Macroeconomics

The Circular Flow of Income and Expenditure

5 Sector Model: Households, Firms, Banks, Government& Rest of World
Closed (Domestic) Economy

Disposable Households
Government
Income 60
Income Consumption Saving
Saving
Taxes 40 80
Expend 20
100 48 100 12

Govt Firms
Expend
Investment
Investment
40
20
12
Banks

Rest
Exports
of Imports
World

National Income (Y) = C + I + G + NX (Exports - Imports)

Gross Domestic Product (GDP)
 GDP is the money value of all the final goods and services
produced within the nation’s geographical territory, in one
year, and valued at their current market price.
 GNP is the money value of all the final goods and services
produced by Nationally owned factors of production, in one
year, and valued at their current market price.
 National Income is the sum of all earnings of all the
households of an economy earned by means of rent, wages,
interest and profits, in one year.
 Sum of everybody’s earning is National Income
3
 Net Factor Income from Abroad
(NFIA) = Exports – Imports

Market Price is when the value of goods and

services are calculated according to the prevailing
price.

Factor Cost is when the value of goods and

services is calculated as per the income received by
the factors of production

4
Relation between Gross & Net, MP & FC

 Gross = Net + Depreciation

 Market Prices = Factor Cost + Net Indirect tax
 National = Domestic + Net Factor Income from Abroad

5
Methods of measuring national income

 Product method

 Income method

 Expenditure method

If done correctly, the following equation must hold:

Production = income = expenditure

6
The Product / Output (Value Added) Method

 The agricultural and extractive industries

 Plus Manufacturing industries
 Plus Services and construction
 Equals Gross Domestic Product at Factor Cost
 Plus Net factor income from abroad ( = income received from abroad –
income paid abroad)
 Equals Gross National Product at Factor Cost
 Less Capital consumption or depreciation
 Equals Net National Product at Factor Cost or National Income

7
Income approach

 Under the income approach, national income equals the sum of the
costs of production of goods and services which equals the earnings
that household receive for their factors of production.
 Thus,
NDPFC= wages+ interest + rent + profit
 Transfer payments are not included such as unemp. benefits and
pensions

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Expenditure Approach
 Consumption (C)
 Plus Gross private domestic investment (Ig)
 Plus Government purchases (G)
 Plus Net exports (NX) + Net factor income from abroad
 Gross National product at market price
 Less Net indirect taxes
 Equals Gross National Product at factor cost
 Less Depreciation
 Equals Net National Product at factor cost (National Income)

9
Introduction to a few important terms
 Recession – Two consecutive quarters of a negative GDP
growth rate is known as a recession.
 A prolonged recession becomes a depression.
 Business Cycles - Alternating periods of expansion and
contraction in economic activity.
 Keynes : “A trade cycle is composed of periods of good trade
characterized by rising prices and low unemployment with
periods of bad trade characterized by falling prices and high
unemployment”.
Business Cycle
Business cycle
 Alternating periods of expansion and contraction
in economic activity.
 Keynes : “A trade cycle is composed of periods of
good trade characterized by rising prices and low
unemployment with periods of bad trade
characterized by falling prices and high
unemployment”.
 Features of Business Cycles

1. Business cycles occur periodically.

2. Business cycles are Synchronic- all embracing
3. Fluctuations occur not only in level of production but also
simultaneously in other variables such as employment,
investment, consumption, rate of interest, price level etc.
4. Investment and consumption of Consumer goods
affected most.
5. Immediate impact on inventories of goods
6. Profits fluctuate more than any other type of income.
7. Business cycles are international in character
 FISCAL POLICY
 The word “fisc” means ‘state treasury’ and fiscal policy
refers to policy concerning the use of ‘state treasury’
or the govt. finances to achieve the macroeconomic
goals.
 “Any decision to change the level, composition or
timing of govt. expenditure or to vary the burden ,the
structure or frequency of the tax payment is fiscal
policy.”
 The Budget
 The fiscal policy operates through budget.
 It is an estimate of government expenditure and revenue
for a year.
 According the Constitution of India:
 No tax can be levied or collected except by authority of law.
 No expenditure can be incurred from public fund except in the
manner provided in the constitution.
 The executives must spend public money only in the manner
sanctioned by the Parliament / State Legislature.
The Budget
 It is presented by the FM in the Parliament on the last working
day of February every year.
 Discussion on the budget follows on later dates and then budget
demands are put to vote.
 When the budget is passed in the Parliament it goes to the
President for his assent.
 Tax proposals of the budget are embodied in the Finance Bill.
 The revenue and expenditure of the govt. are audited by CAG.
 Fiscal Policy and Economic Growth

 Instruments of Fiscal policy contributing in economic

growth are:
 Budgetary surplus and deficit
 Government expenditure
 Taxation- direct and indirect
 Public debt
 Deficit financing
 Taxation
 Meaning : Non quid pro quo transfer of private income to
public coffers.
 Classified into:
1. Direct taxes- Corporate tax, Div. Distribution Tax, Personal
Income Tax, Fringe Benefit taxes, Banking Cash Transaction
Tax
2. Indirect taxes- Central Sales Tax, Customs, Service Tax,
excise duty.
 Proportional, progressive, and regressive
 An important feature of tax systems is the percentage of the tax
burden as it relates to income or consumption. The terms
progressive, regressive, and proportional are used to describe the
way the rate progresses from low to high, from high to low, or
proportionally.
 A progressive tax is a tax imposed so that the effective tax rate
increases as the amount to which the rate is applied increases.
 The opposite of a progressive tax is a regressive tax, where the
effective tax rate decreases as the amount to which the rate is
applied increases.
 In between is a proportional tax, where the effective tax rate is
fixed as the amount to which the rate is applied increases.
Revenue vs. Capital Budget

 Revenue Budget : The revenue budget consists of revenue

receipts of the government (revenues from tax and other
sources) and the expenditure met from these revenues.
 Expenditure that does not result in the creation of assets, and
grants given to state governments and other parties are
revenue expenditures.
Capital Budget
 It consists of capital receipts and payments. The main items of
capital receipts are loans raised by Government from public,
borrowings by Government from Reserve Bank, loans from
foreign Governments and bodies and recoveries of loans granted
by Central Government to State and Union Territory
Governments and other parties.
 Capital payments consist of capital expenditure on acquisition of
assets like land, buildings, machinery, equipment, as also
investments in shares, etc., and loans and advances granted by
Central Government to State and Union Territory Governments,
Government companies, Corporations and other parties.
Budget Structure
Budgetary Revenues

Revenue Receipts Capital Receipts

Tax Revenue Non-Tax Revenue

Direct Indirect Dividend (PSU) Mkt Borrowings

IT Sale Tax Admin Revenues PF / Gratuity
Corp. Tax Excise Duty Grants & Aids Govt. Bonds
Wealth Tax Customs Duty Socio-Eco Services
Cap. Gain Tax Service Tax
Interest Tax
Budget Structure
Budgetary Expenditure

Plan Non-Plan

Revenue Capital Revenue Capital

Central Plan Central Plan Interest Defence (C)
Agriculture Plan Projects Defence (R ) Loan to PSEs
Energy Soc & Community Subsidies Loans to SG/UT
Industry Dev. Police
Transport & Comm. Eco. Development Pensions
Science & Tech Loan to Foreign Govt. Eco Service
Environment Defence Grants
Soc. Ser. & Othrs. General Services
Central Asst. Central Asst.
to State Plan to State Plan
Monetary policy

 Monetary Policy is a programme of action taken by the

monetary authorities generally the central bank, to control and
regulate the supply of money with the public and flow of credit
with a view to achieve predetermined macroeconomic goals.
Objectives of monetary policy

1. Maximum feasible output

2. High rate of economic growth
3. Fuller employment
4. Price stability
5. Greater equality in the distribution of income and wealth
6. Healthy balance of payments
Instruments of monetary policy
 Quantitative credit control:-
1. Open market operations
2. Bank Rate Policy
3. Reserve Requirement changes
 Selective / Qualitative Credit Control:-
1. Direct Action
2. Changes in margin requirements
3. Regulation of consumer credit
4. Moral suasion
Open-Market Operations

 Open-Market Operations
 The money supply is the quantity of money available in the
economy.
 The primary way in which the RBI changes the money supply is
through open-market operations.
 The RBI purchases and sells government securities.
Open-Market Operations

 Open-Market Operations
 To increase the money supply, the RBI buys

government bonds from the public (Commercial Banks).

 To decrease the money supply, the RBI sells
government bonds to the public (Commercial Banks).
Reserve Ratios

 Cash Reserve Ratio (CRR) – is the percentage of bank

deposits which must be parked with the RBI against which the
RBI does not offer any interest (4% as on 13 Feb 2016).
 Statutory Liquidity Ratio (SLR) – is the percentage of bank
deposits which a bank must keep in the form of cash, gold or
other RBI approved securities (21.5% as on 13 Feb 2016)
Tools of Monetary Control

 Changing the Reserve Requirement

 The reserve requirement is the amount (%) of a bank’s total
reserves that may not be loaned out.
 Increasing the reserve requirement decreases the money
supply.
 Decreasing the reserve requirement increases the money
supply.
Tools of Monetary Control

 Changing the Discount Rate

 The discount rate (repo rate) is the interest rate the RBI charges
banks for loans.
 Increasing the discount rate decreases the money supply.

 Decreasing the discount rate increases the money supply.

Reserve Bank of India
 It is the Central Bank of India Established in “1st April 1935” under the
“RESERVE BANK OF INDIA ACT”.
 Its head quarter is in Mumbai (Maharashtra). Its present governor is “Dr. Urjit
Patel”.
 It has “22 Regional Offices”, most of them in State capitals.
 It was set up on the recommendations of the “Hilton Young Commission”.
 It was started as Share-Holders Bank with a paid up capital of 5 crores.
 Initially it was located in Kolkata.
 It moved to Mumbai in 1937.
 Initially it was Privately Owned.
 FUNCTIONS OF RBI
 Issue of currency
 Development role
 Banker to government
 Banker to bank
 Role of RBI in inflation control
 Formulate monetary policy
 Manager of foreign reserve
 Clearing house functions
 Regulations of banking system
 Financial System

 An institutional framework existing in a country to enable financial

transactions
 Three main parts
 Financial assets (loans, deposits, bonds, equities, etc.)
 Financial institutions (banks, mutual funds, insurance companies, etc.)
 Financial markets (money market, capital market, forex market, etc.)
 Regulation is another aspect of the financial system (RBI, SEBI, IRDA,
FMC)
Financial assets/instruments

 Enable channelising funds from surplus units to deficit units

 There are instruments for savers such as deposits, equities, mutual
fund units, etc.
 There are instruments for borrowers such as loans, overdrafts, etc.
 Like businesses, governments too raise funds through issuing of
bonds, Treasury bills, etc.
 Instruments like PPF, KVP, etc. are available to savers who wish to
lend money to the government
 Financial Institutions

 Includes institutions and mechanisms which

 Affect generation of savings by the community
 Mobilisation of savings
 Effective distribution of savings
 Institutions are banks, insurance companies, mutual funds-
promote/mobilise savings
 Individual investors, industrial and trading companies-
borrowers
 Financial Markets

 Money Market- for short-term funds (less than a year)

 Organised (Banks)
 Unorganised (money lenders, chit funds, etc.)

 Capital Market- for long-term funds

 Primary Issues Market
 Stock Market
 Bond Market
 Organised Money Market

 Call money market

 Bill Market
 Treasury bills
 Commercial bills
 Bank loans (short-term)
 Organised money market comprises RBI, banks (commercial
and co-operative)
Purpose of the money market

 Banks borrow in the money market to:

 Fill the gaps or temporary mismatch of funds
 To meet the CRR and SLR mandatory requirements as stipulated by
the central bank
 To meet sudden demand for funds arising out of large outflows (like
advance tax payments)

 Call money market serves the role of equilibrating the short-

term liquidity position of the banks
Call money market

 Is an integral part of the Indian money market where day-to-

day surplus funds (mostly of banks) are traded.
 The loans are of short-term duration (1 to 14 days). Money
lent for one day is called ‘call money’; if it exceeds 1 day but
is less than 15 days it is called ‘notice money’.
 Money lent for more than 15 days is ‘term money’
 The borrowing is exclusively limited to banks, who are
temporarily short of funds.
Call money market

 Call loans are generally made on a clean basis- i.e. no collateral is

required
 The main function of the call money market is to redistribute the pool of
day-to-day surplus funds of banks among other banks in temporary
deficit of funds
 The call market helps banks economise their cash and yet improve
their liquidity
 It is a highly competitive and sensitive market
 It acts as a good indicator of the liquidity position
Call Money Market Participants

 Those who can both borrow and lend in the market – RBI,
banks and primary dealers
 Once upon a time, select financial institutions viz., IDBI, UTI,
Mutual funds were allowed in the call money market only on
the lender’s side
 These were phased out and call money market is now a pure
inter-bank market (since August 2005)
Developments in Money Market

 Prior to mid-1980s participants depended heavily on the

call money market
 The volatile nature of the call money market led to the
activation of the Treasury Bills market to reduce
dependence on call money
 Emergence of market repo and collateralized borrowing
and lending obligation (CBLO) instruments
 Bill Market

 Treasury Bill market- Also called the T-Bill market

 These bills are short-term liabilities (91-day, 182-day, 364-day) of the Government
of India
 It is an IOU of the government, a promise to pay the stated amount after expiry of
the stated period from the date of issue
 They are issued at discount to the face value and at the end of maturity the face
value is paid
 The rate of discount and the corresponding issue price are determined at each
auction
 RBI auctions 91-day T-Bills on a weekly basis, 182-day T-Bills and 364-day T-Bills
on a fortnightly basis on behalf of the central government
Money Market Instruments

 Money market instruments are those which have maturity

period of less than one year.
 The most active part of the money market is the market for
overnight call and term money between banks and institutions
and repo transactions
 Call money/repo are very short-term money market products
Money Market Instruments

 Certificates of Deposit
 Commercial Paper
 Inter-bank participation certificates
 Inter-bank term money
 Treasury Bills
 Bill rediscounting
 Call/notice/term money
 CBLO
 Market Repo
Certificates of Deposit
 CDs are short-term borrowings in the form of UPN issued by all scheduled banks and
are freely transferable by endorsement and delivery.
 Introduced in 1989
 Maturity of not less than 7 days and maximum up to a year. FIs are allowed to issue CDs
for a period between 1 year and up to 3 years
 Subject to payment of stamp duty under the Indian Stamp Act, 1899
 Issued to individuals, corporations, trusts, funds and associations
 They are issued at a discount rate freely determined by the market/investors
Commercial Papers
 Short-term borrowings by corporates, financial institutions, primary dealers from the
money market
 Can be issued in the physical form (Usance Promissory Note) or demat form
 Introduced in 1990
 When issued in physical form are negotiable by endorsement and delivery and hence,
highly flexible
 Issued subject to minimum of Rs. 5 lacs and in the multiple of Rs. 5 lacs after that
 Maturity is 7 days to 1 year
 Unsecured and backed by credit rating of the issuing company
 Issued at discount to the face value
Market Repos

 Repo (repurchase agreement) instruments enable collateralised short-

term borrowing through the selling of debt instruments
 A security is sold with an agreement to repurchase it at a pre-
determined date and rate
 Reverse repo is a mirror image of repo and reflects the acquisition of a
security with a simultaneous commitment to resell
 Average daily turnover of repo transactions (other than the Reserve
Bank) increased from Rs.11,311 crore during April 2001 to Rs. 42,252
crore in June 2006
Collateralised Borrowing and Lending Obligation
(CBLO)
 Operationalised as money market instruments by the CCIL in 2003
 Follows an anonymous, order-driven and online trading system
 On the lenders side main participants are mutual funds, insurance
companies.
 Major borrowers are nationalised banks, PDs and non-financial
companies
 The average daily turnover in the CBLO segment increased from Rs.
515 crore (2003-04) to Rs. 32, 390 crore (2006-07)
 The Indian Capital Market

 Market for long-term capital. Demand comes from the

industrial, service sector and government
 Supply comes from individuals, corporates, banks, financial
institutions, etc.
 Can be classified into:
 Gilt-edged market
 Industrial securities market (new issues and stock market)
 The Indian Capital Market

 Development Financial Institutions

 Industrial Finance Corporation of India (IFCI)
 State Finance Corporations (SFCs)
 Industrial Development Finance Corporation (IDFC)
 Financial Intermediaries
 Merchant Banks
 Mutual Funds
 Leasing Companies
 Venture Capital Companies
Industrial Securities Market

 Refers to the market for shares and debentures of old and

new companies
 New Issues Market- also known as the primary market- refers
to raising of new capital in the form of shares and debentures
 Stock Market- also known as the secondary market. Deals
with securities already issued by companies
Financial Intermediaries

 Mutual Funds- Promote savings and mobilise funds which are invested
in the stock market and bond market
 Indirect source of finance to companies
 Pool funds of savers and invest in the stock market/bond market
 Their instruments at saver’s end are called units
 Offer many types of schemes: growth fund, income fund, balanced
fund
 Regulated by SEBI
Financial Intermediaries

 Merchant banking- manage and underwrite new issues, undertake

syndication of credit, advise corporate clients on fund raising
 Subject to regulation by SEBI and RBI
 SEBI regulates them on issue activity and portfolio management of
their business.
 RBI supervises those merchant banks which are subsidiaries or
affiliates of commercial banks
 Have to adopt stipulated capital adequacy norms and abide by a code
of conduct
 Securities and Exchange Board of India (SEBI)

 SEBI is the regulator of securities market in India. It was established on 12

April 1988.
 SEBI is required to regulate and promote the securities market by:
 Providing fair dealings in the issues of securities and ensuring a market place
where funds can be raised at a relatively low cost.
 Providing a degree of protection to the investors and safeguard their rights
and interests so that there is a steady flow of savings into the market.
 Regulating and developing a code of conduct and fair prices by
intermediaries in the capital market like brokers and merchant banks with a
view to make them competitive and professional.

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 Role of SEBI in Indian Capital Market
 Power to make rules for controlling stock exchange
 To provide license to dealers and brokers
 To check irregularities in Capital Market by banning brokers and imposing
penalties as it deems fit.
 To Control the Merge, Acquisition and Takeover the companies
 To audit the performance of stock market
 To make new rules on carry - forward transactions
 To create relationship with ICAI
 Introduction of derivative contracts on Volatility Index
 To Require report of Portfolio Management Activities
 To educate the investors

57
International Trade

 An English princess with an Egyptian boyfriend,

crashes in a French tunnel, driving a German car with
a Dutch engine, driven by a Belgian who was drunk
on Scottish whisky, followed closely by Italian
paparazzi, on Japanese motorcycles, treated by an
American doctor, using Brazilian medicine.
 We live in a world of GLOBALIZATION…
The Gold Standard: A Fixed Exchange Rate System

 Between 1867 and 1933, most of the world’s

economies used the gold standard.
 Gold standard – a system of fixed exchange
rates in which the value of currencies was
fixed relative to the value of gold and gold
was used as the primary reserve asset.
The Gold Standard: A Fixed Exchange Rate System

 Under the gold standard, the amount of

money a country issued was directly tied to
gold.
 By fixing its currency’s price to gold, it
automatically fixed its currency’s price to other
currencies.
 Gold flowed out of the country when it
experienced a balance of payments deficit
and into the country with a balance of
payments surplus.
 With the outbreak of World War 1, the gold standards system
came to an end.
 Physical transfer of gold started becoming a problem. Even a
very small piece of gold had its own value.
 Scarcity of gold fuelled the problems and most of the nations
discarded the Gold Standards.
 Bretton Woods (1944 - 1973)
 44 countries met at Bretton Woods, US to design a new
system in 1944 and proposed to establish:
 International Monetary Fund (IMF) and World Bank
 IMF: maintain order in monetary system
 GATT : Reduction in tariff
 World Bank: promote general economic development
 Fixed exchange rates pegged to the US Dollar
 US Dollar pegged to gold at $35 per ounce
 By the early 1970s, the number of U.S. dollars held by
foreigners exceeded the amount of U.S. gold.
 When France and other countries demanded gold for their
dollars, the U.S. ended its policy of exchanging gold for
dollars in 1971.
 With that change, the Bretton Woods system was dead.
International Monetary Fund ( IMF )
 Established on 27th December 1945 and began financial
operations on March 1,1947
 Result of Bretton –Woods Conference of nations
 Open to every country that controls its foreign relations
and is able and prepared to fulfill the obligations of
membership.
 Membership is prerequisite for membership in the World
Bank (IBRD)
 In 2010, IMF had a membership of 187 countries.
 India is one of the founder members of IMF and World
Bank
The different divisions of the World bank

One group - Five agencies

 IBRD (The International Bank For Reconstruction

and Development):
provides loans and development assistance to
middle-income countries

 IDA (International Development Agency):

Interest free loans and grants to poorest
countries
 IFC (International Finance Corporation):
Financing private sector investments and
technical assistance to governments and
business

 MIGA (Multilateral Investment Guarantee Agency):

Provides guarantees to foreign investors – also
technical assistance to help developing countries
promote investment

 ICSID (International Centre for the Settlement of

Investment Disputes)
 World Trade Organization: History
 Mid-1940s:
 Meeting in Bretton Woods, New Hampshire, Created IMF and World
Bank
 US tried to create ITO = International Trade Organization
 Interim agreement: GATT = General Agreement on Tariffs and Trade
 When ITO failed to be approved (by US!), GATT governed trade
policy by default
World Trade Organization: History

 What GATT (and WTO) Does

 Rules for trade policy
 Forum for negotiation
 Of both trade policies (tariffs) and rules
 Negotiations take place in “Negotiating Rounds”
 Decisions made at occasional meetings of trade ministers: “Ministerial
Meetings”
 Born in 1995, but not so young
 The WTO began life on 1 January 1995, but its trading system is half
a century older. Since 1948, the General Agreement on Tariffs and
Trade (GATT) had provided the rules for the system.
 It did not take long for the General Agreement to give birth to an
unofficial, de facto international organization, also known informally as
GATT. Over the years GATT evolved through several rounds of
negotiations.
 The last and largest GATT round, was the Uruguay Round which
lasted from 1986 to 1994 and led to the WTO’s creation. Whereas
GATT had mainly dealt with trade in goods, the WTO and its
agreements now cover trade in services, and in traded inventions,
creations and designs (intellectual property).
World Trade Organization: Rounds
Rounds of GATT
Multilateral Trade Negotiations
No. Years Name Accomplishments
1-5 1947-61 Reduced tariffs
6 1964-67 Kennedy Tariffs + anti-dumping
7 1973-79 Tokyo Tariffs + NTBs
8 1986-94 Uruguay Tariffs, NTBs, Services, Intellectual Property, Textiles, Ag.,
Dispute Settlement, Created WTO

9 2001-? Doha ? (Doha Development Agenda)

WTO Principles
 Non-Discrimination (MFN treatment)
 Freer trade, predictable policies, encouraging competition
 Extra provisions for LDCs.
 Balance of Payment
 A systematic record of all economic transactions between
the residents of two countries during a specific period of
time.
 Presents a classified record of all receipts on account of
goods exported, services rendered and capital received
by residents.
 BoP is merely a way of listing receipts and payments in
international transactions for a country.
 Balance of Payment
 A country’s balance of payments accounts keep track
of both its payments to and its receipts from foreigners.
 Any transaction resulting in a payment to foreigners is
entered in the balance of payments accounts as a
debit and is given a negative (—) sign.
 Any transaction resulting in a receipt from foreigners is
entered as a credit and is given a positive (+) sign.
Balance of Payment
 The balance of Payment consists of two parts:
 The Current Account
 The Capital Account
 The current account includes the visible trade
(tangible goods) & the invisible trade (services).
 The Balance of trade is another term used to
describe the balance of only visible items –
goods.
 The balance of trade is included in the current
account.
 Balance of
Payments

Current a/c Capital a/c

Visible Trade Banking

Income Services Transfers Investment Loans Reserves
(BoT) Capital

Tourism, FCNR
Profits Remittances FDI Sovereign
Banking, etc. Accounts

Interest Donations FPI Commercial

Gifts
Dividend