rate)
What is National Income??
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It represents the total income accrued to all factors
of production
Wages + Interest + Rent + Profit
Measures of Aggregate Income
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Gross Domestic Product (GDP)
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Gross National Product (GNP)
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Net National Product (NNP)
Calculating Aggregates
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At Market Price
At Factor Cost
Factor costs are really the costs of all the factors of production
such as labor , capital, energy, raw materials like steel etc that
are used to produce a given quantity of output in an economy.
Factor costs are also called factor gate costs since all the costs
that are incurred to produce a given quantity of goods and
services take place behind the factory gate ie within the walls of
the firms, plants etc in an economy.
Gross Domestic Product
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The GDP of a country is defined as the market value of all final
goods and services produced within a country in a given period of
time usually a year
 Includes only goods and services purchased by their final users,
so GDP measures final production.
 Counts only the goods and services produced within the country's
borders during the year, whether by citizens or foreigners.
 Excludes transfer payments since they do not represent current
production.
It provides the measure of aggregate output and its comparison
over time enables us to calculate the rate of growth (usually
calculated both at current and constant prices)
GDP at Market Price
GDP@ market price = GNP@ factor cost – Subsidies +
Indirect Taxes
GDP@ market price refers to the total final output of all
final goods and services produced within the national
frontiers of a country by its citizens and the
foreign residents who reside within those frontiers that are
sold at market prices in various markets.
GDP at factor Cost
GDP@ factor cost = GDP@ market price + Subsidies - Indirect
Taxes
GDP@ factor cost refers to the total final output of all final goods
and services produced within the national frontiers of a country by
its citizens and the foreign residents who reside within those frontiers
that are assessed at production or factor cost prior to leaving the
irrespective factory gates for various markets where they are
bought and sold.
IMF's GDP forecast same as Govt's:
Arvind Virmani
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The International Monetary Fund’s (IMF) recent 9.4% GDP growth
forecast for the current year surprised economy watchers as its far
upbeat version of what the traditionally pessimistic fund has had to
say for the growth of the Indian economy. The government reacted
with caution and said India would be happy with 8.5% growth.
Explaining the difference Arvind Virmani, India's Executive Director
at the fund said these forecasts were for the calendar year. “Our
forecasts are for GDP at market prices as against the official
forecasts which are for GDP at factor cost,” he said adding, a 9.4%
GDP at market price implies a 8.5% GDP at factor cost.
Nominal GDP
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Nominal GDP is the value of the total flow of goods
and services produced in an economy over a
specified period of time (usually a year] at current
market price
At current prices, GDP growth is partly due to
increase in output and partly due to increase in prices
so that GDP at current prices can give misleading
conclusions on growth
Real GDP
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GDP data is also calculated at constant prices taking
the year in the past as base year to filter our the
impact of current prices.
Real GDP is the physical quantity of goods and
services produced in a given period changes in real
GDP measure changes in living standard
Example
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Assume economy only produces apples and pears. The price
for an apple is $2 in 2000, whereas the price for a pear is
$3. Same year we produce 100 apples and 50 pears. In
2005, because of the inflation the price for an apple goes up
to $3, whereas the price for a pear is $4 at the same
production levels.
The nominal GDP in 2000 is $350 and the nominal GDP in
2005 is $500. However real GDP did not change, because
real GDP only changes with the changing production level and
therefore is a better size measure for economy.
Gross National Product (GNP)
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Total market value of all final goods and services produced by citizens of a
country no matter where they are residing
Is total Income received by residents for their contributions as factors of
production anywhere in the world
GDP measures output within the borders of a country no matter regardless
of citizenship of the producer, GNP measures output of the country’s citizens
regardless where they live
GNP at factor cost =GDP at factor cost + Net Income from
abroad
Examples - GNP
The income of an Indian working in Bahrain is part of Bahrain's GDP as
well as India's GNP
Suppose Toyota owns a plant in Bahrain to produce Camry's using
Bahraini workers. How to count the product of this plant in the GDP and
GNP of Bahrain and Japan?
With GDP, Bahrain gets all of it, because the plant and the workers are
all located in Bahrain.
With GNP, the capital share goes to Japan
Net National Product
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NNP equals GNP less replacement investment
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NNP = GNP – Depreciation
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This is an estimate of how much the country has to spend to
maintain the current GNP
If the country is not able to replace the capital stock lost
through depreciation, then GNP will fall.
Contd….
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In addition, a growing gap between GNP and NNP
indicates increasing obsolescence of capital goods,
while a narrowing gap would mean that the condition
of capital stock in the country is improving.
NNP at factor cost = GNP at factor costDepreciation which is accurate measure of
National Income
Approaches used to calculate GDP
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Production Approach
Income Approach
Expenditure Approach
Expenditure Approach
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Considers total spending on all final goods & services
during the year
It is a demand based concept
Includes:
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Personal Consumption
Durable Goods & Non-Durable Goods and Services
Gross Private Investment
Government Consumption and Gross Investment
Net Exports of Goods and Services
So, GDP = C + I + G + (X-M)
Income Approach
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Measures by summing the following components
 Employee
Compensation
 Proprietor’s Income
 Corporate Profits
 Rent
 Interest Income
 Indirect Business Taxes
 Net Income from foreigners
Major Limitations of GDP
The GDP fails to measure or express changes in a
nation's:
 Quality of life
 Unpaid labor
 Wealth distribution
 Underground economy
 Externalities
Money Supply
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Money supply is another important indicator of
macroeconomic environment
This refers to the total volume of money circulating in the
economy, and conventionally comprises currency with the
public and demand deposits (current account + savings
account) with the public.
Money supply in an economy determines liquidity
conditions in the market, which in turn impacts interest
rate structure and hence the cost of capital to the firms.
Contd..
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Money supply is basically determined by the central
bank of a country (e.g. Reserve Bank of India) and the
commercial banking network.
RBI has adopted four measures of money supply viz.-Ml,
M2, M3 and M4 .
M3 (broad money) is most popular from operational
point of view. M3 includes time deposits (fixed deposits),
savings deposits with post office saving banks and all the
components of M1.
Factors affecting Money supply
Bank credit
 Deficit financing
 Foreign exchange reserves
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Inflation
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1.
2.
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A sustained increase in the general level of prices so
that a given amount of money buys less and less.
Reasons of inflation
inflation caused by monetary expansion (monetary
inflation)
inflation caused by real demand expansion
inflation caused by aggregate supply contraction
Money supply & Inflation – Monetary inflation
It was Milton Friedman who famously quipped,
“Inflation is always and everywhere a monetary
phenomenon.” If the quantity of money grows at a
pace greater than warranted by the growth of the
economy, then the excess money supply drives up
prices.
Types of Inflation
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Demand pull inflation: Arises when aggregate demand outpaces
aggregate supply in an economy. It involves inflation rising as the
real gross domestic product rises and unemployment falls
Cost Push inflation: This is because of large increases in the cost
of important goods or services where no suitable alternative is
available. A situation of this kind has been cited during oil crisis in
1970s
Hyperinflation: Hyperinflation is also known as runaway inflation
or galloping inflation. This type of inflation occurs during or soon
after a war
Remedies - Real Demand Inflation
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If inflation is caused by strong real demand, the best response may
be to support aggregate supply growth. Part of the solution may be
to let prices rise. Suppliers need incentives to invest in new
capacity.
Stimulating aggregate supply include encouraging business
investment; reducing input costs; and increasing competitive intensity.
If aggregate supply is sufficiently stimulated, inflation may be
converted into balanced economic growth:
If instead money supply is tightened in the face of strong real demand,
the result will be a surge in interest rates, which may be
counterproductive in this case, as it will be harder for aggregate
supply to expand when borrowing costs are high.
Remedies – Monetary Inflation
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If the cause of inflation is instead monetary
expansion, aggregate supply should still be
stimulated, but the focus of effort should be
constraining further monetary expansion.
Real v/s Money Inflation
To distinguish real demand inflation from
monetary inflation is to look at interest
rates. When inflation is caused by strong real
demand, interest rates will tend to be
high. When inflation is caused by excessive
monetary growth, in contrast, interest rates will
tend to be low.
Measurement of Inflation
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Inflation is measured by the
 Wholesale Price Index (WPI)
 Consumer Price Index (CPI)
A Wholesale Price Index (WPI) is the price of a
representative basket of wholesale goods.
Some countries use the changes in this index to
measure inflation in their economies, in particular
India – The Indian WPI figure is released weekly
WPI as a measure of inflation in India
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WPI is preferred to CPI
 wider commodity coverage
 available on weekly basis
 computed at all-India basis
WPI Inflation is divided into three broad categories
 Primary Articles
 Fuel Products and
 Manufacturing Items.
Headline inflation
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Headline inflation is a measure of the total inflation within an
economy and is affected by certain components which may
experience sudden inflationary spikes such as food or energy.
As a result, headline inflation may not present an accurate
picture of the current state of the economy.
WPI is the measure of headline inflation in India
Core inflation
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Core inflation has emerged as an alternative for measuring
inflation. In this, volatile items like food prices and fuel items are
excluded.
The first two categories include food articles and fuel items
which can be excluded. The third category – Manufacturing
also includes food products which tends to be volatile as well
and moves in line with prices of primary articles. So after
excluding food products from manufacturing sector, we get
non-food manufactured products inflation. This can also be
called as core inflation for India
Consumer Price Index
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CPI, also retail price index is a statistical measure
of a weighted average of prices of a specified set
of goods and services purchased by wage earners
in urban areas. It is a price index which tracks the
prices of a specified set of consumer goods and
services, providing a measure of inflation.
CPI in India based on different economic
groups.
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CPI UNME (Urban Non-Manual Employee)
CPI AL (Agricultural Labourer)
CPI RL (Rural Labourer)
CPI IW (Industrial Worker).
While the CPI UNME series is published by the
Central Statistical Organization, the others are
published by the Department of Labor.
Effects of inflation
 Wealth
costs – inflation affects those on fixed incomes and
redirects wealth to other (physical) assets
 Planning costs – businesses uncertain about future price
changes may be reluctant to invest – hits economic growth
 Competitiveness – inflation at a higher rate in the UK than
elsewhere hits domestic competitiveness and affects the
balance of payments
 Social stability - At very high rates, confidence in the
currency is eroded and production and exchange can be
stifled – can lead to food riots, looting and violence
Real & Nominal Interest rates
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Real Interest Rate = Nominal Interest Rate –
Inflation
Real interest rate, is one where the effects of inflation
have been factored in. A nominal variable is one
where the effects of inflation have not been accounted
for.
Economic Policies
Economic Policies
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Monetary Policy
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Fiscal Policy
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Industrial Policy
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Foreign Trade Policy
Monetary policy
Monetary policy is one of the tools used to influence
its economy. Using its monetary authority to control
the supply and availability of money, a government
attempts to influence the overall level of economic
activity in line with its political objectives. Usually this
goal is "macroeconomic stability" - low
unemployment, low inflation, economic growth, and a
balance of external payments. Monetary policy is
usually administered by a Government appointed
"Central Bank“.
What is Monetary Policy??
It is the process by which the central bank or
monetary authority of a country regulates (i)
the supply of money (ii) availability of money
and (iii) cost of money or rate of interest in
order to attain a set of objectives oriented
towards the growth and stability of the
economy
Monetary policy provides
a) an overview of economy
b) specifies measures that RBI intends to take to
influence such
 key factors like…money supply….interest
rates….inflation
c)lays down norms for financial institutions like
banks, financial companies etc. relating to CRR,
capital adequacy
Monetary policy & Inflation
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When inflationary pressures build up:
 raise the short-term interest rate (the policy
rate)
 which raises real rates across the economy
 which squeezes consumption and investment.
Monetary Policy Instruments
Open Market Operations
 Bank rate
 Cash Reserve Ratio
 Statutory Liquidity Ratio
 Repo rate
 Reverse Repo rate
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Open Market Operations
OMOs are the means of implementing
monetary policy by which a central bank
controls the nation’s money supply by buying
and selling government securities, or other
financial instruments
What is the outcome on account of OMO?
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When the RBI buys bonds from the market and infuses liquidity, the
consequences are:
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It tends to soften the interest rates
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It enables corporates to borrow at favorable interest rates
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It prevents the rupee from strengthening unnecessarily and
thereby protects the interest of exporters
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It may tend to increase inflation
Consequently… If the RBI were to sell bonds
instead and suck in liquidity, the effect would
exactly be the opposite!!
Bank rate
Rate at which Central Bank lends money to commercial
Banks
The bank rate signals the central bank's long-term outlook
on interest rates. If the bank rate moves up, long-term
interest rates also tend to move up, and vice-versa.
Any increase in Bank rate results in an increase in interest
rate charged by Commercial banks which in turn leads to
low level of investment and low inflation
Cash Reserve Ratio
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It refers to the cash which banks have to maintain
with RBI as certain percentage of their demand
and time liabilities
An increase in CRR reduces the cash with commercial
banks which results in low supply of currency in the
market, higher interest rate and low inflation
Statutory Liquidity Ratio
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Commercial Banks have to maintain liquid assets cash,
gold and approved securities equal to not less than
25% of their total demand and time deposit
liabilities
Objectives of SLR
 To restrict expansion of Bank credit
 To augment bank’s investment in government
securities
 To ensure solvency of banks
Meaning of Repo
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The term Repo is used as an abbreviation for
Repurchase Agreement or Ready Forward. A Repo
involves a simultaneous "sale and repurchase"
agreement.
It enables collateralized short term borrowing and
lending through sale/purchase operations in debt
instruments
Repo Rate
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In current monetary policy RBI raised repo rate by 25
basis points to 5.75%
Repo rate is the interest rate charged by the Central
bank when banks borrow money from it against
pledging its securities
If the RBI wants to make it more expensive for the
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.
Reverse Repo
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The rate at which RBI borrows money from the banks (or banks lend
money to the RBI) is termed the reverse repo rate.
If the reverse repo rate is increased, it means the RBI will borrow money
from the bank and offer them a lucrative rate of interest. As a result,
banks would prefer to keep their money with the RBI (which is absolutely
risk free) instead of lending it out (this option comes with a certain amount
of risk)
Consequently, banks would have lesser funds to lend to their customers.
This helps stem the flow of excess money into the economy
Reverse repo rate signifies the rate at which the central bank absorbs
liquidity from the banks, while repo signifies the rate at which liquidity is
injected.
Importance of Repo & Reverse Repo
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It helps borrower to raise funds at better rates
An SLR surplus and CRR deficit bank can use the Repo
deals as a convenient way of adjusting SLR/CRR
positions simultaneously.
RBI uses Repo and Reverse repo as instruments for
liquidity adjustment in the system
Reverse Repo is undertaken to earn additional income
on idle cash.
Major Players in Repos/Reverse Repos
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The major players in the repo and reverse repurchase market
tend to be banks who have substantially huge portfolios of
government securities as approved by RBI (Treasury Bills,
Central/State Govt securities).
Besides these players, primary dealers who often hold large
inventories of tradable government securities are also active
players in the repo and reverse repo market.
DFHI is very active in the Repo Market. It has been selling and
purchasing on repo basis T-Bills and eligible dated
Government Securities.
Call Rate – Short term Inter bank rate
Call rate is the interest rate paid by the banks for
lending and borrowing for daily fund requirement.
Since banks need funds on a daily basis, they lend to
and borrow from other banks according to their daily
or short-term requirements on a regular basis.
Liquidity Adjustment Facility

A tool used in monetary policy that allows banks to
borrow money through repurchase agreements. This
arrangement allows banks to respond to liquidity
pressures and is used by governments to assure basic
stability in the financial markets.
Liquidity adjustment facilities are used to aid banks in
resolving any short-term cash shortages during periods
of economic instability or from any other form of stress
caused by forces beyond their control. Various banks will
use eligible securities as collateral through a repo
agreement and will use the funds to alleviate their shortterm requirements, thus remaining stable.

Liquidity Adjustment Facility
Objective : The funds under LAF are used by the banks for their day-to-day mismatches in liquidity.
Tenor :Under the scheme, Reverse Repo auctions (for absorption of liquidity) and Repo auctions (for injection of
liquidity) are conducted on a daily basis (except Saturdays).
Eligibility : All commercial banks (except RRBs) and PDs having current account and SGL account with RBI.
Minimum bid Size : Rs. 5 cr and in multiple of Rs.5 cr
Eligible securities: Repos and Reverse Repos in transferable Central Govt. dated securities and treasury bills.
Discretion to RBI : Under the revised Scheme, RBI will continue to have the discretion to conduct overnight reverse repo
or longer term reverse repo auctions at fixed rate or at variable rates depending on market conditions and other
relevant factors. RBI will also have the discretion to change the spread between the repo rate and the reverse repo
rate as and when appropriate. (As per an IMF 1997 publication, “the sale and repurchase transactions (reverse repo),
are sales of assets by the central bank under a contract providing for their repurchase at a specified price on a given
future date; they are used to absorb liquidity”. On the contrary, prior to above change, in the Indian context, “repo”
denotes liquidity absorption by the Reserve Bank and “reverse repo” denotes liquidity injection).
Highlights of RBI Monetary Policy Review for first
quarter of the financial year FY2010-11






The Bank Rate has been retained at 6.0%
Repo rate increased by 25 bps from 5.5% to 5.75% with immediate
effect
Reverse repo rate increased by 50 bps from 4.0% to 4.50% with
immediate effect
Cash Reserve Ratio (CRR) of scheduled banks has been retained at
6.0% of their net demand and time liabilities (NDTL)
The projection for WPI inflation for March 2011 has been raised to
6.0% from 5.5%
Baseline projection of real GDP growth for FY2010-11 is revised to
8.5%, up from 8.0% with an upside bias
Contd..


The move was aimed to moderate inflation by reining in demand
pressures and reduce the volatility of short-term rates, RBI governor
Subbarao was quoted as saying. "Inflation is now being significantly
driven by demand-side factors," Subbarao said. "It is imperative that
we continue in the direction of normalizing our policy instruments to a
level consistent with the evolving growth and inflation scenarios."
The RBI said that the Monetary Policy actions are expected to:



Moderate inflation by reining in demand pressures and inflationary
expectations.
Maintain financial conditions conducive to sustaining growth.
Generate liquidity conditions consistent with more effective transmission of
policy actions.
Public Finance
and
Fiscal Policy
Public Finance




Study of State Finance is called Public Finance
Deals with the income and expenditure of central, state and
local governments.
Raising of necessary funds for incurring expenditure for public
goods constitutes the subject matter of Public Finance
Components of Public Finance
 Public Revenue
 Public Expenditure
 Public Debt
 Fiscal Policy
Meaning of Fiscal Policy


Fiscal policy is also called Budgetary policy. It is
primarily concerned with the receipts and expenditures
of the Central government; it also relates to the study of
economic effects of these receipts and expenditures
Fiscal policy refers to government policy that attempts to
influence the direction of the economy through changes in
taxation, public borrowing and public expenditure with
specific objectives in view.
Contd..

Changes in the level and composition of taxation
and government spending can impact on the
following variables in the economy:
 Aggregate Demand and the level of
economic activity
 The pattern of resource allocation
 The distribution of income.
Importance of
Depression
Fiscal Policy –Post Great
 The
ineffectiveness of monetary policy as a means of
overcoming the severe unemployment of the Great
Depression
 The
development of the new economics by Keynes with
its emphasis on aggregate demand. Fiscal policy is
based on the theories of British economist John Maynard
Keynes. Also known as Keynesian Economics, this theory
basically states that governments can influence
macroeconomic productivity levels by increasing or
decreasing tax levels and public spending. This influence, in
turn, curbs inflation (generally considered to be healthy
when at a level between 2-3%), increases employment and
maintains
a
healthy
value
of
money.
Main Concern of Fiscal Policy in LDCs






Development
Allocation of resources for development
Reduction in economic inequality
Inducing savings and investment
Control of inflation
Reduction in regional inequalities
Budget



The main instrument of fiscal policy is the budget,
presented annually by the Minister of finance to
Parliament.
Budget means ‘plans of government finances submitted
for the approval of the Legislature’
It is a time bound financial program systematically
worked out and ready for execution in the ensuing
fiscal year. It is a comprehensive plan action which
brings together in one consolidated statement all
financial requirements of the government.
Budget has four major Functions-Prof
Musgrave




Proper allocation of resources or the
provision of social goods
Equitable distribution of income and wealth
Securing economic stability or full
employment
Long term economic growth
Public Revenue :Major Sources For Centre
Revenue Receipts
Tax revenue: Direct Taxes

Income Tax

Corporate Tax

Wealth Tax
Indirect Taxes

Customs

Excise

Others
Non tax Revenue

Interest receipts

Dividend

Profits of PSUs

Revenue from social services
like education and hospitals

External Grants
Capital Receipts
Market Borrowing-internal debt

Disinvestment of PSUs

Recoveries of loans

Borrowing from external markets
External loans/Debts from world
institutions

Public Revenue :Major Sources For States
Revenue Receipts
Tax revenue

land revenue,

stamp duties and registration fees,

Urban immovable property tax
Indirect Taxes

Sales tax on goods

Entertainment tax

Luxury tax





Interest receipts
Dividend from state enterprises
Share in Central taxes
Grants in aid from Centre
And other contributions from Centre
Like those given for central schemes
Capital Receipts


Market Borrowing
Loans which flow from Centre
Public Expenditure
Revenue Expenditure
Capital Expenditure
Plan Expenditure
Plan Expenditure
Central Plan such as agriculture, Developmental Projects
rural development, social service
and others
Central Assistance for plans to
States and UTs
Non – Plan Expenditure
Interest Payments
Subsidies
Debt relief to farmers
Grant to states and UTs
Others
Non – Plan Expenditure
Loans to PSUs
Loans to states and UTs
Defense
Meaning of Public Debt




It represents government borrowing from public.
Government debt can be categorized as internal debt, owed
to lenders within the country, and external debt, owed to
foreign lenders.
Internal Debt is comprised of market borrowings, special
securities issued to RBI, Provident funds, Small savings
collections, Treasury bills, Ways and Means Advances
Government Borrowing leads to Crowding out effect
Crowding out Effect

In economics, when the government expands its borrowing to
finance increased expenditure, crowding out occurs of private
sector investment by way of higher interest rates

If increased borrowing leads to higher interest rates by creating
a greater demand for money and loanable funds and hence a
higher "price" (ceteris paribus), the private sector, which is
sensitive to interest rates will likely reduce investment due to a
lower rate of return. This is the investment that is crowded out.

More importantly, a fall in fixed investment by business can hurt
long-term economic growth of the supply side, i.e., the growth
of potential output.
Features of Public Debt




Size of debt has been on increase
Internal debt constituted a larger proportion in first
and Second Plans and position was reversed in
Third Plan where external loans contributed to a
larger proportion
However from 4th till 10th plans greater reliance has
been placed on internal borrowings
Market Borrowings form a significant portion
Indicators of Fiscal Imbalances


Revenue Deficit
Fiscal Deficit
Revenue Deficit

Current revenue expenditure of the central
government is composed of plan and non-plan
expenditure of the government. Revenue expenditure
is met out of current revenue receipts
Revenue Deficit = Revenue expenditure – Revenue
receipts
Fiscal Deficit




It is the difference between the government's total
receipts (excluding borrowing) and total expenditure.
Fiscal deficit gives the signal to the government about
the total borrowing requirements from all sources.
Components of fiscal deficit
revenue deficit and
capital expenditure.
Fiscal Deficit

In India, the fiscal deficit is financed by obtaining
funds from Reserve Bank of India, called deficit
financing. The fiscal deficit is also financed by
obtaining funds from the money market
(primarily from banks)
Methods of raising funds or financing
Deficit
 Borrowing from market or external sources
 Government may print currency or govt issue
adhoc treasury bills to RBI(deficit financing)
Ad hoc Treasury bills




Under this old system started in 1955 government was allowed
to draw money from RBI automatically and to an unlimited
extent
It stipulated that whenever the government’s cash balances
with went below Rs 50 crore adhoc treasury bills would be
issued to raise the cash balance Rs 50 crore. It became an
attractive source of financing since it was available at interest
rate of 4.6% since 1974
However over a period of time the limit got extended to an
ever increasing amount
According to C.Rangarajan this operational arrangement
opened up the floodgates of automatic monetization which
changed the entire course of monetary history for the next 40
years
Monetized Deficit

It is net increase in net Reserve Bank credit to
Central government which is sum of increase in RBI’s
holdings of govt of India dated securities, treasury
bills, rupee coins and loans and advances from
Reserve Bank to Centre since April 1, 1997
Ways and Means Advances-New Scheme




Under the new scheme RBI provides facilities for
temporary accommodation up to a ceiling fixed in
advance
The limit for WMA and rate of interest on WMA will
be mutually agreed to between the Reserve Bank and
govt from time to time
The credit thus drawn has to be repaid or in technical
language Govt vacates WMA from time to time.
As a result WMA will be reduced to zero at the end of
financial year

Scheme of Ways and Means Advances (WMA) to State
Governments for the fiscal year 2007-08
On a review of the State-wise limits of Normal Ways and
Means Advances for the year 2006-07, the Reserve Bank of
India has decided to keep these limits unchanged for the year
2007-08. Accordingly, the aggregate Normal WMA limit
would be retained at Rs.9,875 crore in 2007-08. Other terms
and conditions of the Scheme would also continue to remain
unchanged for 2007-08.
Deficit Financing in India






In first plan it was modest at Rs 333 crore
Second Plan to Rs 954 crore
Third- 1,133 crore
Fourth – 2060
Fifth- 15684 crore
Eight plan – 33,037 crore
The FRBM Act, 2003
It became effective from July 5, 2004
eliminate revenue deficit by March, 2009 and
to reduce fiscal deficit to an amount
equivalent to 3 per cent of GDP by
March,2008.
BUDGET ESTIMATES 2010-11

The Gross Tax Receipts are estimated at Rs. 7,46,651 crore

The Non Tax Revenue Receipts are estimated at Rs. 1,48,118 crore.




The total expenditure proposed in the Budget Estimates is Rs. 11,08,749
crore, which is an increase of 8.6 per cent over last year.
The Plan and Non Plan expenditures in BE 2010-11 are estimated at Rs.
3,73,092 crore and Rs. 7,35,657 crore respectively. While there is 15 per
cent increase in Plan expenditure, the increase in Non Plan expenditure is
only 6 per cent over the BE of previous year.
Fiscal deficit for BE 2010-11 at 5.5 per cent of GDP, which works out to
Rs.3,81,408 crore.
Taking into account the various other financing items for fiscal deficit, the
actual net market borrowing of the Government in 2010-11 would be of
the order of Rs.3,45,010 crore. This would leave enough space to meet the
credit needs of the private sector.
Fiscal Consolidation- Budget 2010 -11



With recovery taking root, there is a need to review public
spending, mobilize resources and gear them towards building
the productivity of the economy.
Fiscal policy shaped with reference to the recommendations of
the Thirteenth Finance Commission, which has recommended a
calibrated exit strategy from the expansionary fiscal stance of
last two years.
It would be for the first time that the Government would target
an explicit reduction in its domestic public debt-GDP ratio.
Meaning of Business Cycle



The business cycle or economic cycle refers to the fluctuations of
economic activity about its long term growth trend.
The cycle involves shifts over time between periods of relatively rapid
growth of output (recovery and prosperity), and periods of relative
stagnation or decline (contraction or recession).
Phases of Business Cycle
 Prosperity
 Recession
 Depression
 Recovery
Prosperity Phase







Unemployment rate declines
Income tends to rise
Investment increases
Investors become more optimistic
Consumption tends to rise
Share price index tends to rise
Money Supply increases
Recessionary Phase




Recession is turning point ie when prosperity ends
recession begins
Liquidation in stock market, fall in prices are
symptoms
Banks & People try to gain greater liquidity so
credit sharply contracts
Business expansion stops
Depression Phase





Shrinkage in volume output
Rise in level of unemployment
Fall in aggregate demand
Contraction of Bank credit
Fall in prices
Recovery Phase


Rise in demand for consumption goods which in turn
lead to demand for capital goods and new
investment is induced
This will give rise to increase in income and
employment
Phases of Business Cycle
Peak
Peak
Peak
Prosperity
Trough
Trough
2005
2010
2015
Year
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