macroeconomics -...
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PAPER TWO, SEMESTER TWO – FIRST YEAR BACHELOR OF ARTS
(As per the prescribed syllabus of University of Mumbai)
Course Material by Krishnan Nandela, Associate Professor and Head, Department of
Economics, Dr.TK Tope Arts & Commerce Night Senior College, Parel, Mumbai – 4000012
MACROECONOMICS
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F.Y.B.A. ECONOMICS (PAPER II)
SEMESTER II
MACRO ECONOMICS
Module I: Concepts and Definitions (12 Lectures)
Circular flow of Income in an Open Economy–GDP-GNP-NNP- GDP Deflator–Real and
Nominal quantities–GDP at purchasing power parity –Exchange rate as a price –GDP Growth:
India’sexperience –Trends in Growth Rate and Sectoral Composition of GDP- Sources of Data.
Module II:Consumption, Saving and Investment (12 Lectures)
National Income Identity in an Open Economy- Keynesian Consumption Function- Investment
Multiplier-Marginal Efficiency of Capital and Rate of Interest-Accelerator- Savings in India:
Trendsand Composition-Capital Formation in India: Trends and Composition- Sources of Data.
Module III: Government (12 Lectures)
Public Goods and their Features- Merit Goods- Sources of Revenue: Direct and Indirect Tax-
Impact,Shifting and Incidence of Tax- Sources of Non- Tax Revenue- Public Expenditure:
Revenue and CapitalExpenditure- Subsidies- Types of Deficit: Revenue, Budgetary, Fiscal and
Primary-Concept of GSTRecentTrends- Sources of Data.
Module IV: External Sector (12 Lectures)
Structure of Balance of Payments, Types of Disequilibrium in BOP, Exchange Rate
Determination, Concept of FOREX and its components and Sources of Data.
References:
1. N. Gregory Mankiw, Principles of Macroeconomics, 7th edition, Cengage Learning, 2015
2. Sikdar, S. (2006), Principles of Macroeconomics, Oxford University Press, New Delhi.
3. Abel, A. B., B. S. Bernanke and D. Croushore (2011), Macroeconomics, Pearson, New Delhi.
PAPER PATTERN FOR SEMESTER-I
1. THERE WILL BE FIVE QUESTIONS ON FOUR MOUDULES AND EACH
QUESTION WILL CARRY 20 MARKS.
2. ON EACH MODULE, THERE WILL BE THREE SUB-QUESTIONS.
3. STUDENTS WILL HAVE TO ATTEMPT ANY TWO OUT OF THREE SUB-
QUESTIONS.
4. QUESTION FIVE WILL BE OF NOTES ONE ON EACH MODULE.STUDENTS
WILL HAVE TO ATTEMPT ANY TWO OUT OF FOUR NOTES.
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SNO Module and Chapter PNO
Module – 1: CONCEPTS AND DEFINITIONS.
1. Circular flow of Income in an Open Economy. 04
2. GDP, GNP, NNP, GDP Deflator. 06
3. Real and Nominal GDP, GDP at purchasing power parity. 10
4. Exchange rate as a price. 12
5. GDP Growth: India’s experience – Trends in Growth Rate. 13
6. Sectoral Composition of GDP. 17
7. Sources of Data.
Module – 2: CONSUMPTION, SAVING AND INVESTMENT.
1. National Income Identity in an Open Economy. 20
2. Keynesian Consumption Function. 21
3. Investment Multiplier. 29
4. Marginal Efficiency of Capital and Rate of Interest. 37
5. Accelerator. 41
6. Savings in India: Trends and Composition. 42
7. Capital Formation in India: Trends and Composition. 44
Module – 3: GOVERNMENT.
1. Public Goods and their Features. 47
2. Merit Goods. 48
3. Sources of Revenue: Direct and Indirect Tax. 50
4. Impact, Shifting and Incidence of Tax. 55
5. Sources of Non- Tax Revenue. 57
6. Public Expenditure: Revenue and Capital Expenditure. 59
7. Subsidies.
8. Types of Deficit: Revenue, Budgetary, Fiscal and Primary. 61
9. Concept of GST. Recent Trends. 64
10. Sources of Data.
Module – 4: EXTERNAL SECTOR.
1. Structure of Balance of Payments. 67
2. Types of Disequilibrium in BOP. 71
3. Exchange Rate Determination. 73
4. Concept of FOREX and its components. 77
5. Sources of Data. 79
CONTENTS
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MODULE I
PREVIEW.
Circular flow of Income in an Open Economy.
GNP, NNP, GDP, GDP Deflator.
Real and Nominal GDP, GDP at purchasing power parity.
Exchange rate as a price.
GDP Growth: India’s experience –Trends in Growth Rate.
Sectoral Composition of GDP.
Sources of Data.
CIRCULAR FLOW OF INCOME IN AN OPEN ECONOMY
The Four Sector Model.A closed economy is one without international trade i.e., when a
country neither exports nor imports, its economy is considered to be closed. We will now
discuss the circular flow of income in an open economy i.e., an economy with international
trade. When we open our economy, the fourth sector, namely: the foreign or the external sector
is obviously added to the three-sector model and the model becomes complete. When a country
exports, it receives monetary flows from abroad and such flows will be considered as injections
into the economy. Similarly, when a country imports, monetary flows eject out of the economy
and such flows will be known as leakages, ejections or out flows. Therefore, exports increase
the level of equilibrium income and imports decrease it. Obviously, if the circular flow of
income is to be in equilibrium, exports and imports must be equal. Thus, if X > M, i.e., when net
exports are positive, the equilibrium income will rise and if X < M, i.e., when net exports are
negative, the equilibrium income will fall. Circular flow of income in an open economy is
depicted in Fig. 1.4
A four-sector open economy will be in equilibrium when leakages are equal to injections.
Savings, taxes and imports are leakages (L) and investment, government expenditure and exports
are injections (I). Symbolically, the circular flow of income in an open economy can be stated
as:
S + T + M = I + G + X
Where, S + T + M = L, and
I + G + X = I
CONCEPTS AND
DEFINITIONS
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The economy will therefore be in equilibrium irrespective of the number of sectors when
leakages are equal to injections i.e. (L = I).
Fig.1.1Circular Flow of Income in an Open Economy.
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GROSS NATIONAL PRODUCT (GDP).
The GNP is the most widely used measure of national income. It is the basic accounting
measure of the total output of goods and services. GNP is defined as the total market value of all
final goods and services produced in a year. It measures the market value of a yearly output and
therefore it is a monetary measure of national income. In the definition above, the term ‘final’ is
used to avoid the possibility of double counting and to ensure that only the value of final goods
and services is considered in measuring GNP. This is because the value of intermediate goods is
included within the value of final goods and services. The term ‘gross’ refer to the fact that
depreciation or capital consumption of goods has not been subtracted from the value of output.
While measuring the GNP, only the final value of goods and services is accounted, i.e., the value
is added in each stage of the production process. For instance, there are many stages in the
production of bread. The farmer produces wheat. The miller converts wheat into flour. The
baker bakes the bread and finally the bread is sold by the retailer to the consumer. The value
addition process in the production of bread is shown in Fig. 1.2.
Stage 1 Stage 2 Stage 3 Stage 4 Stage 5
Value Added Value Added Value Added Value Added Final Value
By the Farmer by the Miller by the Baker by the Retailer of the Bread
Rs.5 Rs.2 Rs.5 Rs.3 Rs.15
Fig. 1.2 Value added in different stages of the Production of Bread.
As shown in Fig.1.2, value is added to the product at every stage of production as cost is incurred
at every stage of value addition. The final value of the bread is the total of the value added at
each stage. Suppose in the second stage, if we add up Rs.7 instead of Rs.2 and in the third sage
Rs.12 instead of Rs.5 and so on then it will be a case of multiple counting. This will give a
wrong and inflated picture of the actual value of the product produced in a given period.
Value of Wheat
Value of Milling Wheat into Flour Value of Wheat
Value of Baking Value of Milling Wheat into Flour Value of Wheat
Value Added by the Retailer Value of Baking Value of Milling Wheat into Flour Value of Wheat
The Final Value of the Bread
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The rate of growth of GNP is the most important indicator of the nation’s economy. It shows the
rate at which the national income of a country is increasing or decreasing. It is the broadest
statistical aggregate of an economy’s output and growth. The estimate of national income in
terms of GNP provides the policy makers and business community a useful tool to analyze the
economic performance of the country.
In an open economy, the value of GNP at market prices may be symbolically stated as follows:
GNP(MP) = C + I + G + Xn + Rn
Where,
GNP(MP) = Gross National Product at market prices.
C = Consumption goods.
I = Investment goods.
G = Government services.
Xn = Net exports i.e. exports minus imports.
Rn = Net receipts i.e. receipts minus payments.
GNP is the basic accounting measure of national output and represents final products valued at
current market prices.
NET NATIONAL PRODUCT (NNP) or NATIONAL INCOME AT MARKET PRICES
(NIMP).
NNP is defined as GNP less depreciation. Symbolically,
NNP = GNP – Depreciation (D).
Depreciation is that part of total productive assets which is used to replace the capital worn out in
the process of creating national output. The value of depreciation is estimated land deducted
from the GNP to find our NJP. The NNP gives the measure of net output available for
consumption of the society. Since the NNP is the measure of the market value of all goods and
services minus depreciation, 9it is also called National Income at Market Prices.
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NATIONAL INCOME AT FACTOR COST (NIFC) or NATIONAL INCOME (NI).
National income at factor cost refers to the sum of all incomes earned by factor owners for their
contribution of factor services namely: land, labor, capital and enterprise in the form of rent,
wages, interest and profits. It shows the quantum of economic resources required to produce the
net output. National Income at Factor cost can be stated as follows:
NIFC or NI = NNP or NIMP – Indirect Taxes (IT) + Subsidies (S).
The differences between national income at factor cost and national income at market prices is
because of the fact that indirect taxes and subsidies cause market prices of output to be different
from the factor incomes. For example, if one litre of oil paint is sold for Rs.100 and it includes
Rs.10 as excise duty and sales tax, the factors would receive only Rs.90 per litre. The value of
oil paint at factor cost would be equal to its value at market prices less indirect taxes (excise duty
and sales tax). The effect of subsidies is such that the market price is less than the factor cost.
For instance, let us assume that one kilogram of groundnut oil is sold at Rs.50 through the Public
Distribution System and the government gives a subsidy of Rs.10 per kilogram. In this case, the
consumer pays Rs.40 for one kilogram of ground nut oil which would be the market price and
the factor of production would receive Rs.50 per kilogram (Rs.40 + Rs.10 = Rs.50). Thus the
value of one kilogram of ground nut oil at factor cost would be equal to its market price plus the
subsidies paid on it. Thus:
NIFC = NNP - IT + S.
GROSS DOMESTIC PRODUCT at MARKET PRICES (GDPMP).
The Gross Domestic Product refers to the value at market prices of goods and services produced
inside the country in a given year. It can be stated as follows:
GDPMP = C + I + G + (X – M)
Where, C = Consumption goods.
I = Capital goods or Gross investments.
G = Government Services.
X = Exports, and
M = Imports.
Here, (X – M) refers to net exports or Xn which can be positive or negative. If exports are
greater than imports, net exports will be positive and vice versa. Net positive exports will lead to
rise in GDP and net negative exports will lead to fall in GDP.
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GROSS DOMESTIC PRODUCT at FACTOR COST (GDPFC).
GDP at factor cost refers to the sum of net value added by the factors of production plus capital
depreciation minus indirect taxes plus subsidies given by the government. GDP at market prices
includes indirect taxes and does not account the subsidies given by the government. Hence to
arrive at GDP at factor cost, indirect taxes must be subtracted, and subsidies should be added to
GDP at market prices. Symbolically, GDP at factor cost can be stated as follows:
GDPFC = GDPMP – IT + S
Indirect taxes are subtracted from GDP at market prices because the market value of goods and
services is higher than their total cost of production by an amount equal to indirect taxes. Since,
indirect taxes constitutes transfer payments from the producers to the government, it must be
subtracted from the total value of the output. Further, consumers receive transfer payments from
the government in the form of subsidies. Hence, the sale price charged by producers is lower
than what it would have been in the absence of subsidies. Thus, to compute the correct factor
cost value of goods and services, subsidies must be added to the market value of the output.
NET DOMESTIC PRODUCT (NDP).
While calculating the GDP, no provision is made for depreciation or capital expenditure. Net
Domestic Product is arrived at by subtracting depreciation from the GDP. Depreciation is
accounted for because factories, buildings etc., get depreciated over their life time during their
use in the production process. These goods need replacement once their life is over. Hence, a
part of the replacement cost of the capital is set aside in the form of depreciation allowance.
Symbolically, Net Domestic Product can be stated as follows:
NDP = GDP – D
Where, D = Depreciation.
THE GDP DEFLATOR.
When we divide nominal national income by real national income, we obtain the national income
deflator. The real national income can be calculated by dividing nominal national income by the
national income deflator. The national income deflator for various years is given in Table 1.1.
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Table 1.1 - Calculating the National Income Deflator.
Source: IES 2017-18, Table A2, Volume II.
You may notice from Table 1.1 that when we divide the nominal national income by the real
income we are able to obtain national income deflator. However, to find out the real national
income one needs the price index of the relevant years. Once we have the current year price
index number, we can find out the national income of the current year by dividing the nominal
national income of the current year by the current year price index and multiply the quotient by
hundred. Alternatively, the national income deflator can be found by dividing the current year
price index by the base year price index. Since the base year price index is always hundred, the
national income deflator can be simply found by moving the decimal points by two digits to the
left. For instance, the wholesale price index in the year 2017-18 divided by 100 would give the
national income deflator as 1.28. You may notice that we have simply shifted the decimal point
by two digits to the left. Now when we divide the nominal national income or the national
income at current prices by the national income deflator, we can obtain the real national income.
For example, Rs.164.39 Trillion divided by 1.28 will give us Rs.128.35 Trillion which is the real
national income for the year 2017-18.
REAL AND NOMINAL GDP.
When goods and services produced in a given year are multiplied with their current market
prices, we get national income at current prices. However, prices do not remain constant. The
value of national income at current prices changes according to the changes in prices. When we
measure, national income at current prices, what we get is the nominal national income. Thus,
during a period of price rise, the nominal national income would rise even when the physical
quantity of output produced remains constant. In order to find out the real rise in national
Year NI at Current
Prices
Rupees Trillion
NI at Constant
Prices
(2011-2012)
Rupees Trillion
The NI Deflator
1 2 3 4 = (2/3)
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
86.60
98.27
110.94
122.98.
135.22
149.94 (PE)
164.39 (FAE)
86.60
91.05
96.80
104.12
112.46
120.35
128.35
1.00
1.08
1.15
1.18
1.20
1.24
1.28
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income, the physical quantity of output should be multiplied with constant prices or base year
prices. This process is called deflating the national income figures for the change in prices that
have taken place during a period. Thus through adjustment or deflation, the national income is
calculated at constant prices. The national income at current prices is deflated by price index
numbers to obtain national income at constant prices. To find out the real national income, the
following formula is used:
National Income at = National Income at Current Prices × 100
Constant Prices Price Index Number
For instance, the estimates of India’s national income (NNP) for various years at current and
constant prices are given in Table 1.1. The table shows that the increase in Net National Income
at current prices is much greater than the increase in Net National Income at constant prices. The
nominal values of NNP are much greater than that of the real values because the prices have
increased during the period 2003-04 to 2007-08.
Table 1.2 Estimating National Income at Constant Prices from
National Income at Current Prices.
Year NI at Current Prices
Rupees Trillion
Wholesale Price Index
No. (Base 1999-2000)
NI at Constant Prices
(2011-12) Rupees Trillion
1 2 3 4 = (2/3 x 100)
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
86.60
98.27
110.94
122.98.
135.22
149.94 (PE)
164.39 (FAE)
100
108
115
118
33
120
124
128
86.60
91.05
96.80
104.12
112.46
120.35
128.35
PEProvisional Estimates. FAEFirst Advance Estimates.
Source: Collated from IES 2017-18, Table A2, Vol.II.
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EXCHANGE RATE AS A PRICE.
The foreign exchange market is the international market in which foreign currencies are bought
and sold. It is an arrangement for buying and selling of foreign currencies in which exporters
sell the foreign currencies and importers buy them. The players in the foreign exchange market
are exporters and importers, travelers and investors, traders, speculators and brokers and
commercial banks and central banks of different countries of the world. The US Dollar was
exchanged for 64.36 Indian rupees on 09th Feb 2018. The rupee – dollar exchange rate was
therefore Rs.64.36 for one US Dollar or One Indian rupee would fetch 0.015 US Dollars i.e.
saying that the value of Indian Rupee in terms of USD is equal to one and a half paise. The
Rupee – Euro exchange rate on 09th Feb 2018 was Rs.78.28 which means the Euro – Rupee
exchange rate would be Euro 0.013 for one Indian rupee. One Euro was exchanged for Rs.78.28
on the same day. In the foreign exchange market, there are two different rates for buying and
selling of foreign currencies. This difference arises due to transaction cost in dealing with foreign
currencies.
Broadly there are two systems of exchange rate determination. They are known as fixed and
flexible or floating exchange rate systems. Under the fixed exchange rate system, the foreign
exchange rate is fixed by the government. The fixed exchange rate was established in the year
1944 under an agreement reached at Bretton Woods in New Hampshire, USA. Under this
system, at the fixed exchange rate if there is disequilibrium in the balance of payments giving
rise to either excess demand or supply of foreign exchange, the Central Bank of the country has
to buy and sell the required quantities of foreign exchange to eliminate the excess demand or
supply.
The system of exchange rate in which the exchange value of a currency is determined by the
market forces of demand and supply of foreign exchange is known as flexible or floating
exchange rate system. The flexible exchange rate system came into existence after the fall of the
fixed exchange rate system in 1977. The changes in the exchange value of a currency in the
foreign exchange market are known by the terms: appreciation and depreciation. For instance, if
the rupee – dollar exchange rate becomes Rs.70.00 in a few days hence, the rupee would be said
to have depreciated against the dollar. Conversely, if the rupee – dollar exchange rate becomes
Rs.60 then the rupee would be said to have appreciated against the dollar. The changes in the
exchange rate are determined by the market forces in a flexible exchange rate system.
In the case of fixed exchange rate system, the central bank has to buy or sell foreign exchange so
that the exchange rate is maintained at the pegged or fixed level. However, the fixed exchange
rate could be changed through devaluation or revaluation only with permission from the
International Monetary Fund (IMF) in case of fundamental disequilibrium in the balance of
payments. Thus, if a country was running large and persistent deficit in her balance of payments,
it was allowed to devalue its currency in order to improve the balance of payment position.
Conversely, if a country was running large and persistent surpluses in the balance of payments, it
was allowed to revalue its currency so that correction is made. The IMF maintains funds which
are contributed by member countries and gives loans to member countries from its reserves when
they face temporary deficit in the balance of payments. If a member country has a persistent
deficit in the balance of payment, the IMF would permit such a country to devalue its currency in
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order to correct the deficit so that a relatively stable or fixed exchange rate system was
maintained for the promotion of world trade. In order to maintain the exchange rate at a given
level, the central banks of different countries were required to maintain reserves of foreign
currencies. The international reserve currencies are the US dollar, UK Pound Sterling, German
Deutsche marks and the Japanese Yen.
TRENDS IN GROWTH RATE OF GDP IN INDIA.
Average Annual Growth Rates.
The national and per capita income figures are computed at current prices, but these figures do
not give a real picture of the performance of the national economy because current prices
includes rise in prices or inflation. In order to find the real changes in national and per capita
income, the figures are computed at constant prices. The growth of net national product at
constant prices is indicative of the rate of growth of goods and services in the economy and the
growth of per capita income at constant prices is an indicator of the changes in the economic
welfare of the people. According to the Central Statistical Organization, the Net National
Product of India (at 1993-94 prices) was Rs.1, 32,379 crore in 1950-51. The average annual
growth rate in NNP for the period 1950-51 to 1980-81 is 3.4 percent. At current prices the
average growth rate turns out to be 8.9 per cent. The decadal growth rates reveal that during the
first decade, the annual growth rate was 3.8 per cent, followed by 3.5 and 3 per cent in the
succeeding decades. It may be noted that the growth performance of the Indian economy was on
a steady decline in the first three decades. However, since the 1980s, there has been a
continuous improvement. The annual growth rate was 5.4 per cent in the decade 1980-81 to
1990-91 and thereafter in the 1990s, it was 5.5 per cent. The first seven years of the 21st century
has shown a remarkable improvement in the growth rate. The average annual growth rate for the
first five years (2001-05) was 6.7 per cent. With the annual growth rate crossing the nine per
cent mark in the year 2006-07 to be 9.7 and 8.7 in the year 2007-08, the first decade of the 21st
century is expected to show some spectacular growth rate in national income. In the year 2007-
08, the national income of India (GNP) stood at Rs. 31,02,000 crore at 1999-2000 prices and at
current prices it was Rs.42,63,000 crore.
Growth of Real Income (1950-51 to 1980-81).
The targeted growth rate in national income and the growth rates actually achieved during the
first thirty years of economic planning are given in Table 1.1. In the first five-year plan, the
targeted growth rate was only 2.1 percent per annum. The country achieved a compound growth
rate of 3.6 percent per annum during the first plan. In the second plan a target of 4.5 percent was
laid down and the actual growth rate achieved fell short of the target by 0.3 percent. The third
plan targeted a growth rate of 5.6 percent per annum. The third plan turned out to be a disaster
as the total growth achieved during the plan was a mere 13.6 giving a compounded growth rate
of 2.7 percent per annum. The fourth plan laid down a target of 5.7 percent growth rate but
achieved only 2.1 percent. The fifth plan had lowered down the targeted growth rate to 4.4
percent per annum and this time the country was able to cross the target to achieve 4.8 percent
per annum growth rate. However, in the year 1979-80, the national income contracted by six
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percent thereby pulling down the average growth rate during the six-year period 1974-75 to
1979-80 to a low of three percent.
Growth Rate since 1980s.
The sixth plan set a target of 5.2 percent per annum and achievement was 5.5 percent per annum.
In order to paint a rosy picture of the economy, the planners adopted 1979-80 as the base year
which was a year of negative growth rate. Factoring for the negative rate of six percent in the
national income, the sixth plan average growth rate turns out to be only 3.4 percent. During the
7th plan, the growth rate targeted was 5 percent. The 7th plan performance was very good as the
country was able to achieve an annual growth rate of six percent. During the 8th plan (1992-93 to
1996-97), the Indian economy achieved a growth rate of 6.7 percent per annum. After the
foreign exchange crisis of 1991, India adopted a program of economic reforms. Liberalization,
privatization and globalization were the three cornerstones of this program. Impressive growth
in the post reforms period was due to the program of economic reforms. During the 9th plan
(1997-2002), the estimated average annual growth rate was 5.5 percent against the targeted
growth rate of 6.5 percent. The 10th plan (2002 to 2007) laid down a target of eight percent
growth and achieved 7.8 per cent.
During the Eleventh Plan period (2007-2012), the national income at constant prices (2004-05)
has increased from Rs 3,451,829 crore in 2007-08 to Rs 45, 73,328 crore in 2011-12, showing
the annual growth of rate of 7.8 per cent and the per capita income attained annual growth rate of
6.3 per cent.
The Twelfth Plan (2012-2017) has set a target of achieving growth rate of 9.0 per cent. During
Twelfth Plan period, the national income at constant prices (2011-12) has increased from Rs
8,193,427 crore in 2012-13 to Rs 9,400,266 crore in 2014-15(A), showing the annual growth of
4.9 per cent.
Table 1.3 -Actual Growth Rates of NI & PCI during the Planning Era (1951 to 2018).
Five Year Plan Period National Income PCI
First 1951-1956 4.2 2.4
Second 1956-1961 4.2 2.2
Third 1961-1966 2.6 0.3
Fourth 1969-1974 3.2 0.9
Fifth 1974-1978 4.9 2.6
Sixth 1980-1985 5.4 3.1
Seventh 1985-1990 5.5 3.5
Eighth 1992-1997 6.7 4.6
Ninth 1997-2002 5.5 3.5
Tenth 2002-2007 7.5 5.9
Eleventh 2007-2012 7.8 6.3
Twelfth 2012-2017 7.1* 6.1*
*Provisional Estimate
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Table 1.4 – Trends in Net National Product and PCI during the Planning Era
(1951 to 2015).
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Salient Features of Growth in National Income.
The trend in growth of national income over the last 60 years of planned economic growth
reveals the following salient features:
1. Fluctuating Growth Rates.
The growth rate in national income over the last sixty years reveals a fluctuating pattern. In
about 13 years, the rate of growth of national income is found to have reduced. In certain years,
the per capita income has fallen due to the rate of growth in national income falling below the
rate of growth of population. In five years, the national income had actually shrunk due to
negative growth rate. Thus the trend in the growth rate of national income reveals a fluctuating
pattern and the objective of achieving sustained economic growth over the last many decades has
not been achieved.
2. Fluctuating Agricultural Fortunes and Fluctuating Growth Rate.
With only one third of the cultivated land receiving irrigation facility, agriculture continues to be
a gamble in the monsoons. When the rains fail, agriculture fails and when agriculture fails,
Indian economy fails. With the agricultural sector contributing 20% to the national income, a
one percent decline in the growth rate of agricultural output reduces the rate of growth of
national income by 0.2 percent. Fluctuating agricultural fortunes is an important cause of
fluctuating growth rate of national income.
3. Acceleration in the Growth Rate.
The average annual growth rate in national income during the first three decades was 3.4 percent.
From 1980 onwards, this rate went up to 5.6 percent per annum and 5.96 per cent in the 1990s.
The growth rate in the 2000s for the period 2001-02 to 2007-08 has been 6.92 per cent per
annum. During the 11th Plan, the average annual growth rate was 7.8 %. The growth rate in the
national income in the 2000s has been the highest in history of planned economic development
in India.
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SECTORAL COMPOSITION OF INDIA’S NATIONAL INCOME.
The study of distribution of national income by industry of origin helps us to understand the
relative performance of the different sectors and sub-sectors of the economy and the structural
changes that may have occurred as a result of different growth rates achieved by these sectors.
In 1950-51, the agricultural sector dominated the Indian economy and its dominance continued
until 1990-91. Presently, the service sector dominates the Indian economy with the share of the
services sector in 2010-11 being 57.73 per cent. The trends in the composition of GDP by
industry of origin are shown in Table 1.5. The major trends as seen in Table 1.2 are as follows:
1. Declining Dominance of the Primary Sector. The share of the primary sector
(agriculture, forestry and fishery) has gone down from 57.7 percent of GDP in 1950-
51 to 21.9 percent in 2002-03. However, with around 90% of the primary sector
output coming from agriculture, the predominance of the agricultural sector in the
primary sector continues. Agriculture contributed 50.2 percent in 1950-51. The
share of agriculture in the GDP declined since then to 36 per cent in 1980-81 and 19.8
per cent in 2002-03. The share of fishing remained more or less constant at around
one per cent in the last five decades. The share of forestry, however, declined from
6.7% to one percent during the period. In 2010-1, according to the advance estimates
of the Central Statistical Organization, the share of the primary sector has come down
to 14.36 per cent.
2. Structural Changes in the Secondary Sector.The share of the secondary sector
consisting of mining, manufacturing, construction, electricity, gas and water supply
has steadily increased from 16.1 percent of GDP in 1950-51 to 26.9 percent in 2002-
03. Manufacturing industries and construction are the two major constituents of the
secondary sector. The share of manufacturing in GDP increased from 8.9 percent in
1950-51 to 15.2 percent in 2002-03 and the share of construction improved from 4.1
to 6.1 percent in the same period. The share of mining and quarrying increased from
1.5 percent to 2.3 percent. The share of electricity, gas and water supply increased
from 0.3 percent to 2.4 percent. In 2010-11, the share of the industry or the
secondary sector has come down to 27.91 per cent.
3. Changes in the Tertiary Sector. The tertiary sector includes transport,
communication, trade, finance, real estate, community and personal services. The
domination of the tertiary sector in the national economy is the logical consequence
of economic growth and development. The share of this sector grew from 28 percent
in 1950-51 to 57.73 percent in 2010-11. The share of transport, communications and
trade improved from 12% to 24% during the period and this sub-sector dominates the
tertiary sector. Finance and real estate also grew substantially from 6.7% to 13.7
percent. Rapid expansion in economic and welfare services such as education, health
and family welfare contributed to the improvement in the share of Community and
Personal Services from 9.4 percent to 14.5 percent. In 2010-11, the share of the
tertiary or the services sector has gone up to 57.73 per cent.
18
Table 1.5 - Estimates of GDP by Industry of Origin (1993-94 prices)
Industry Group Percentage Distribution
1950-51 1980-81 *2000-01 2010-11 +2016-17
I. Primary
1. Agriculture
2. Forestry
3. Fishing
57.7
50.2
6.7
0.9
39.7
35.8
3.0
1.0
21.9
19.8
1.0
1.1
14.36 15.11
II. Secondary
1. Mining and Quarrying
2. Manufacturing:
a) Registered.
b) Unregistered.
3. Electricity, Gas & Water
Supply.
4. Construction.
14.8
1.5
8.9
4.4
4.5
0.3
4.1
23.7
2.1
13.8
8.1
5.8
1.7
6.1
26.9
2.3
15.2
10.2
5.2
2.4
6.1
27.91 31.12
III. Tertiary
1.Transport, Communication
and Trade
2. Finance and Real Estate.
3. Community and Personal
Services.
28.0
11.9
6.7
9.4
36.6
18.4
6.5
11.7
52.2
24.0
13.7
14.5
57.73 53.77
A. Commodity Sector (I + II) 72.0 63.4 48.8 42.27
B. Service Sector (III) 28.0 36.6 51.2 57.73
Total 100.0 100.0 100.0 100.0 Source: EPW Research Foundation (2002), NAS (1950-51 to 2000-01), NAS 2003 and CSO. *New Series at
1999-00 prices.+(at 2011-12 prices).
Conclusions.
The structural change in the composition of national income by industrial origin is the result of
planned economic growth since the 1950s. Some important conclusions that can be drawn from
the growth performance of the Indian economy as revealed in Table 1.3 are as follows:
1. The growth of the manufacturing sector was a natural result of the program of rapid
industrialization in India. The growth rate of this sector was 6.4 percent during the first decade.
It improved to 7.6 percent during 1980-81 to 1990-91. However, in the first five years of the 21st
century, the manufacturing growth rate declined to 6.1 percent.
19
2. The agricultural sector lagged behind due to inadequate investment and the continued
dependence of Indian agriculture on monsoons. The rate of growth of agriculture declined from
three percent in the first two decades to 1.5 percent in the third decade and thereafter it went up
to 3.4 percent in the fourth decade. It further declined to 2.6 percent in the fifth decade. During
the period 2000-01 and 2004-05, the rate of growth of agriculture was only 2.4 percent.
3. The rate of growth of transport, communication and storage was about 5 to 6 percent
during the first four decades. In the post reform period, the rate of growth of this sector went up
to eight percent.
4. The rate of growth of service sector was about 4.5 percent in the first three decades, went
up to 6.7 percent in the fourth decade and then to 7.5 percent in the fifth decade. It further went
up to 8.1 percent during the period 2000-01 to 2004-05.
5. The overall GDP growth of the economy declined from 3.9 percent in 1950-51 to 1960-
61 to 3.1 percent during 1970-71 to 1980-81. Thereafter, it improved to 5.6 percent during 1980-
81 to 2000-01.
6. The slow growth of agriculture and manufacturing has pulled down the rate of growth of
GDP in the post reform period.
7. The service sector has been rapidly growing in the post reform period and has improved
the GDP growth over six percent since 1990-91.
Questions.
1. Explain the Circular flow of Income in an Open Economy.
2. Explain the concepts of GNP, NNP, GDP, GDP Deflator.
3. Explain the difference between Real and Nominal GDP.
4. Explain the concept of GDP at purchasing power parity.
5. Explain how exchange rate is determined in a free market economy.
6. Explain the GDP Growth of India with regard to trends and growth rate.
7. Explain the Sectoral Composition of GDP of India.
20
MODULE II
PREVIEW.
8. National Income Identity in an Open Economy.
9. Keynesian Consumption Function.
10. InvestmentMultiplier.
11. Marginal Efficiency of Capital and Rate of Interest.
12. Accelerator.
13. Savings in India: Trends and Composition.
14. Capital Formation in India: Trends and Composition.
15. Sources of Data.
NATIONAL INCOME IDENTITY IN AN OPEN ECONOMY.
National income is the money value of all economic activities of a nation conducted in a given
year. An economic activity refers to production of goods and services which can be valued at
market prices. It includes agricultural production, industrial production and production of
services. Goods and services which do not have an exchange value or market value are non-
economic in nature. For instance, services of a house wife or a house husband, services of
members of family to other members or their own selves, hobbies etc. The national income of a
country can be defined as the total market value of all final goods and services produced in the
economy in a given year.
National income measures market value of annual output. It is therefore a monetary measure of
the value of goods and services. In order to measure the real national income or the measure the
changes in physical output of goods and services, the figure for national income is adjusted for
price changes. Further, for the accurate calculation of national income, all goods and services
produced in a year must be counted only once. Generally, goods are produced in different stages
before they reach the markets in their final form. Hence, components of goods are exchanged
many times. Thus to avoid multiple counting, national income includes only the market value of
all final goods. This is how national income is defined in terms of product flow.
National income can also be defined in terms of money flow. Economic activities generate
money flow in the form of payments i.e., wage, interest, rents and profits. National income can
thus be obtained by adding the factor incomes and adjusting it for indirect taxes and subsidies.
National income obtained in this manner is known as National Income at Factor Cost.
CONSUMPTION, SAVING
AND INVESTMENT
21
National income can be viewed from different angles. It represents total receipts and it also
represents total expenditure. When goods and services are valued at their market prices, three
identities are created, namely: the value of receipts equal to the value of payments equal to the
value of goods and services produced and sold. These three identities can be put as: National
Income = National Expenditure = National Product.
To understand the concept, let us assume a two-sector model of an economy consisting of
households and firms. Firms produce goods and services. In order to produce, firms require
factor services namely: land, labor, capital and enterprise. Factors of production are paid their
prices in the form of rents, wages, interests and profits for their contribution to the production of
goods and services. The money value of net production must equal the total money value of
factor prices i.e. rents, wages, interests and profits. These incomes become the source of
expenditure. Thus income flows from the firms to the households in exchange for productive
services. The income goes back to the firms in the form of expenditure made by households on
goods and services. This process is also referred to as the Circular Flow of Economic Activities.
There are thus three measures of national income of a country, namely:
1. The total value of all final goods and services produced.
2. The total of all incomes received by the factor owners in a year, and
3. The total of consumption expenditure, net investment expenditure and government
expenditure on goods and services.
These three measures denote the three fundamental functions of an economic system or a
national economy, namely: production, distribution and expenditure. The fourth fundamental
function is that of consumption and is subsumed in expenditure.
KEYNESIAN CONSUMPTION FUNCTION.
Consumption demand is an important component of the aggregate demand function. The
aggregate demand function is the sum of consumption and investment demand in the economy.
It determines the level of employment, output and national income. The consumption function is
an expression of an empirical relationship between income and consumption. According to
Keynes, consumption is a function of income. When the income of a community rises,
consumption also rises. The extent of rise in consumption as a result of rise in income is
determined by the propensity to consume. The propensity to consume is a schedule which
describes the amounts of consumption at various levels of income. The consumption function
schedule is given in Table 2.1 below.
22
Table 2.1: Consumption Function Schedule.
Income (Y)
(Rupees Trillion)
Consumption (C)
(Rupees Trillion)
2 2.2
3 3.0
4 3.8
5 4.6
6 5.4
7 6.2
8 7.0
Table 2.1 indicates various levels of income and their corresponding levels of consumption
expenditure by households. It also indicates that income and consumption expenditure are
directly related. The consumption expenditure is found to be increasing at a constant rate, the
marginal propensity to consume remains constant in the short run. The consumption function is
graphically shown in Fig. 2.1 below.
Fig.2.1: Consumption Function
23
In Fig. 2.1 above, the Y-axis measures consumption expenditure and the X-axis measures real
income. The ‘C’ curve measures consumption function. The line of unity ‘OZ’ drawn at 45
degrees angle indicates the equality between income and expenditure. Any point on the line of
unity indicates that consumption is equal to income. The slope of the ‘C’ curve is flatter than the
income curve after the intersection point ‘D’ indicating that the change in consumption is less
than the change in income. You will notice that the change in consumption C1C2 is less than the
change in income Y1Y2. The vertical distance between the income and the consumption curves
measures savings to the right of the intersection point and dissaving to the left. At Y2 level of
income, the savings are equal to SS’. You may also notice that ‘C’ curve intercepts the Y-axis at
point ‘A’ indicating that when income is zero, consumption expenditure is equal to OA. Such a
situation indicates society in the state of nature wherein it consumes without producing. Further,
at lower levels of income, a society or a nation may use its accumulated savings or borrow from
other nations to maintain its consumption standards.
Average Propensity to Consume (APC).
The APC is the ratio of total consumption to total income in a given period of time. The value of
APC at any income level can be found by dividing consumption expenditure by the level of
income (APC = C/Y). The APC is calculated in column 3 of Table 2.2 below. You will notice
that the proportion of income spent on consumption decreases as income increases. It
progressively falls from 100% to 95, 92, 88 and 87.5%.
Table: 2.2
Average & Marginal Propensity to Consume
Income
(Y)
Consumption
(C)
Average Propensity
to Consume (APC = C/Y)
Marginal Propensity
to Consume (MPC = C/Y
3000 3000 3000/3000 = 1 or 100% -
4000 3800 3800/4000 = 0.95 or 95% 800/1000 = 0.8 or 80%
5000 4600 4600/5000 = 0.92 or 92% 800/1000 = 0.8 or 80%
6000 5400 5400/6000 = 0.90 or 90% 800/1000 = 0.8 or 80%
7000 6200 6200/7000 = 0.88 or 88% 800/1000 = 0.8 or 80%
8000 7000 7000/8000 = 0.875 or 87.5% 800/1000 = 0.8 or 80%
*All figures in Rupees Billion.
APC reveals what percentage of the total cost of a given output is expected to be recovered by
selling consumer goods. The reciprocal of APC is the average propensity to save (APS = 1 –
APC). APS reveals what percentage of the total cost of a given output is expected to be
recovered by selling capital goods. Thus the relative development of the capital and consumer
goods industries in the economy is dependent upon the APC and APS. The APC is low in
developed rich countries and it is high in underdeveloped poor countries. Symbolically, MPC =
C
Y
24
The Marginal Propensity to Consume.
The Marginal Propensity to Consume is the ratio of the change in the level of total consumption
to a change in the level of total income. It reveals the effect of additional income on
consumption. The marginal propensity to consume can be obtained by dividing change in
consumption by change in income. Symbolically, MPC = C/ Y.
In column 4 of table 2.2 above, the marginal propensity to consume is calculated at various
levels of income. The MPC is found to be constant at all levels of income because Keynes
assumed that MPC remains constant in the short run. The value of MPC lies between zero and
one because a rise in consumption will always be less than a rise in income and a rise in income
will always be followed by a rise in consumption. According to KK Kurihara, the concept of
MPC helps us to understand the reality of under-full employment equilibrium. The gap between
income and consumption at various levels of income cannot be adequately filled by investment
because savings are never equal to investment. The MPC may however change during cyclical
fluctuations i.e. the MPC may fall during the upswing and rise during the downswing. In the
long run, the MPC declines along with rising prosperity of the country. Thus the MPC is higher
amongst the poor countries and lower amongst the rich countries.
In Fig.2.2 below, the APC and MPC are graphically measured.
Fig.2.2: The Relationship between APC & MPC.
25
The APC is measured on a single point on the consumption curve and the MPC is measured by
the slope of the consumption curve. You will notice that MPC is the ratio of the vertical length
PM to the horizontal length AM.
The relationship between MPC and APC can be explained as follows:
1. When the MPC is constant, the consumption function is linear.
2. As income rises, MPC falls but the fall in MPC is greater than the fall in APC.
3. As income falls, the MPC rises. The APC also rises but the rise in APC will be less than
the rise in MPC.
The Savings Function.
Savings (S) is the difference between income (Y) and consumption (C). Therefore S = Y – C.
The Savings function can be derived from the consumption function. The derivation of the
savings function from the consumption function is shown in Fig.2.3 below.
You will notice that savings is a direct function of income. Thus S = f (Y). The savings curve
therefore slopes upward. The Average Propensity to save is the ratio of savings to income.
Symbolically APS = S/Y. Similarly, the marginal propensity to save is the ratio of a change in
savings to a change in income. Symbolically, it can be stated as MPS = S/ Y. The marginal
propensity to save can be derived from the marginal propensity to consume. Thus MPS = 1 –
MPC. The value of MPS is also between zero and one.
26
Factors Affecting the Consumption Function.
According to Keynes, consumption function is influenced by both subjective and objective
factors.
Subjective Factors.
Subjective factors are those factors which motivate households to save. People save to safeguard
against uncertainties such as illness, unemployment, accidents, death etc and want to make
provision for expected future needs such as education, marriage, buying a new house etc. People
also save to invest and enjoy a more prosperous future and improve one’s own social status.
People may also save to leave a good fortune for their heirs and some may save purely on
account of miserly habits. These subjective factors are responsible to raise the marginal
propensity to save and reduce the marginal propensity to consume. They also determine the
shape and position of the consumption function. However, there are also factors which raise the
marginal propensity to consume. People copy the consumption habits of the rich thereby raising
the consumption expenditure. According to Duesenberry, people in relatively lower income
groups imitate the consumption habits of people in relatively higher income groups. This
behavior leads to rise in propensity to consume and is known as demonstration effect.
Subjective factors also influence the saving and spending habits of firms. Firms make savings so
that they can invest and expand in future. They also maintain liquid savings to provide for
contingencies. Professionally managed firms may save more to prove their thriftiness and
competence. Firms may also set aside a part of their savings to provide for depreciation.
Finally, firms save to repay their debts. Saving more on account of these factors will reduce the
propensity to consume and vice versa.
Objective Factors.
According to Keynes, the following objective factors determine the consumption function:
1. Changes in the General Price Level. When the general price level rises, the
consumption function shifts downwards. This is due to the fall in purchasing power of money
balances and financial assets with fixed monetary values. This is known as real balance effect.
Similarly, when the general price level falls, the purchasing power rises and the consumption
function shifts upwards.
2. Fiscal Policy. If taxes are raised, the consumption expenditure will fall and if the taxes
are reduced, consumption expenditure will rise. Welfare measures by the government transfer
income from the rich to the poor. This raises the consumption function in the country.
3. Rate of Interest. Higher the rate of interest, higher will be the savings and lower the
consumption function and vice versa.
4. Stock of Wealth. Wealth includes real assets such as land, building, gold etc and
financial assets such as savings and fixed deposits, cash balances, stocks and bonds. The higher
27
the amount of wealth accumulated by households, higher will be the consumption function and
vice versa.
5. Credit Conditions and the level of Indebtedness. The availability of easy credit raises
consumption expenditure and vice versa. For example, liberal personal loans and credit cards
have contributed to the rise in consumption expenditure. However, if the households are heavily
indebted, the consumption function falls.
6. Income Distribution. If income inequalities are high, consumption function will be
low and vice-versa. Rich people have low propensity to consume and poor have high propensity
to consume. Thus if income is concentrated in the hands of few people in the society, the
propensity to consume will be low.
7. Windfall Gains and Losses. During the cyclical upswing, the share prices go up
rapidly and stock market investments fetch capital gains. This is known as a windfall gain. On
account of such gains, the consumption function goes up. When share prices fall during the
downswing, consumption function shifts downwards.
8. Change in Expectations. If people expect future prices to go up on account of an
impending war or natural calamity, the consumption function during the current period will go
up. Similarly, if the expectation is that prices will fall in future, people will postpone their
current consumption expenditure and as a result the consumption function in the current period
will go down.
Prof. Keynes believed that consumption function remains fairly stable in the short run. It
changes only in the long run when there is a substantial increase in the national and per capita
incomes. Institutional factors change only in the long run. For example, income distribution
undergoes change only in the long run. Hence the level of employment, output and income could
be manipulated only through changes in investment demand.
Importance of Consumption Function.
According to Prof. AH Hansen, the concept of consumption function has heralded the beginning
of a new era in the history of economic theory. The concept is very useful in determining the
macro-economic policy of an economy. The importance of consumption function can be
explained as follows:
1. Invalidation of the Say’s Law of Markets. Prof. JB Say put forward his law of market
as “Supply creates its own demand”. According to him, there cannot be a deficiency in
aggregate demand and hence the economy will always operate at full employment level.
However, Prof. Keynes have adequately proved the fact that saving which is leakage in the flow
of income is never equal to investment and since the gap between income and expenditure
cannot be filled by adequate quantity of investment, aggregate demand will always be less than
aggregate supply and the economy will operate at less than full employment level.
28
2. Importance of Investment Demand. In order to maintain a given level of
employment, the gap between income and expenditure should be filled by an adequate level of
investment. If investment demand is less than the savings gap, the previous level of
employment, output and income cannot be maintained. Thus, the concept of consumption
function has helped to highlight the importance of investment demand in maintaining a given
level of employment. Changes in investment demand cause fluctuations in the economy.
Further the propensity to consume remains constant in the short run and hence only increase in
investment demand can increase the level of employment, output and income in the economy in
the short run.
3. Importance of the concept of Investment Multiplier. The concept of investment
multiplier has been derived from the concept of consumption function. The investment
multiplier K = 1/1-mpc tells us as to by how many times a given amount of investment will
multiply over time and take the economy to a higher level of income. Since the value of MPC is
always greater than zero, the increase in net investment has a multiplier effect on income. The
change in income depends upon the size of the multiplier and the value of the multiplier directly
depends upon the value of MPC.
4. Importance of the concept of Marginal Efficiency of Capital. The level of
investment demand in an economy depends upon the marginal efficiency of capital. MEC is the
expected rate of return on capital over its life time. If the MEC is high, investment demand will
be high and vice-versa. However, the MEC depends upon the marginal propensity to consume.
If the MPC remains constant in the short run, the MEC will also remain constant in the short run.
Since the MPC declines in the long run, the MEC must decline in the long run bringing about fall
in investment and recession in the economy. A capitalist economy is a demand driven economy
and in order to drive the economy forward, the MPC must rise.
5. Importance of the concept of Business Cycle. The turning points of the business cycle
are caused by the behavior of marginal propensity to consume. During the downturn when
income is falling, the fall in MPC is less than the fall in income and hence it helps the economy
to take the upturn. Similarly, during the upturn the rise in consumption is less than the rise in
income and hence the peak peters out and the down-turn begins.
The concept of consumption function has therefore a very important role to play in determining
the level of investment, employment, output, income and demand in a capitalist economy.
29
INVESTMENT MULTIPLIER.
The effect of changes in investment upon national income and consumption expenditure
and the resultant generation of income in the short run are explained by the concept of
Multiplier or Investment Multiplier. The concept of investment multiplier helps us understand
as to by how many times income would increase with a given change in investment given the
marginal propensity to consume. The multiplier refers to the effects of changes in investment
expenditure on aggregate income through induced consumption expenditures. The multiplier
therefore expresses a relationship between an initial change in investment and the consequent
increase in national income. The multiplier is a numerical coefficient which indicates increase in
income as a result of increase in investment. For example, if change in investment is Rs.100
Billion and the national income rises by Rs.500 Billion, then the investment multiplier is 5
i.e., change in national income divided by change in investment or Rs.500/Rs.100 Billion.
The investment multiplier is therefore the ratio of change in national income to the given
change in investment.
Symbolically, K = Y/I
Where; K = refers to investment multiplier.
Y = refers to change in national income, and
I = refers to a given change in investment.
According to Samuelson, investment multiplier is the number by which the change in investment
must be multiplied in order to present us with the resulting change in income. If you find the
investment multiplier ‘K’, the change in national income as a result of change in investment can
easily be measured. Thus Y = K.I. The marginal propensity to consume determines the size of
the multiplier and the resultant national income. When a change in investment occurs, the
national income increases by the same amount and with the increase in national income,
consumption expenditure also increases. However, increase in consumption expenditure is less
than the increase in national income. Increased consumption expenditure becomes additional
income to productive factors engaged in the production of consumer goods, resulting in a further
increase in income. The process continues till the initial investment is exhausted through a series
of changes in income and expenditure. Since the marginal propensity to consume is less than
one, the process of income generation must be exhausted when change in investment becomes
equal to change in savings. Keynes believed that with the change in real income, consumption
expenditure will also change but not in the same proportion. The change in consumption
expenditure as a result of change in income will be always be less than one i.e., proportionate
change in consumption expenditure will always be less than proportionate change in income.
The value of the investment multiplier is therefore determined by the marginal propensity to
consume. Greater the value of the marginal propensity to consume, greater will be the value of
the investment multiplier and vice versa. The multiplier formula can therefore be stated as
follows:
30
k = 1/1-mpc
Where; ‘k’ = is the multiplier coefficient and
mpc = marginal propensity to consume.
Since 1-mpc = mps, the multiplier formulate can be restated as follows:
k = 1/mps
Where ‘mps’ = marginal propensity to save.
Thus the multiplier coefficient is measured as the reciprocal of the marginal propensity to save.
Working of the Investment Multiplier.
The working of the investment multiplier can be explained as follows. Let us assume that the
size of the initial investment is Rs.100 Crore. This investment will generate an income of Rs.100
Crore for the capital goods industry. If we further assume that the marginal propensity to
consume is fifty percent in the first round of income generation, then Rs.50 Crore will be spent
by the income recipients of the first round on consumption goods and fifty per cent will be saved.
Now in the second round of income generation, Rs.50 Crores will be received by the consumer
goods industry and they in turn will spend Rs.25 Crores on consumption and save Rs.25 Crores
because the value of mpc is 0.5 or fifty per cent. This sequence of income and expenditure is
based on the principle that one man’s expenditure is another man’s income. This process will
continue till the initial investment of Rs.100 Crores gets exhausted through a series of
expenditures, income and savings. Each round of expenditure takes about three months to
materialize. The time interval between consumption responses is the multiplier period or
propagation period. The income propagation process can be explained with the following
equation:
Y = I (I + c + c2 + c3 + c4 + …… + cn)
Where Y = change in income,
I = change in investment, and
c = marginal propensity to consume.
Since the value of mpc is less than one, the sum of an infinite geometrical progression is as
follows:
Y = I 1/1-c
Substituting the values of the above example in the formula, we get:
31
Y = 100 X 1/1-0.5 = 100 X 1/0.5 = 100 X 2 = Rs.200 Crores.
Thus, if the value of mpc is 0.5 or fifty per cent, an initial investment of Rs.100 crores will
generate a total income of Rs.200 Crores. Table 2.3 below shows a hypothetical example of
income generation.
Table 2.3
Income Generation Process (Single Injection Model).
(MPC = 0.5 or 50%)
You will notice that Rs.100 Crores of initial investment generate over a period of time a total
income of Rs.200 Crores. When the total new income level is Rs.200 Crores, Savings of Rs.100
Crores equals investment of Rs.100 Crores and the income generation process comes to an end.
Keynes has assumed that the multiplier process does not take time to work itself out i.e., an
increase in investment generates income by the multiple amount immediately. Keynes has
therefore ignored time lags in the multiplier process. Modern economists have taken into
account time lags in the multiplier process and consider the multiplier process over time.
In order to keep the total income to the level of the multiplier, repeated increments of
investment are required because a single injection of investment will raise the multiplier
value but as soon as the multiplier effect has worked itself out, total income will fall back to
its original level. A steady injection of new investment is therefore required to raise the
total income to the multiplier level and maintain it there. Thus in order to maintain the
new income level of income of Rs.200 Crores and income of the previous period, a steady
investment of Rs.100 Crores in each round must be made. This is called the Steady
Injection or Continuous Injection Model which is depicted in Table 2.4 below.
Periodic Rounds of New Consumption New Income
(Rs. Crores)
New Savings
(Rs. Crores)
Initial Investment 100 Nil
1st Round of new consumption 50 50
2nd Round of new consumption 25 25
3rd Round of new consumption 12.5 12.5
4th Round of new consumption 6.25 6.25
5th Round of new consumption 3.125 3.125
Remaining rounds of new consumption 3.125 3.125
Total 200 100
32
TABLE 2.4
Continuous Injection Model of Investment Multiplier
(MPC = 0.5 Or 50%)
The multiplier model with a steady investment of Rs.100 Crores and with 50% marginal
propensity to consume is shown in the aforesaid table. You will notice that continuous
investment of Rs.100 Crores in each round of consumption helps the national income to rise to
the level of the multiplier along with the income of the previous period and stay there. The
effect of investment multiplier is diagrammatically shown in Fig. 2.4 below. In this figure, the
‘C’ curve denotes consumption function with a constant MPC of 50%. While we superimpose
the investment curve on the consumption curve, we get the C+I curve which also reflects the
level of effective demand. The C+I curve intersects the line of unity (Y = C+S) at point E1 and
equilibrium level of national income OY1 is determined. When investment is increased by
Rs.100 Crores the C+I curve shifts upwards and new curve is C+I+I. The vertical distance
between the two curves is the monetary value of new investment. This new curve intersects the
line of unity at point E2 and accordingly national income OY2 is determined. The rise in income
Y1 Y2 is 100 per cent more than the initial investment of Rs.100 Crores. This is because the
value of the multiplier is Two.
Multiplier
Period
Initial
Investment
Rs. Crores (I)
MPC = 0.5
Increase in Consumption
Total Increase
in Income
0 100 - 100
1 100 50 150
2 100 50 + 25 175
3 100 50 + 25 + 12.5 187.5
4 100 50 + 25 + 12.5 + 6.25 193.75
5 … ………………….. ………
…… …. ………………….. ………
…… …. ………………….. ………
100 100 200
33
Fig. 2.4: The Multiplier
Assumptions of the Theory of Multiplier.
The theory of multiplier holds good only under the following assumptions:
1. Advanced Economy. The multiplier can work only in an industrially advanced
economy because it requires a large stock of capital and open unemployment. Only when there
is substantial unemployment productive resources will the multiplier work and create more
income. In the event of full employment, fresh investment will only compete for the existing
resources and raise their prices.
2. The Marginal Propensity to Consume is Constant. The mpc is assumed to remain
constant during the process of income generation. However, in reality the mpc is known to fall
at higher levels of income and in that case the size of the multiplier will get reduced and the
resultant national income will be less than expected.
34
3. Stable Fiscal and Monetary Policies. Both monetary and fiscal policies influence consumption
demand. For instance a contractionary monetary policy will reduce money supply, raise interest rate and
thereby reduce investment, employment, output and income in the country. Similarly, a contractionary
fiscal policy with higher tax rates will reduce the disposable income of the people and affect consumption
demand.
4. Closed Economy. Keynes assumed a closed economy so that the impact of new investment is
not dissipated into the open world economy. For instance, if people who receive income as a result of
fresh investment spend the money to buy imported goods then such an investment will help the national
income of the exporting country to increase and the multiplier will not work along expected lines in the
home country.
5. Static Economy. In order to prove the working of the multiplier, Keynes assumed a static
economy which means the level of technology, capital formation, labor supply, stock of raw materials etc
are all assumed to be constant.
6. Absence of Time Lag. There is no time lag involved in the receipt of income and its
expenditure. The process of income generation is assumed to be instant in each round of investment.
7. Excess Capacity in Consumer Goods Industry. When national income rises as a result of
new investment and the working of the multiplier, the demand for consumer goods will increase. There
should be excess capacity in the consumer goods industry so that the supply of consumer goods is
adequate to keep their prices constant. A rise in the prices of consumer goods will eat into the value of
the multiplier.
Leakages in the Multiplier Process.
The value of the Multiplier will be reduced by the leakages in the income stream. These leakages are as
follows:
1. Increase in the MPC. Keynes assumed a constant MPC and therefore a constant MPS to prove
his concept of Investment Multiplier. However, in reality when income rises the MPC falls and MPS
rises. This will reduce the size of the multiplier and therefore the ultimate rise in national income.
2. Hoarding of Cash Balances. People tend to hold a part of their income in the form of idle cash
balances. These balances will constitute a leakage in the income generation process. Further, the size of
idle cash balances would be large during a recession and small during the prosperity phase of business
cycle. Thus in a dynamic economy on account of hoarding and spending of cash balances the size of the
multiplier will change.
3. Purchase of Secondary Shares and Securities. If people decide to invest their new
found additional income in the stock market, their consumption expenditure will reduce and
neither will investment expenditure rise as buying secondary shares and securities constitute
speculation. Fall in consumption expenditure will reduce the MPC and thus the size of the
multiplier.
35
4. Repayment of Debt. If people who receive the newly generated income to repay their
debts, their consumption expenditure will fall thereby reducing the size of the marginal
propensity to consume and hence the multiplier will fall and the expected rise in national income
will not materialize.
5. Net Positive Imports. Although Keynes assumed a closed economy to explain his
concept of investment multiplier, in reality economies are open. Hence, if net imports are
positive, income from the domestic stream will flow into international channels and thereby
reduce the size of the multiplier.
6. Inflation. When the investment multiplier is in operation, incomes rise and along with
rise in incomes, prices may also rise. On account of price rise, the real consumption of the
people may remain constant or even fall thus affecting the multiplier.
If these leakages are not taken care of, they will reduce the size of the multiplier and the
expected rise in national income will not materialize. If the leakages do not occur, the national
income will continue to increase through the multiplier process until full employment of
resources is achieved.
REVERSE MULTIPLIER.
The investment multiplier can also reduce the size of the national income by operating in
the reverse direction. If existing investment is withdrawn the national income will fall by
the size of the reverse multiplier given the marginal propensity to consume. For instance, if
investment worth Rs.100 Crore is withdrawn and the marginal propensity to consume is
0.5 or 50 per cent. It will reduce the income in the capital goods industry by Rs.100 Crore
and reduce consumption expenditure by fifty per cent in each round of consumption until
the national income is reduced by Rs.200 Crores. The size of the reverse multiplier being
Two, a withdrawal of Rs.100 Crore of investment will reduce the national income by two times
the size of disinvestments. The impact of the reverse multiplier is shown in Fig.2.5 below. You
will notice that the initial national income is OY. When the investment declines by II1, the
national income is reduced to OY1. Thus on account of withdrawal of investment, the national
income falls by YY1. Reduction in national income takes place due to the reverse working of the
multiplier.
We assumed the marginal propensity to consume to be 0.5 or fifty per cent. However, the MPC
is high, the multiplier will be higher and there will be much more reduction in the national
income. For instance, if the MPC is 0.8, the size of the reverse multiplier will be 5 and the
reduction in national income will be five times the reduction in investment. Thus greater the size
of the MPC, greater will be the multiplier and in this case, greater will be the fall in national
income.
36
Fig. 2.5: The Reverse Multiplier
Limitations of the Theory of Multiplier.
The Keynesian theory of multiplier has the following limitations:
1. The Impact of Investment on National Income is not Instantaneous. Keynes
assumed an instant relationship between investment, income and consumption. In reality, there
is a time lag between the receipt of income and consumption and between consumption
expenditure and income.
2. The Keynesian Multiplier is a Static Concept. The Keynesian concept of investment
multiplier is a static concept. In reality, the world is dynamic and dynamic factors would affect
the progression of the multiplier thereby either reducing its impact or accelerating its impact on
the national income.
3. The Keynesian Multiplier has no Empirical Basis. There is no real life evidence to
the working of the investment multiplier. No statistical data has been acquired to prove the
Keynesian hypothesis.
37
4. It Over-emphasizes Consumption. According to Prof. Gordon, Keynes has over
emphasized consumption to the neglect of expenditure per se. Keynes thus neglected the impact
on total private investment and government expenditure.
5. It Neglects Derived Demand from Investment in Capital Goods. The concept of
investment multiplier considers the impact of induced consumption on income. However, it
neglects the impact of induced consumption on induced investment. It fails to see that the
demand for capital goods is a derived demand whereas the demand for consumption goods is
direct demand.
6. It operates only under the condition of under employment. The Keynesian concept
of investment multiplier will not work under the conditions of full employment. Unemployed
productive resources must be available for the working of the investment multiplier.
MARGINAL EFFICIENCY OF CAPITAL.
Marginal Efficiency of Capital means the expected rate of profit. Marginal Efficiency of a given
capital asset is the highest rate of return over the cost expected from additional unit of that
capital asset. According to Kurihara, the MEC is the ratio between the prospective yields of
additional capital assets and their supply price. Symbolically, the MEC can be stated as follows:
e = Q/P
Where `e’ = Marginal Efficiency of Capital.
Q = Prospective or expected rate of return of a capital asset per unit of time.
P = Supply price of the capital asset.
Thus the marginal efficiency of capital depends upon two factors. They are the prospective
return from the capital asset and the supply price of the capital asset. Prospective yield or return
refers to the rate of return an investor expects to obtain from selling the output obtained from his
capital asset during its life time. It is the life time total net return of a capital asset. By dividing
the total expected life of a capital asset into a series of annuities represented by Q1, Q2, Q3….Qn,
we obtain the prospective yield of investment. The supply price of the capital asset is the
replacement cost of the asset. Thus, the MEC of a capital asset is the rate at which the
prospective yield expected from one additional unit of the asset must be discounted if it is just
equal to the supply price of that asset. The equality between the supply price of a capital asset
and the discounted presented value of a series of annuities over the life time of the capital asset
can be stated as follows:
SP = Q1 Q2 Qn
________ + _________ + ________
(1 + e) (1 + e )2 (1 + e )n
38
Where; SP is the supply price of the capital asset. Q1, Q2, Qn are a series of anticipated annual
returns or the prospective yields of the capital assets in the years 1, 2..n respectively and e is the
rate of discount or the MEC. The term Q1/ (1+e) represents the current value of the annuity
receivable at the end of the first year discounted at the rate e. If the rate of discount is assumed
to be 10 per cent, Rs.100/- expected to be received a year later is worth Rs.90.91 now. It means
that Rs.90.91 currently invested at 10 per cent will become Rs.100 a year later. Let us assume
that the life of a capital asset is three years. If the current supply price of the asset is Rs.9601
and if its life is three years, then 5% must be rate of discount which would make the sum of
discounted values of the prospective annual yields equal to the supply price of the capital asset.
It means that the MEC is 5%. This is shown below:
Rs.9601 = 2100 1764 6946
_______ + ________ + ________
(1.05) (1.05)2 (1.05)3
= Rs.2000 + Rs.1600 + Rs.6001
= Rs.9601/-
If the prospective yields are less than the figures given above, the discount rate will be less than
5% so as to equate the discounted prospective yields to the supply price. Further, if there is a
decline in the prospective yields, there would be a fall in the rate of discount. If the supply price
of the capital asset is more than Rs.9601, the rate of discount would be lower, assuming the
yields remain constant. Thus when the net prospective yield is more than the supply price, there
would be an inducement to invest. The volume of investment depends upon the current supply
price of the capital asset and its demand price i.e. it depends upon the MEC and the rate of
interest.
Rate of interest, MEC and Investment Demand.
The marginal efficiency of a capital asset will decline as more and more investment is made in it
i.e. the marginal efficiency of a given capital asset will be sloping downward as the stock of
capital asset increases. This happens because the prospective yield from capital asset fall as
more units of capital are installed and used for production of a commodity. Prospective yield
decline because when more quantity of a good is produced with greater amount of capital assets,
prices of goods fall. Further with more demand for capital assets, the supply price of capital
assets rise. The marginal efficiency of capital can therefore be represented by a downward
sloping curve which is shown in Fig. 2.6 below. In Fig. 2.6, investment in capital assets is
measured along the X-axis and the rate of interest and marginal efficiency of capital is shown on
the Y-axis. You will notice that when investment in capital asset is OI1, the MEC is i1. When
the investment is increased to OI2, MEC of the capital asset falls to i2.
You will notice that the inducement to invest depends upon the MEC and the rate of interest.
Given the rate of interest and the MEC, the equilibrium level of investment in the economy can
be determined. The equilibrium level of investment will be established at the point where MEC
is equal to the given current rate of interest. Thus, if the rate of interest is i1, OI1 investment will
39
be undertaken because at OI1 level of investment, MEC is equal to the rate of interest i1. If the
rate of interest falls to i2, investment in capital assets will rise to OI2 because at OI2 level of
investment, the new rate of interest i2 is equal to the MEC. Thus, the MEC curve shows demand
for investment at various interest rates. The MEC curve, therefore, represents the investment
demand curve. This curve shows how much investment will be undertaken by the firms at
various rates of interest. If the investment demand curve is relatively inelastic, proportionate rise
in investment demand will be less than the fall in the rate of interest. And if the investment
demand curve is relatively elastic then a given fall in rate of interest will result in a more than
proportionate change in investment demand.
Fig. 2.6: The MEC Curve
Profit Expectations and Shift in Investment Demand Curve.
The MEC depends upon the supply price of capital and the prospective yields of capital asset.
The prospective yields are influenced by the changing profit expectations of firms. The level of
investment is actually determined by the profit expectations of firms. If profit expectations are
poor, investment demand will be low and the MEC will also be low. In contrast when profit
expectations are good, investment demand raises leading to higher levels of employment and
income. With change in profit expectations, the MEC curve shifts i.e. when profit expectations
are good, the MEC curve shifts to the right and vice versa. Fig.2.7 below shows shift in the
investment demand curve as a result of change in profit expectations. You will notice that the
rate of interest remaining constant, when profit expectations are poor, the investment demand
curve II shifts downwards or to the left to become I1I1 i.e. investment demand falls from OI to
40
OI1 and when profit expectations are good, the investment demand curve shifts to the right to
become I2I2 and investment demand rises from OI to OI2. Downward shift in the marginal
efficiency of capital curve indicates that at the given rate of interest, less investment will be
undertaken than before and vice versa.
Fig.2.7: Shifts in the MEC Curve
It can be concluded that the volume of investment depends upon the marginal efficiency of
capital and the rate of interest. If the rate of interest is higher than the marginal efficiency of
capital, new investment will not be profitable and entrepreneurs will be interested in lending
capital and enjoy the high interest rate rather than investing in capital assets and obtain a return
lower than the rate of interest. Similarly, if the rate of interest is lower than the marginal
efficiency of capital, the entrepreneurs will invest more in physical assets i.e. invest in
productive activities and earn more profits. Thus the equilibrium level of investment is possible
only when the marginal efficiency of capital is equal to the current rate of interest.
41
The rate of investment also depends upon the rate of interest. With the marginal efficiency of
capital remaining constant, the rate of interest falls, investment demand will rise and vice versa.
However, in the short run, the interest rate is more or less stable but not the marginal efficiency
of capital. The market forces will bring the two rates to equality in due course because when the
MEC is higher than the rate of interest, investment demand will raise leading to higher interest
rates. This process will continue till the two rates become equal.
THE ACCELERATOR.
The multiplier brings about rise in national income through induced changes in consumption.
However, induced consumption may also induce investment. The effect of induced investment
on national income is measured through the accelerator. A change in investment
expenditure will lead to change in consumption expenditure by an amount equal to the
acceleration coefficient. The accelerator is a ratio of induced investment expenditure (I)
to a change in the consumption expenditure (C). Symbolically, the accelerator equation
can be stated as follows :
a = I/C
where ‘a’ = is the accelerator coefficient,
I = change in investment expenditure
C = change in consumption expenditure.
Here I/C is the capital output ratio. The accelerator coefficient therefore depends upon the
capital output ratio. The capital output ratio refers to the amount of capital required to produce
one unit of output. For example, if consumption expenditure increases by Rs.100 Billion and if
the induced investment increases by Rs.500 billion, then the accelerator coefficient would be 5
(500/100) i.e. to produce one unit of output, five units of capital input are required. Thus to
produce goods worth Re. One, capital worth Rs.5/- is required. The capital output ratio is 5:1.
The accelerator coefficient also depends upon the durability of capital goods. The durability of
capital goods would determine the changes in induced investment in the capital goods industries.
The greater the durability of capital goods, the greater would be the fluctuations in investment in
the capital goods industry and vice versa. The greater the durability of capital goods and the
higher the capital output ratio, the greater will be the effect of acceleration.
The Working of the Accelerator.
The working of the accelerator can be explained with the help of a hypothetical example. Let us
assume that the current demand for consumption goods is 100,000 units and the capital output
ratio is 1:10. Given the capital output ratio, in order to produce One lac units of consumption
goods on a regular basis, 10,00000 units of capital goods will be required. Let us also assume
that the life of the capital goods is 10 years which means 100, 000 units of capital goods will
wear out in ten years and the rate of depreciation is 10 per cent. At 10 % depreciation rate, every
42
year 10 % of the capital goods will have to be replaced i.e. every year 100,000 units of capital
goods will have to be replaced. The capital output ratio being 1:10, the acceleration coefficient
is ten. Now let us assume that in the subsequent period, demand for consumption goods goes up
by 10%. Thus the new demand for consumption goods will be 1,10,000 units. In order to
produce 10,000 units of additional consumption goods, 100,000 units of capital goods will be
required. Now, a total of 200,000 units of capital goods will be required additionally. One lac
units to make allowance for depreciation and one lac more for making allowance for rise in
demand for consumption goods by 10,000 units. The effect of acceleration on investment is
shown in Table 2.5 below.
TABLE : 2.5
Effects of Acceleration on Investment
Period
Units of
Consumption
Goods
Units of
Capital
goods
Investment
for
replacement
Induced
Investment
Expenditure
Total
Investment
% Change
in
Investment
0 100,000 10,00000 100000 Nil 100000 Nil
1 1,10,000 11,00000 100000 100000 200000 100
You will notice from Table 2.5 that a ten per cent increase in the demand for consumption goods
has led to a 100 per cent increase in the investment outlay because the acceleration coefficient is
ten.
SAVING IN INDIA - TRENDS AND COMPOSITION.
The Gross Domestic Saving as a percentage of GDP has consistently increased since the
beginning of planned economic development in India. It was about 10 percent in the 1950s to 17
percent in the 1970s, and thereafter to over 25 percent by the turn of the century (Tables 2.6 and
2.7). Private saving has always dominated the savings scene in India. Public saving consistently
increased in the first thirty years and thereafter experienced a regular decline to enter in the
negative territory during the period 1996-2000. The share of household saving in total private
saving declined marginally from over 88 percent in the early 1950s to 84 percent in the late
1990s, reflecting increased corporate saving, from 1 percent to 3.6 percent of India's gross
domestic product (GDP) over this period.
The Government of India and the Reserve Bank of India has been successful in maintaining an
environment that is conducive to private domestic savings and hence the private domestic rate
has been healthy until now. Real interest rates have always remained positive and has
contributed to the growth of private domestic savings. The policy of targeting inflation rate and
maintaining macro-economic stability has delivered the results in terms of single digit inflation
rate and a high rate of growth of national income since the 1990s. The incentive for saving has
always remained positive. In the late sixties and then in the year 1980, the policy of
43
nationalizing the banking industry helped in the widening and deepening of the banking sector in
India. Bank density (population per bank branch) declined from over 90,000 in the mid-1950s to
around 14,000 in the mid-1990s,thereby, improving the access of India's average household to
banking facilities and reducing the cost of banking transactions.
From the year 2003-04, GDS crossed the 30 per cent mark and thereafter remained in the thirty
plus range throughout the 2000s until the year 2015-16. In the year 2007-08, the GDS touched
an all-time high of 36.4 per cent. Both household and private corporate sector savings have
substantially improved in the 2000s and hence the GDS was able to remain in the range of 30 to
36 per cent of GDP. Public Sector savings remained marginal throughout the period after
independence.
Table 2.6 - Gross domestic savings in India and its components as a percent of GDP (in
current market prices) 1950 to 2000
Household saving
Period (1) Financial Physical Total Private
corporate
saving
Total
private
saving
Public
saving
Gross
domestic
saving
1950–55 1.6 5.1 6.7 1.0 7.7 1.7 9.4
1956–60 2.5 5.3 7.8 1.2 9.0 2.0 11.0
1961–65 3.0 4.7 7.7 1.6 9.3 3.2 12.5
1966–70 2.4 7.2 9.6 1.3 10.9 2.5 13.4
1971–75 4.1 7.0 11.1 1.6 12.7 3.2 15.9
1976–80 5.6 8.4 14.0 1.6 15.6 4.3 19.9
1981–85 6.5 6.8 13.3 1.6 14.9 3.6 18.5
1986–90 7.6 9.4 17.0 2.1 19.1 2.0 21.1
1991–95 10.0 8.1 18.1 3.5 21.6 1.6 23.2
1996–2000 10.5 8.4 18.9 4.0 22.9 -0.1 22.8 SOURCE: Compiled from National Accounts Statistics of India 1950–51 to 2000–01.
44
Table 2.7 - Gross domestic savings in India
and its components as a percent of GDP
Year Household
Sector
Private
corporate sector
Public Sector Gross domestic
saving
(1) (2) (3) (4) (2+3+4)
2004-05 SERIES
2000-01 21.3 3.7 -1.3 23.7
2001-02 23.1 3.3 -1.6 24.8
2002-03 22.2 3.9 -0.3 25.9
2003-04 23.1 4.6 1.3 29.0
2004-05 23.6 6.6 2.3 32.4
2005-06 23.5 7.5 2.4 33.4
2006-07 23.2 7.9 3.6 34.6
2007-08 22.4 9.4 5.0 36.8
2008-09 23.6 7.4 1.0 32.0
2009-10 25.2 8.4 0.2 33.7
2010-11 23.1 8.0 2.6 33.7
2011-12 22.8 7.3 1.2 31.3
2011-12 SERIES
2011-12 23.6 9.5 1.5 34.6
2012-13 22.5 10.0 1.4 33.9
2013-14 20.3 10.7 1.0 32.1
2014-15 20.5 11.7 0.9 33.1
2015-16 19.2 11.9 1.3 32.3
Source: Economic Survey 2017-18 Vol.2 Table A26 & 27.
CAPITAL FORMATION IN INDIA – TRENDS AND COMPOSITION.
Domestic saving has majorly contributed to Domestic investment in India since the beginning of
planned economic development. Foreign capital inflows accounted for less than 1 percent of
GDP (Tables 2.8 and 2.9). India has been a significant recipient of foreign aid, but total aid flows
have remained negligible relative to the size of the economy. The role of foreign direct
investment and other forms of private capital, portfolio investment, and bank-related flows has
been even less important, reflecting the Indian government's unwillingness to invite foreign
investment uncritically as well as the highly restrictive capital account regime. The saving-
investment relationship has not undergone noticeable change, even after the reforms of 1991.
The relative contributions of the public and private sectors to gross domestic capital formation
have changed considerably from the early 1950s to the early 1980s. Public investment, which
increased from about 30 percent to 50 percent, accounted for much of the total increase in
45
investment. However, the rise in the investment rate after the mid-1980s can be attributed
primarily to the increase in private investment. Private investment since the 1990s has mostly
come from private corporate investment. The share of corporate investment in total private
investment increased to over 45 percent in the 1990s. Relative to GDP, private corporate
investment increased from 4.3 percent in the second half of 1980s to 7.1 percent by the mid-
1990s. (Household investment, on the other hand, fell from 9.3 percent of GDP to 8.5 percent.)
Economic reforms since 1991 have begun to play an important role in promoting corporate
investment, reflecting the declining cost of capital brought about by import liberalization and
favorable changes in investor perception.
In the first three decades after independence and even in the1980s, a highly interventionist trade
and industry policy regime limited the potential growth effect of domestic investment. Thus,
investment levels maintained through macroeconomic stability and financial deepening enabled
India to achieve a moderate economic growth until 1990.
Economic reforms since 1991 had changed the relationship between investment and growth by
lifting import restrictions and dismantling India's industrial "license permit raj," system. The
LPG reforms contributed to lowering of relative prices of capital goods, more investment and the
replacement of outdated machinery. Reforms have also contributed toimproved efficiency of
investment. Further, the private sector was assigned the commanding heights of the economy and
accordingly private sector investment surged ahead with public sector investment remaining in
single digits in the entire post-reform period except in few years. Gross investment or gross
capital formation crossed the thirty per cent mark in the year 2004-05 and assumed an all-time
high of 39 per cent in the year 2011-12. Gross capital formation has remained high in the 2000s
and particularly in the second decade of the new millennium. This situation augurs well for the
economy as it would entail a high rate of growth of the Indian economy
Table 2.8 - Gross investment in India and its components as a percent of GDP
(in current market prices) Private investment
Period Household Private
corporate
Total Public
investment
Gross
investment
1950–1955 5.1 1.5 6.6 3.4 10.0
1956–1960 5.3 2.5 7.8 6.0 13.8
1961–1965 4.7 3.3 8.0 7.6 15.6
1966–1970 7.2 2.0 9.2 6.3 15.5
1971–1975 7.0 2.7 9.7 7.7 17.4
1976–1980 8.4 2.2 10.6 9.1 19.7
1981–1985 6.8 4.7 11.5 10.3 21.8
1986–1990 9.4 4.1 13.5 9.8 23.3
1991–1995 8.2 6.8 15.0 8.4 23.4
1996–2000 8.4 7.1 15.5 6.9 22.4 SOURCE: National Accounts Statistics of India, 1950–51 to 2000–01.
46
Table 2.9 - Gross Capital Formation (as % of GDP)
Year Public
Sector
Private sector Valuables Total Errors &
Omissions
Adjusted
Total
(1) (2) (3) (4) 5=(2+3+4) 6 5+6 = 7
2004-05 SERIES
2000-01 7.1 16.3 0.7 24.1 0.1 24.2
2001-02 7.2 17.8 0.6 25.6 -1.3 24.3
2002-03 6.4 18.0 0.6 25.0 -0.2 24.8
2003-04 6.6 18.7 0.9 26.1 0.7 26.8
2004-05 7.4 23.8 1.3 32.5 0.4 32.9
2005-06 7.9 25.2 1.1 34.3 0.4 34.7
2006-07 8.3 26.4 1.2 35.9 -0.2 35.7
2007-08 8.9 28.1 1.1 38.0 0.1 38.1
2008-09 9.4 24.8 1.3 35.5 -1.2 34.3
2009-10 9.2 25.4 1.8 36.3 0.2 36.5
2010-11 8.4 26.0 2.1 36.5 0.0 36.5
2011-12 7.7 25.9 2.7 36.4 -0.9 35.5
2011-12 SERIES
2011-12 7.5 29.2 2.9 39.6 -0.6 39.0
2012-13 7.2 28.4 2.8 38.3 0.3 38.7
2013-14 7.1 25.5 1.4 34.0 -0.2 33.8
2014-15 6.8 26.1 1.7 34.6 -0.2 34.4
2015-16 7.5 23.9 1.4 32.9 0.4 33.3
Source: Economic Survey 2017-18 Vol.2 Table A26-27.
Questions.
1. Explain the Keynesian concept of Consumption Function.
2. Explain the concepts of Average and Marginal Propensity to Consume.
3. Explain the concept of Savings function?
4. Explain the factors affecting the consumption function.
5. Explain the concept of Multiplier.
6. Explain the working of the investment multiplier.
7. Explain the assumptions of the multiplier theory.
8. Explain the Leakages in the Multiplier Process.
9. Explain the concept of Reverse Multiplier.
10. Explain the limitations of the theory of multiplier.
11. Explain the trends and composition of savings in India.
12. Explain the trends and composition of capital formation in India.
47
MODULE III
PREVIEW.
1. Public Goods and their Features.
2. Merit Goods.
3. Sources of Revenue: Direct and Indirect Tax.
4. Impact, Shifting and Incidence of Tax.
5. Sources of Non- Tax Revenue.
6. Public Expenditure: Revenue and Capital Expenditure.
7. Subsidies.
8. Types of Deficit: Revenue, Budgetary, Fiscal and Primary.
9. Concept of GST. Recent Trends.
10. Sources of Data.
PUBLIC GOODS.
According to Paul Samuelson and William Nordhaus, “Public goods are those goods whose
benefits are indivisibly spread among the entire community, whether or not people desire to
purchase it”. For example, the police machinery extends equal protection to all the members of
the society whether or not people desire to make use of the machinery. Similarly, defense
services, roadways, the judicial system etc are examples of public goods. Public goods have two
important characteristics. They are non-rival in consumption and they are non-excludable.
A good is non-rival in consumption when more than one person can consume the same
thing without reducing the consumption of any other person. Public goods like defense,
police machinery, roads, judicial system etc are all non-rival in consumption because
people can consume these services to the extent of their needs without reducing the
consumption of others.
A good is non-excludable when people cannot be prevented from enjoying its benefits. For
example, a public garden, public health, public education etc. These goods and services are
available to all even if no payment is made.
In contrast to public goods, private goods are rival in consumption. For example, if one person is
working on a personal computer, the other person cannot use it at the same time without
reducing the consumption of the first person. There is a trade-off involved in private goods.
Similarly, if one person is drinking a can of beer, the other person cannot drink beer from the
same can. Thus private goods are divisible in consumption and somebody has to pay for it.
GOVERNMENT
48
Private goods are also excludable. For instance, a person will be admitted into a movie theatre
only if he has a valid ticket. A private good is therefore rival or divisible in consumption and is
also excludable.
The Problem caused by Public Goods.
The free market may fail to produce public goods. There may be consumers willing and able to
pay for public goods, but the free market may not produce them. Markets cannot provide public
goods because of the problem of free riders. Consumers attempt to gain a free ride on the back
of other consumers of the public good. For example, if a fisherman decides to put up a light
house close to some dangerous rocks for his benefit, all other fishermen in the area will benefit
equally from the lighthouse without paying for it and thus get a free ride. If everybody follows a
policy of wait and watch as to who puts up the light house, the light house will never come to
existence. The existence of public goods may thus mean that scarce resources are not used in a
way that would be desirable. People may wish for the provision of such goods, but the demand
may never be registered in the market.
MERIT AND DEMERIT GOODS.
A merit good is defined as a good that is better for a person than the person who may consume
the good realizes. For example, education is a merit good. The individuals who make decisions
about how much education to receive or how much to allow their children to receive do not fully
appreciate quite how much benefit will be received through being educated. We do not
appreciate how good education is for us. We do not perceive its full benefits at the time of
making the decision about how much education to receive.
Demerit goods are those products that are worse for the individual consumer than the individual
realizes. Cigarettes are taken to be a typical example. It is suggested that when a person makes
a decision to smoke a cigarette, he or she is not fully in possession of the information concerning
the harmful effects of smoking. If he or she were in possession of such information, then there
would be a greater reluctance to smoke.
Problems caused by Merit and Demerit Goods. The market mechanism fails when it comes
to merit and demerit goods. The market mal-allocates scarce resources to the production of these
goods. In case of merit goods, resources are under-allocated and in case of de-merit goods,
resources are over-allocated. Figures 3.1 and 3.2 indicate under-production of a merit good and
over-production of a demerit good respectively.
49
Y So
P1
P2
D1
D2
O Q2 Q1 Y
Fig.3.1: Under production of a merit good by the market.
Y So
P2
P1
D2
D1
O Q1 Q2 X
Fig.3.2: Over-production of a demerit good by the market.
Quantity
Pri
ce
Quantity
Pri
ce
50
Figure 3.1 indicates that the correct level of demand if consumers appreciated the true value of
the product would be D1 leading to a market price of P1 and optimum quantity of good will be
produced at Q1. Since consumers under-value the product, demand is only registered as D2
leading to a market price of P2 and Q2 output which is below the optimum level. The market
therefore fails. Figure 12.2 shows the opposite case of a demerit good. Here the correct demand
should be D1, price P1 and output Q1. As consumers overvalue the product, demand is registered
at the higher level of D2 with P2 price and Q2 output. As excessive resources are allocated to the
production of demerit good, the market has failed.
SOURCES OF REVENUE (DIRECT AND INDIRECT TAXES).
The sources of public revenue can be classified into two categories. They are: tax revenue and
non-tax revenue. The revenue from taxes is called tax revenue. The sources of tax revenue
would be direct and indirect taxes. Direct taxes may include taxes such as income tax, property
tax, corporation tax, gift tax etc. Indirect taxes may include taxes such as custom duties, excise
duties, sales tax, service tax etc. The sources of non-tax revenue would include profits from
public enterprises, administrative revenue and gifts and grants.
Tax Revenue. A tax is a compulsory contribution made by the residents and citizens of a
country to the Government. Government collects tax revenue for its own survival and to carry
out the various functions of the State. In order to carry out the various functions of the State, the
Government spends the revenue collected in such a manner that it does not generate a
corresponding benefit to the tax payers. In this context, it would be pertinent to mention the
definition of tax given by Prof. Seligman. According to him, “a tax is a compulsory
contribution from the person to the government to defray the expenses incurred in the
common interest of all without reference to special benefits conferred.” Taxes imposed by
the Government have the following characteristics:
1. A tax is a compulsory payment made to the Government. All tax payers must pay taxes
to the Government. Non-payment of taxes by persons who are liable to pay is a punishable
offence.
2. According to FW Taussig, there is no direct quid pro quo between the tax payer and the
Government. It means that tax payers cannot claim a corresponding benefit from the
Government for having paid the taxes. The return obligation of the Government is not toward
the individual but to the community of people constituting the Nation.
3. Tax is a contribution made by the citizens and residents to the Government for meeting
the expenses incurred in the common good of the Nation.
4. A tax is required to be paid regularly and periodically according to the amount and rate
determined by the Government.
In addition to the aforesaid features of tax, it is also used as an instrument of fiscal policy.
Changes in the types of taxes and the rates of taxes are made to achieve the macroeconomic
objectives of full employment, economic growth, equitable distribution of income and price
stability.
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A direct is paid by the person on whom it is imposed. In this case, the incidence and impact of
the imposition of tax is on the same person. For instance, the incidence and impact of income
tax is on the tax payer on whom the income tax is imposed. The income tax payer cannot shift
the burden of his or her tax liability, either in full or in part on any other person. Personal
income tax, corporation tax, property tax, capital gains tax etc are examples of direct taxes. The
incidence and impact of indirect taxes can be distributed between the buyers and sellers of goods
and services. For instance, the imposition of sales tax gets distributed between the buyer and
seller. In this case, the seller can shift the burden of indirect taxes on to the buyer either in whole
or in part, depending upon the elasticity of demand for the product. If the demand for the
product is perfectly inelastic, the entire burden of indirect tax can be shifted on to the buyer and
if the demand is perfectly elastic, the entire burden of indirect taxes has to be borne by the seller.
If the demand is relatively elastic, a greater proportion of the tax burden will be shouldered by
the seller and if the demand is relatively inelastic, a much lesser burden will be shouldered by the
seller. Other examples of indirect taxes could be custom duty, excise duty, securities transaction
tax and service tax. Thus, in the case of direct taxes, the impact or the initial tax burden and the
incidence or the final tax burden falls on the same person on whom the tax is imposed.
However, in case of indirect taxes, the burden can be distributed between the buyers and the
sellers in proportions determined by the elasticity of demand for the product.
According to JS Mill, when it is the intention of the government that a person who legally pays
the tax must bear its burden, it is a direct tax and when the government intends that a tax
collected from one should be shifted to others, it should be called an indirect tax. Thus a tax
which cannot be shifted is a direct tax and one which can be shifted is an indirect tax. Another
way of looking at direct and indirect taxes is like this. Taxes imposed on income earned or
received are direct taxes and taxes imposed on expenditures are indirect taxes.
Merits of Direct Taxes.
The merits of direct taxes are as follows:
1. Equity. Direct taxes are just and equitable. The burden of direct taxes is equitably
distributed among different classes in the society on the basis of the principle of ‘Ability to Pay’.
For instance, a progressive tax system is known to be just and equitable because the amount of
tax liability is determined by the size of the income earned or received. Thus low-income
persons either pay the minimum amount of tax or are exempted from paying income taxes and
middle and high-income persons are required to pay high and higher levels of taxes. For
instance, in India, annual income up to Rs.2, 00,000 is exempt from income tax. For income
between Rs.2, 00,000 and 500, 000, the income tax rate is 10 percent, between Rs.5 and 10 lakh,
the income tax rate is 20 per cent and above Rs.10 lakh, the income tax rate is 30 per cent.
2. Elasticity and Productivity. Revenue earned through direct taxes is elastic in nature. It
changes directly with changes in the level of national income. Direct taxes have therefore built-
in flexibility.
52
3. Economy. The administrative cost of collecting direct taxes is low as compared to
indirect taxes. Direct taxes are collected at source and therefore the chances of tax evasion are
minimized. In contrast, indirect taxes need expansive tax collection machinery which raises the
cost of collection.
4. Certainty. Future tax receipts can be accurately estimated by the government because of
the certainty in direct tax receipts. Further, the tax payers can also estimate their tax liability.
5. Reduction in Income Inequalities. Progressive nature of direct taxes reduces income
inequalities in a society because the tax imposed is based on the principle of ‘Ability to Pay’.
6. Creates Civic Consciousness. The persons who pay direct taxes to the government
develop civic consciousness. He feels involved in the governance of the country and hence
would want to know as to how the tax collected by the government is spent. Tax payers may
therefore act as conscience keepers of the government.
7. Anti-cyclical. Taxes are an instrument of fiscal policy and are used as instruments of
anti-cyclical fiscal policy. Thus during an inflationary period, the rates of direct taxes may be
raised so as to reduce aggregate demand and control the price rise. Similarly, during a period of
recession, tax rates may be reduced to raise the level of aggregate demand and promote
investment, employment, output, income, demand and prices in the economy. Direct taxes can
therefore be used to achieve the macroeconomic goal of stable prices.
Demerits of Direct Taxes.
The demerits of direct taxes are as follows:
1. Tax Evasion. In developing countries, the unorganized sector of the economy is the
predominant sector. Financial and other records are not honestly maintained by the business
units in the unorganized sector. For instance, tiny and small enterprises, unregistered
manufacturing units, private hospitals, nursing homes, dispensaries, hotels, restaurants and
various types of shops selling both goods and services do not maintain proper record of their
income and expenditure. Under-reporting of incomes and exaggeration of expenses is done to
either evade paying any income tax or to reduce tax liability. However, salaried personnel have
to pay their income taxes because salaries are properly documented, and business units have no
incentive to hide salary expenses.
2. Arbitrary in Nature. The direct tax structure is arbitrary in nature. There is no
scientific basis to the direct tax structure. The rates of direct taxes for various income slabs are
arbitrarily fixed. For instance, in India the marginal rate of personal income tax is 30 per cent
and is applicable to income over Rs.10 lakhs per annum. Further, income tax slabs are not
indexed to the changing price level and revisions made in the tax slabs are not according to rising
price level. Thus, more and more tax payers are added from the bottom of the income pyramid. 1According to a study conducted by the Federation of Indian Chamber of Commerce and
Industry (FICCI) in 2005-06, in China, such a rate is applicable to income over Rs.40 lakhs.
Similarly, corporation tax rate is 30 per cent in India and if we add other direct tax
53
liabilities such as dividend distribution tax, fringe benefit tax and surcharge, the
corporation tax liability goes up to 40 per cent. However, in Honkong, the corporation tax
rate is only 17.5 per cent, Singapore and Canada has 22 per cent, Germany, Mauritius,
Nepal, Romania and Taiwan has 25 per cent1.
3. Complexity and Corruption. If the direct taxes have a very complex structure
containing numerous exemptions on various accounts, it creates corrupt tax administration
machinery. If the exemptions are numerous, it creates a breeding ground for corrupt tax
administrators. As a result, the tax potential of the country is never realized, and vested interests
develop to keep the tax system complicated and archaic. 2According to the India Corruption
Study 2005 conducted by Transparency International India, about 24 lakh income tax
paying households in India paid petty bribes amounting to Rs.496 crore to the income tax
personnel. This amount excludes bribes paid by companies and business units2.
4. Unpopular and Inconvenient. Direct taxes become unpopular particularly when the
rates of taxation are perceived by the tax payers to be high and therefore unjust. They become
inconvenient when detailed and copious accounts are required to be maintained and filing of
income tax returns is tedious. For instance, 55% of the respondents in a study conducted by
Transparency International, India reported that they had to make four visits in a year to the
income tax department in connection with filing of returns whereas only 15 per cent of the
respondents could finish their work in their first visit to the income tax department. Further, 60
per cent of the respondents perceived the income tax department to be corrupt.
5. Narrow Based in Poor Countries. The direct tax-GDP ratio and the ratio of direct to
indirect taxes are very high developed countries. However, in developing countries, these ratios
are very low. For instance, in India, the number of income tax payers are only about three crore
which is less than three per cent of the population. This is because of the predominance of the
unorganized sector and rampant tax evasion in developing economies.
Merits of Indirect Taxes.
The merits of indirect taxes are as follows:
1. Convenience. Indirect taxes are collected in a lump sum by the government from
importers, producers and sellers who in turn collect it from the buyers in small amounts. Since
the indirect taxes are included in the price, the impact is not felt by the consumers. Sellers find it
convenient because the burden is entirely shifted on to the consumers in most of the cases.
2. Wider Tax Base. Theoretically, indirect taxes are paid by all those who buy and
therefore the entire society constitutes the tax base as far as indirect taxes are concerned.
However, in developing countries, the unorganized sector of the economy is predominant and
hence the output produced may not be entirely accounted for indirect taxes.
3. Absence of Tax Evasion. It is argued that since the incidence of indirect taxes is
on the consumers, producers and sellers would have no incentive in evading payment of indirect
taxes. They would therefore diligently collect indirect taxes from the consumers and pay it to the
54
government. However, if substantial economic activity is unreported or under-reported, tax
evasion becomes a reality even in the case of indirect taxes. Further, it is possible that producers
may collect indirect taxes and end up not paying to the government.
4. Social Welfare. Alcoholic and narcotic products reduce both individual and
social welfare because they not only have negative externalities but are also harmful to the
individual who consumes these products. Heavy indirect taxes on such products would
definitely reduce both the demand for such products and their output, thereby improving social
welfare. Further, heavy taxation on such products would not be unpopular and the government
would be able to collect substantial revenue.
5. Elasticity. When the national income increases, the revenue collected through
indirect taxes also increases because consumption demand increases. Increasing incomes and
rise in population imparts elasticity to indirect taxes.
Demerits of Indirect Taxes.
The demerits of indirect taxes are as follows:
1. Unjust and Inequitable. All economic classes are included in the indirect tax net.
There is no discrimination between economic classes and principle of ‘Ability to Pay’ is given a
silent burial. The rich and the poor have to proportionately bear the burden of indirect taxes.
Indirect taxes are therefore unjust and inequitable.
2. Uncertainty. Demand for various goods and services depend upon the tastes and
preferences of the people. The tastes and preferences of people keep changing and hence the
elasticity of demand for various goods and services also change. Changing elasticity of demand
and supply will influence indirect tax revenue. Consumer behavior cannot be accurately
predicted and therefore it imparts uncertainty to revenue generated through indirect taxes.
3. Uneconomic. The administrative cost of indirect taxes is higher in comparison to direct
taxes. Indirect taxes therefore do not satisfy the canon of economy.
4. Does not create Civic Consciousness. Since the incidence of indirect taxes is not felt
by the tax payers, they do not create any sense of civic consciousness. The desire to hold the
government accountable for the revenue receipts and expenditures is therefore absent amongst
the indirect tax payers.
5. Inflationary. Indirect taxes have inflationary potential, particularly when they are
imposed and increased on basic goods such as fuel and transportation. The government in an
effort to increase tax revenues may increase the rate of indirect taxes on goods and services
having relatively inelastic demand. But such increases may translate into a higher general price
level in the economy.
55
Conclusion.
From the study of merits and demerits of direct and indirect taxes, it can be concluded that direct
taxes can be made progressive whereas indirect taxes cannot be made progressive. Indirect taxes
are in fact regressive when they are imposed on all goods and services consumed by one and all
in the society. However, both the types of taxes have their own utility and they are found to be
complementary to each other. A taxation system, purely dependent upon direct taxes would be
inefficient and irrational and hence a judicious and thoughtful mix of direct and indirect taxes is
essential to ensure revenue and welfare maximization.
IMPACT, SHIFTING AND INCIDENCE OF TAXATION.
When a tax is imposed by the government on a person and he pays the tax to the government, the
impact and incidence of the tax is on the same person. Here impact refers to the person who
appears to be paying and incidence refers to the person who is actually paying. For instance, the
impact and incidence of direct taxes like income and corporation tax is on the same person (the
corporation is a person or entity). However, when a tax is imposed by the government on one
person and the tax is actually paid by other persons, then the impact is on the person who appears
to be paying the tax and the incidence is on the persons who actually pay tax. For instance, the
impact of indirect taxes like import duty, excise duty, sales tax and service tax is on the seller
whereas the incidence is on the consumer. However, the extent of incidence will be determined
by the elasticity of demand and supply for goods and services.
Between the impact and the incidence of taxation, shifting of taxation takes place. Shifting of
tax is a process in which the money burden of a tax is transferred from one person to another.
For example, when excise duty is imposed on a producer, he shifts it to the wholesaler who in
turn shifts to the retailer and the retailer shifts it to the consumer. Here, the tax is shifted
forward, and each person passes the burden to the next in the chain. In this example, the
incidence of taxation is ultimately on the consumer. The producer, the wholesaler and the
retailer are in a position to shift the tax whereas the ultimate consumer cannot. He or she bears
the burden and the incidence of taxation. A tax may be shifted backwards on the suppliers of
intermediate goods by forcing the suppliers to reduce the prices of their goods by the extent of a
tax. Thus the impact of taxation is in the initial stages of the imposition of the tax, shifting takes
place in the intermediate stage and the incidence is at the final stage.
Elasticity of Demand and the Incidence of Taxation.
The burden of taxation will be more on the seller and less on the buyer if the demand for the
commodity is relatively elastic. The opposite will be the case if the demand for the commodity
is relatively inelastic. If the demand for the product is perfectly elastic, the entire burden or the
incidence of taxation will be on the seller and the buyers will have zero burden. However, if the
56
demand for the product is perfectly inelastic the entire burden of taxation will be on the buyers.
The elasticity of demand and burden of taxation is shown in Table 3.1.
Table 3.1 – Elasticity of Demand and Incidence of Taxation.
SNO Elasticity of Demand Incidence of Taxation
Seller Buyer
1. Perfectly Elastic. Bears full burden. Bears no burden.
2. Perfectly Inelastic. Bears no burden. Bears full burden.
3. Relatively Elastic. Bears the major burden. Bears the minor burden.
4. Relatively Inelastic. Bears the minor burden. Bears the major burden.
5. Unitary Elastic. Bears half the burden. Bears half the burden.
Elasticity of Supply and the Incidence of Taxation.
If the supply of a product is relatively elastic, a greater burden of taxation will be on the buyer
and vice versa. When the supply is relatively elastic, the supplier will be able to change the
quantity supplied in accordance to the changes in price resulting from an imposition of tax. For
instance, when a tax is imposed on the product, the supplier can reduce the supply and shift the
burden of taxation on the buyer. Thus when the supply is perfectly elastic, the entire burden of
taxation can be shifted to the buyer and vice versa. In case of unitary elastic supply, the burden
of taxation will be shared equally by the supplier and the buyer. The elasticity of supply and
burden of taxation is shown in Table 3.2.
Table 3.2 – Elasticity of Supply and Incidence of Taxation.
SNO Elasticity of Supply Incidence of Taxation
Seller Buyer
1. Perfectly Elastic. Bears no burden. Bears full burden.
2. Perfectly Inelastic. Bears full burden. Bears no burden.
3. Relatively Elastic. Bears the minor burden. Bears the major burden.
4. Relatively Inelastic. Bears the major burden. Bears the minor burden.
5. Unitary Elastic. Bears half the burden. Bears half the burden.
Elasticity of Demand and Supply and the Incidence of Taxation.
In reality, the elasticity of demand and supply determines the incidence of taxation. According
to Hugh Dalton, the direct money burden of a tax on any commodity is divided between the
buyers and sellers according to the ratio of elasticity of supply to the elasticity of demand of the
taxed commodity. According to Dalton, the incidence or the direct money burden of tax can be
measured with the following equation:
57
𝐼𝑛𝑐𝑖𝑑𝑒𝑛𝑐𝑒 𝑜𝑓 𝑇𝑎𝑥𝑎𝑡𝑖𝑜𝑛 = 𝑒𝑠
𝑒𝑑
Where, es and ed are elasticity of supply and demand respectively.
The incidence of taxation on the basis of elasticity of supply and demand is shown in Table 3.3.
Table 3.3 – Elasticity of Demand and Supply and Incidence of Taxation.
SNO Elasticity of Demand
and Supply
Incidence of Taxation on Seller
and Buyer
Impact on Price
1. Es = Ed Incidence will be equal. Price will go up by 50%
of the tax.
2. Es > Ed Incidence on the buyer will be
greater than the seller.
Price will go up by >
50% of the tax.
3. Es < Ed Incidence on the seller will be
greater than the buyer.
Price will go up by <
50% of the tax.
4. Ed = α and Es < 1 Full incidence on the seller. No change in price.
5. Ed = 0 and Es = α Full incidence on the buyer. Price will go up by
100% of the tax.
6. Es = α and Ed < 1 Full incidence on the buyer. Price will go up by
100% of the tax.
7. Es = 0 and Ed > 1 Full incidence on the seller. No change in price.
SOURCES OF NON-TAX REVENUE.
The sources of non-tax revenue are profits from public enterprises, administrative revenue and
gifts and grants.
1. Profits from Public Enterprises. Public goods like public transport consisting of
railways, roadways and airways, water supply, electricity generation and distribution
etc are supplied by the Government. Prices paid by the consumers for these goods
become the non-tax revenue of the Government. Further, a Government may also
invest and compete with the private sector in certain areas of production goods and
services. For instance, India being a mixed economy, the Government has made huge
investments in the basic and heavy industries, oil and gas exploration and distribution,
banking and insurance services etc. The Government of India earns a dividend on the
profits made by the public enterprises. These dividends become a source of non-tax
revenue to the Government. In free market economies like the United States of
America, profits from public enterprises may be insignificant but in mixed economies
like India, profits from government enterprises may constitute a significant source of
public revenue.
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2. Administrative Revenue. The Government performs a number of administrative
functions. While performing these functions, the beneficiaries may be charged a fee.
Governments may also impose fines, forfeitures and penalties on the offenders.
Governments may also acquire wealth and property through escheats. Escheat refers
to reversion of property to the State on account of absence of legal heirs to the wealth
and property left behind by a dead person.
3. Fee. Fees are levied by the Government for giving services to the people.
According to Seligman, “a fee is a payment made by a person to the government
to provide for the cost of each recurring service provided by the Government,
primarily in the public interest but conferring a measurable advantage to the
payer.” For example, Court fee, fee for issuing passport etc.
4. License Fee. License fee is charged by the Government to give permission to the
license fee payer to obtain the use of certain articles or to begin certain productive
activity. For example, license fee charged for the registration of firms, cars, liquor
license, driving license, gun license etc. License fee is therefore charged to regulate
the conduct of persons obtaining licenses.
5. Special Assessment. According to Seligman, “a special assessment is a
compulsory contribution levied in proportion to the special benefits derived to
provide for the cost of a specific improvement to property under taken in public
interest”. For example, the Government may impose an additional charge on the
users of public goods like flyovers, rail transport, road transport etc in order to
recover the cost of providing these goods to the people.
6. Fines and Penalties. A fine is a deterrent to crime and therefore not designed to
earn revenue. A fine is arbitrarily determined and therefore may not be in proportion
to the cost of maintaining law and order. Fines and penalties do not become a
significant source of revenue. A fine is a penalty imposed on the offender for the
infringement of a law.
7. Forfeiture. Forfeitures are penalties imposed by courts for the failure of individuals
to appear before the courts, failure to abide by the terms of the contract or failure to
protect valuable assets. Forfeitures therefore do not become a significant source of
revenue to the Government.
8. Escheat. Escheat refers to reversion of property to the State on account of absence of
legal heirs or due to the absence of a Will in respect of the wealth and property left
behind by a dead person. Escheats do not constitute an important source of revenue
to the Government.
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9. Gifts and Grants. Gifts are voluntary contributions by individuals, private bodies
such as institutions and organizations and other governments to the Government.
Grants refer to the funds provided by a Government at a higher level to a government
at a lower level in a federal set up. For instance, in India the State Governments
receive grants for performing various functions from the Central Government. The
State Governments may also give grants to local bodies such as municipal
corporations and village panchayats. These are unilateral payments and hence there
is no obligation to repay the sums received on account of gifts and grants.
In a broader sense, public revenue also consists of public receipts. Public receipts consist of
public borrowings, deficit financing and income from public assets and the sale of public assets.
1. Public Borrowing. Modern governments generally follow a deficit budget.
Governments therefore borrow from individuals and financial institutions within the
country to finance the deficit. Loans obtained by the Government from internal sources
constitute public borrowing. Public borrowing is a significant source of public receipts.
2. Deficit Financing. When public borrowing fails to bridge the deficit in government
budgets, they may resort to deficit financing by printing of currency notes. However,
deficit financing is inflationary in nature and therefore not a desirable method of
financing government expenditure. Deficit financing is also a significant source of public
receipts.
3. Income from Public Assets and Sale of Public Assets. Governments obtain income in
the form of rent on assets leased to individuals and private bodies, income from the sale
of government buildings, government land etc. Such income does not become a
significant source of public receipts.
PUBLIC EXPENDITURE (REVENUE AND CAPITAL EXPENDITURE).
Public expenditure is the expenditure incurred by the government at various levels. These levels
may be the Federal or the Central level, the State level and the Local level. The government
receives income from tax and non-tax sources of revenue and spends the revenue received on
various heads of expenditure. Today, the main function of the State is to provide public and
merit goods. Most of the economic and social infrastructure consisting of roads, bridges, dams,
canals, transport and communication, public lighting, public parks, public hospitals, government
funded education at all levels are provided by the Government in modern economies. The free
market economy fails to produce public goods. Similarly, the free market economy would not
produce merit goods in sufficient quantity. Thus there is a problem of under-production of merit
goods and over-production of demerit goods. The governments therefore need to either
subsidize the production of merit goods or supply them in their entirety. In modern economies,
public expenditure is directed to achieve the macro-economic, macro-political and macro-social
objectives of the State.
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Capital expenditure is the money spent by the government to create fixed assets. The
government has to incur capital expenditure because the mixed nature of modern economies and
development of social and economic infrastructure has become the responsibility of the State.
Creation of economic and social infrastructure which includes construction of dams, canals,
roads and highways, flyovers and bridges, public transport, water supply, schools, colleges and
universities, hospitals etc needs heavy investment of capital. The rate of return on such
investment is either low or external to the investor. Thus private capital shies away from such
investment. The government therefore takes the greater part of the responsibility in creating
economic and social infrastructure, particularly in the developing countries. Capital expenditure
is productive in nature and the social benefits of public capital expenditure far outweigh its costs
and hence it makes eminent sense to incur capital expenditure by the government.
Capital expenditure can also be non-developmental in character. For instance, enormous
amount of money spent on defense is clear example of non-developmental capital expenditure.
Defense expenditure is non-developmental because in no way it is productive and leads to the
economic development of the country. Governments should therefore spend more time and
efforts in establishing international peace and friendship to bring about more economic
development. War mongering and grandstanding by nation States is clearly an indication of
political immaturity and lack of statesmanship. Defense expenditure is an avoidable burden on
the State. Keeping defense expenditure to the bare minimum would reduce debt and interest
burden on the society and also free scarce resources for productive purposes. Since capital
expenditure is largely financed through public borrowings, care should be taken that it is used for
productive purposes and helps in generating sufficient revenue receipts to retire public debt.
Revenue Expenditure.
Modern governments incur large revenue expenditure. Huge amount of money is spent by the
government on maintaining and running the public administrative apparatus. The government
also spends large amounts of money on social, economic and community services. Revenue
expenditure is classified into developmental and non-developmental expenditures.
Revenue expenditure that contributes to the development of the country is called developmental
revenue expenditure. Expenditure on social and community services which includes health,
education and welfare contributes to the development of the society. Revenue expenditure made
by the government on economic services such as agriculture, industries and minerals, foreign
trade and export promotion, energy, transport and communications and science, technology and
environment directly contribute to national income and hence it is categorized as developmental
revenue expenditure.
Governments also incur non-developmental revenue expenditure. Revenue expenditure on
defense, administrative services and interest payments is non-developmental in nature.
61
TYPES OF DEFICIT.
The basic fiscal concepts such as the budget deficit, revenue deficit, fiscal deficit, primary deficit
and monetized deficit are explained based on the budget data of the Central Government of India
for various years in Table 3.4.
Budget Deficit. Budget deficit is the differences between total expenditure and total receipts of
the central government. Both receipts and expenditures are divided into categories i.e., revenue
receipts and capital receipts and correspondingly we have revenue expenditure and capital
expenditure. The budget deficit in the year 1990-91 was Rs.11,347 crore. From 1997-98
onwards, the government began to show nil budget deficit. This was done by cleaning up the
revenue deficit entirely with a matching surplus on the capital account. The difference between
capital receipts and capital expenditure (4-5) has been equal to the revenue deficit from 1997-98
onwards. The government has discontinued showing budgetary deficit in their income and
expenditure accounts and hence budgetary deficit does not appear in the aforesaid table.
Revenue Deficit. Revenue deficit is the difference between revenue receipts and revenue
expenditure of the government. It indicates the excess of revenue expenditure over revenue
receipts or dis-savings by the government. It shows an increase in the liabilities of the Central
Government without corresponding increase in its assets. In 1990-91, the revenue deficit was
Rs.18, 562 crore. In 2001-02, the revenue deficit rose to Rs.100, 162 crore. According to budget
estimates for the year 2009-10, the revenue deficit is estimated to be Rs.2,82,735 crore. The
government has been using capital account receipts to clean up the revenue deficit i.e. capital
receipts are being used by the government to finance revenue expenditure. The revenue deficit
as a percentage of GDP had declined from 3.3 per cent in 1990-91 to 1.0 per cent in 2008-09.
However, 2009-10, the revenue deficit went up to 4.6 per cent of the GDP. This was on account
of the fiscal stimulus package that was announced in the wake of the Global Financial Crisis of
2008-09. The revenue expenditure as a percentage of GDP also had increased from 12.7 per cent
in 1990-91 to 14.6 per cent in 2009-10. However, capital expenditure as a percentage of GDP
had declined from 4.4 percent to 2.0 per cent during the same period against receipts of 5.6 per
cent and 4.6 per cent. According to the golden rule of public finance, all borrowings by the
government must be used for public investment. Unfortunately, in India’s case, a great part of
the capital receipts have been used to finance revenue or current expenditure. The burden of
fiscal correction has fallen on capital account whereas it should have fallen on the revenue
account.
Fiscal Deficit. The fiscal deficit is obtained by subtracting total receipts (excluding government
borrowings) from the total expenditure. The fiscal deficit was Rs.37, 606 crore in 1990-91. In
the year 2001-02, the fiscal deficit rose to Rs.140, 955 crore and since then there has not been
much of an absolute growth in the fiscal deficit. The fiscal deficit as a percentage of GDP had
declined from 6.6 per cent in 1990-91 to 2.6 % in 2007-08 and it increased to 7.8 per cent
(revised estimates) in 2008-09. However, the decline in fiscal deficit has been achieved by
increasingly drawing upon the capital account which is an indicator of poor fiscal management.
In 2009-10, the fiscal deficit came down to 6.9% of GDP (revised estimates). The budget
estimates of fiscal deficit for the year 2010-11 is 5.5% of GDP.
62
Primary Deficit. The primary deficit is obtained by deducting interest payments from the fiscal
deficit. It is therefore also known as non-interest deficit. Primary deficit is also calculated by
deducting net interest payments (interest payments – interest receipts) from the fiscal deficit.
The net primary deficit is considered as a relevant measure to determine the stability of debt to
GDP ratio. The net fiscal deficit is obtained by excluding governments net lending (loans and
advances of government less recoveries of loans) from the fiscal deficit. The primary deficit in
the year 1990-91 was Rs.16, 108 crore and for 2009-10 it is estimated to be Rs.1,75,485 crore. It
only indicates that interest payments have increased over the years. As a percentage of GDP,
primary deficit declined from 2.8% in 1990-91 to -1.1 % in 2008-09. However, in 2009-10, it
went up once again to 2.8%.
Table 3.4
Receipts and Expenditures of the Central Government of India.
(in Rs. Crore)
1990-
91
2006-07 2007-08
2008-09
(B.E)
2009-10
(B.E.)
1. Revenue Receipts of which:
a) Tax revenue
(Net of States share)
b) Non-tax revenue
54,954
42,978
11,976
4,34,387
3,51,182
83,205
5,41,864
4,39,547
1,02,317
6,02,935
5,07,150
95,785
6,14,497
4,74,218
1,40,279
2. Revenue expenditure
Of which:
a) Interest Payments.
b) Major subsidies.
c) Defense Expenditure.
73,516
21,498
9,581
10,874
5,14,609
1,50,272
53,495
51,682
5,94,433
1,71,030
67,498
54,219
6,58,118
1,90,807
67,037
57,593
8,97,232
2,25,511
1,06,004
86,879
3. Revenue Deficit (2 – 1) 18,562 80,222 52,569 55,183 2,282,735
4. Capital Receipts (a + b + c)
a) Recovery of loans.
b) Other receipts (mainly
from PSU disinvestments)
c) Borrowings and other
liabilities.
31,971
5,712
0
26,259
1,49,000
5,893
534
1,42,573
1,70,807
5,100
38,795
1,26,912
1,47,949
4,497
10,165
1,33,287
4,06,341
4,225
1,120
4,00996
5. Capital expenditure 24,756 68,778 1,18,238 92,766 1,23,606
6. Total expenditure
[ 2 + 5 = 6(a) + 6 (b)]
a) Plan expenditure.
b) Non-plan Expendt.
98,272
28,365
69,907
5,83,387
1,69,860
4,13,527
7,12,671
2,05,082
5,07,589
7,50,884
2,43,386
5,07,498
10,20,838
3,25,149
6,95,689
7. Fiscal Deficit [6 – 1 – 4(a) – 4(b)] 37,606 1,42,573 1,26,912 1,33,287 4,00,996
8 Primary deficit
[7 – 2(a)
16,108
-7,699
-44,118 -57,520 175485
63
Table 3.4 (Continued)
Receipts and Expenditures of the Central Government of India.
(As per cent of GDP)
1990-
91
2006-07 2007-08
2008-09
(B.E.)
2009-10
(B.E.)
1. Revenue Receipts of which:
b) Tax revenue
(Net of States share)
b) Non-tax revenue
9.7
7.6
2.1
10.1
8.2
1.9
11.0
8.9
2.1
11.4
9.6
1.8
10.0
7.7
2.3
2. Revenue expenditure
Of which:
d) Interest Payments.
e) Major subsidies.
f) Defense Expendt.
12.9
3.8
1.7
1.9
12.0
3.5
1.2
1.7
12.0
3.5
1.4
1.4
12.4
3.6
1.3
1.4
14.3
3.7
1.7
1.3
3. Revenue Deficit (2 – 1) 3.3 1.9 1.1 1.0 4.6
4. Capital Receipts (a + b + c)
d) Recovery of loans.
e) Other receipts (mainly
from PSU disinvestments)
f) Borrowings and other
liabilities.
5.6
1.0
0.0
4.6
3.5
0.1
0.0
3.3
3.5
0.1
0.8
2.6
2.8
0.1
0.2
2.5
6.6
0.1
0.0
6.5
5. Capital expenditure 4.4 1.6 2.4 1.7 2.0
6. Total expenditure
[ 2 + 5 = 6(a) + 6 (b)]
c) Plan expenditure.
d) Non-plan Expendt.
17.3
5.0
12.3
13.6
4.0
9.7
14.4
4.1
10.3
14.2
4.6
9.6
16.6
5.3
11.3
7. Fiscal Deficit [6 – 1 – 4(a) – 4(b)] 6.6 3.3 2.6 2.5 6.5
8. Primary deficit (7 – 2a) 2.8 -0.2 -0.9 -1.1 2.8
Memorandum Items
a) Interest receipts.
b) Dividend and profits.
c) Non-plan revenue
expenditure
8, 730
564
60,896
22,524
18,969
3,72,191
21,060
21,531
4,20,861
19,135
24,758
4,48,351
19,174
19,340
6,18,834
Source: Compiled and computed from Indian Economic Survey 2009-10.
64
CONCEPT OF GST – RECENT TRENDS.
In 1954, France was first country who adopted GST. Today, more than 160 countries in the
world accepted GST system. Goods and Service Tax (GST) means tax on goods and or Services.
It is Indirect Tax. GST is levy on consumption of goods or services. It is destination base tax
system.
India has adopted GST w.e.f. 1 July 2017 implementing Five Acts. GST Act is application to
whole of India including Jammu and Kashmir. India has been accepted dual GST system. Many
illiterate people are loudly showing wrong picture i.e. one nation one tax. But in our country
adopted dual system of tax system because of mixed economy. Government has imposed Five
Acts:
1. Central Goods and Service Tax Act (CGST).
2. State Goods and Service Tax Act (SGST).
3. Union Territory Good and Service Tax Act (UTGST).
4. Integrated Goods and Service Tax Act (IGST).
5. Goods and Service compensation Act
Some of the major Amendments since the launch of GST are as under:
1. Introduction of GSTR 3B.
GSTR-3B is a simple return form introduced by the CBEC initially for July 2017 to
September 2017 but slowly it has been made compulsory upto March 2018. GSTR-3B
has to be filed by 20th of next month. GSTR-3B contains details of outward and inward
supplies. We do not have to provide invoice level information in this form. Only total
values for each field have to be provided.
2. Changes in Composition Scheme.
It started with a threshold limit of 75 lakh, afterwards in the 22nd meeting of the GST
Council it was decided to increase the threshold for composition scheme to Rs.1crore
from the original Rs.75 lakh. The GST Council in its 23rd meeting in Guwahati has
decided to increase the threshold for once again to Rs 1.5crores and also decided to
amend the law to increase the statutory threshold to Rs.2crores. Now there is a uniform
rate of 1% (0.5% Central tax plus 0.5% State tax) on composition scheme for dealers and
manufacturers. Manufacturers under this scheme earlier paid 2% (1% Central tax plus 1%
State tax) of the turnover.
65
3. Changes in Return Filing.
As per the model GST law the GSTR-1, GSTR-2, and GSTR-3 forms had to be filed by
the 10th, 15th, and 20th of the subsequent month, respectively. The GST Council decided
to relax these deadlines for both small businesses as well as large enterprises, although in
different ways for each. Assessee with a turnover of up to Rs 1.5 crore a year will now be
able to file their GSTR-1 forms for each month in a quarterly manner. That is, the GSTR-
1 forms for July to September are to now be filed by January 10, the October to
December forms by February 15, 2018 and the January to March forms by April 30,
2018. Assessees with a turnover of Rs 1.5 crore or more a year can file their July to
November forms by January 10. Thereafter, they will have to file monthly returns.
4. Changes in Rate Structure.
The GST council in its 23rd meeting held in Guwahati slashed down the rate on over 200
items, The Council pruned the list of items in the top 28 per cent Goods and Services Tax
(GST) slab to just 50 from initial 228. GST on 13 items has been reduced to 12 % from
18 %. GST on 2 items has been brought into 12 % GST slab from 28 % bracket. 6 items
have been brought into 5 % from 18 % slab. GST on 8 items has been cut to 5% from 18
%.Tax rate on six items has been lowered to zero from 5%.
5. Eating out in Restaurants got Cheaper.
The GST Council in its 23rd meeting slashed down GST rates on restaurant bills from 18
per cent to 5 per cent and restaurants will not be eligible for any ITC. Only restaurants in
starred hotels, that is who charge a tariff of Rs.7,500 or above for their rooms, will attract
GST at 18 per cent. Outdoor catering will continue to be charged at 18 per cent GST and
will be eligible for input tax credit.
6. Anti-Profiteering Committee.
The Government has approved the constitution of a National Anti-Profiteering Authority
(NAA) the institutional mechanism under the GST law to check the unfair profit-making
activities by the trading community. The Authority core function is to ensure that the
benefits of reduction in Tax rates under GST made by the GST Council is passed on to
the ultimate consumers by way of a reduction in prices by traders.
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7. E-Way Bill gets a nod.
E-Way bill rules will be rolled out on a trial basis from 16th January 2018 and will be
implemented from 1st February 2018. E-Way bill will improve the turnaround time of
vehicles and help the logistics industry.
Questions.
1. Explain the concept of Public Goods and their Features.
2. Explain the concept of Merit Goods.
3. Explain the sources of Revenue.
4. Explain the concepts of Impact, Shifting and Incidence of Tax.
5. Explain the sources of Non- Tax Revenue.
6. What is Public Expenditure? Explain the difference between Revenue and Capital
Expenditure.
7. Explain the concept of Subsidies.
8. Explain the types of Deficit: Revenue, Budgetary, Fiscal and Primary.
9. Explain the Concept of GST and the recent trends in GST in India.
67
MODULE IV
PREVIEW.
1. Structure of Balance of Payments.
2. Types of Disequilibrium in BOP.
3. Exchange Rate Determination.
4. Concept of FOREX and its components.
5. Sources of Data.
BALANCE OF PAYMENTS ACCOUNTS. The Balance of Payments accounts are divided
into two categories namely current and capital accounts. Payments made by residents of the
reporting country to foreigners are called debits and payments made by the residents of the rest
of the world to the reporting country are called credits.
Current Account. The current account contains entries related to export and import of
merchandise and service that change the current level of consumption or national income of the
country.
Capital Account. The capital account contains entries relating to movement of short term and
long-term capital both in and out of the country along with gold and foreign exchange reserves
leading to increase or decrease of a country’s total stock of capital.
Current Account. The current account of the Balance of payments of a country consists of real
economic transactions of actual transfer of goods and services from one country to other
countries. While imports reduce national income, exports lead to rise in national income.
➢ Entries at Serial Numbers 1 to 4 and 8 to 11 are real or income creating transactions.
➢ The current account has two types of income creating transactions i.e. trade or
merchandise account and the invisible account.
➢ The trade account consists of exports of goods. Thus the income earned from goods
exported (Rs.800 Crore) is shown as the credit entry and the import payment (Rs.1200
Crore) is shown as the debit entry.
➢ The invisible account consists of all other transfer payments in the form of incomes.
Income earned through the export of services is insurance, banking, interest on loans,
tourist expenditure, transport charges etc. The reporting country has earned Rs.400 Crore
EXTERNAL SECTOR
68
from the export of services and has spent Rs.800 Crore for receiving these services from
foreign countries.
➢ The second entry in the invisible account is income from investment in the foreign
countries through interest/dividend. This amounts to Rs.400 Crore on the credit side and
Rs.800 Crore on the debit side.
➢ The third entry in the invisible account shows unilateral receipts on the credit side and
unilateral payments on the debit side. These payments and receipts consist of gifts and
charities which are given and received freely without the obligation to repay. Thus
receipts or payments on account of goods exported or imported constitute the visible
account or the trade account. All other income earning transactions constitute invisible
accounts.
According to the International Monetary Fund, the following transactions have been accepted as
invisible transaction:
1. Travel on account of business, education and health.
2. Insurance premium and payment of claims.
3. Investment income including interest, rents, dividends and profits.
4. Transnational transportation of goods, warehousing during transit and other transit
expenses.
5. Income from services such as advertising, commissions, pensions, patent fees,
royalties, subscription to periodicals, membership fees etc.
6. Repayment of commercial credits.
7. Donations, migrant remittances, legacies.
8. Contractual amortization and depreciation of direct investment.
Capital Account.
The capital account of Balance of Payment consists of those items which affect the existing
capital stock of the country. The broad categories of capital account items are short term and
long-term capital movements both in and out of the country and changes in the gold and
exchange resources.
➢ Short term capital movements include purchase of short-term securities such as treasury
bills, commercial bills and acceptance bills, speculative purchase of foreign currency and
cash balances held by foreigners.
➢ Long term capital movements include direct investments in shares or bonds or real estate
or physical assets such as plant building, equipment etc, portfolio investment in
government securities, and securities of firms etc and amortization of capital.
➢ Export of capital is a debit item whereas export of merchandise is a credit item because of
export of merchandise leads to inflow of foreign exchange which adds to the national
income of the reporting country and export of capital leads to outflow of foreign
69
exchange which leads to withdraw from the foreign exchange resources of the reporting
country.
➢ Gold and foreign exchange reserves are maintained to impart stability to the exchange
rate of the home currency and to make payments to the creditors in case there are
payment deficits on all other accounts.
➢ Assistance provided by IMF, World Bank etc is shown in the capital account. Countries
like the US and the UK show a separate official settlement account in addition to current
and capital accounts. The official settlement account records the change in the foreign
exchange reserves and reserves of monetary gold held by the monetary authority.
➢ Increase in reserves is debit items and decrease is credit item.
Table 4.1
Balance of Payments Accounts (A hypothetical example)
Credit (Receipts)
(in Rs. Crore)
Debit (Payments)
(in Rs. Crore)
(A) Current Account
1. Goods Exported 800 8. Goods imported 1200
2. Services Exported 400 9. Services imported 800
3. Incomes from investment
in the foreign country.
400 10. Incomes to foreigners on
investment in the reporting
country.
800
4. Unilateral receipts. 800 11. Unilateral payments. 400
Total 2400 Total 3200
(B) Capital Account
5. Long term borrowing 800 12. Long term lending 320
6. Short term borrowing 400 13. Short term lending 240
7. Sale of gold/assets 400 14. Purchase of gold/assets 200
15. Errors and omissions 40
Total 4000 Total 4000
Balance of Payment and Balance of Trade.
Balance of Payment is a wide concept than Balance of Trade. Balance of payment includes all
the entries on account of trading in goods, services, capital flow etc. Balance of trade refers to
only the difference between the value of imports and exports of merchandise or visible items
whereas balance of payment covers total debits and credits of all items visible and invisible.
The net balance on the visible items i.e., merchandise exports and imports are called balance of
trade. If exports are greater than imports, the Balance of Trade is positive and vice versa. The
70
balance on current account is carried over to the capital account. A deficit in Balance of Trade is
made good by external borrowing or assistance which will have a matching surplus entry in the
capital account thus balancing the accounts.
Balance of Payments always Balance.
The Balance of Payment accounts is maintained on the basis of double entry book system where
total debits will always equal total credits. Hence in the accounting sense, the balance of
payment will always balance. However imbalances do exist in different account heads as shown
in the table. The balance of trade reflects a deficit of Rs.400 Crore (Rs.800 – 1200). Net
negative exports of goods indicate unfavorable balance of trade. On the invisible account, the
balance of services and the balance of investment income also show a deficit of Rs.400 Crore
each. However, there is a surplus of Rs.400 Crore on account of net unilateral receipts. Thus
there is a deficit of Rs.400 Crore each on the visible as well as the invisible account. The net
balance which is the sum of net visible exports and net invisible exports is the balance on current
account. In this case, there is a deficit on the current account amounting to Rs.500 Crore. You
will notice that the deficit on current account is made good on the capital account. The balance
of loan transactions and the balance of monetary gold flow i.e., net borrowing and net monetary
gold flow shows a positive balance of Rs.640 crore and Rs.200 crore. Errors and omissions of
Rs.40 crore is entered to make the deficit of Rs.800 crore on current account match with the
surplus of Rs.840 crore on the capital account. The items errors and omissions indicate the value
of certain discrepancies in estimation resulting in situation where debits are not exactly equal to
the credits. A negative value indicates that receipts are over-stated, or payments are understated
or both. Similarly, a positive value indicates that receipts are understated, or payments are
overstated or both. If such errors are large and persistent, they indicate serious weakness in
recording of transactions. Thus on account of double entry book keeping system, the balance of
payments will always balance. Any negative balance in the current account is made corrected by
a surplus balance on the capital account and vice versa. Therefore, balance of payment always
balances from the accounting point of view.
DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS.
Equilibrium or disequilibrium in the balance of payments refer to the balance on those heads of
the account which do not include the drawings from the IMF, use of special drawing rights,
drawings from the reserves of foreign currencies held by the Central government etc. Excluding
these items, if there is neither deficit nor surplus in the balance of payments, it is known to be in
equilibrium. Otherwise, it will be in disequilibrium. The deficit in the balance of payment can
be financed by drawings from the IMF, use of Special Drawing Rights and drawings from the
reserves of foreign currencies. In 1999-2000, the deficit on the current account was financed by
the surplus on the capital account of India’s balance of payment. Nonetheless, India’s balance of
payment remains unfavorable and in disequilibrium because of a deficit on the current account.
It thus means that when there is neither surplus nor deficit on the current account, the balance of
payment is said to be in equilibrium. A more important concept of balance of payment is the
concept of basic balance. It is based on autonomous items in the balance of payment.
Autonomous items are those items which cannot be easily changed or influenced by the
government because they are determined by long term factors. Autonomous transactions take
71
place on their own because of peoples’ desire to consume more or to make higher profits. For
instance, both export and import of goods and services which are items on the current account
are undertaken to make profit or consume more goods and services. Exports and imports take
place irrespective of other transactions included in the balance of payment accounts. It is for this
reason they are called autonomous transactions. Autonomous transaction also includes long term
capital movements both on private and government account contained in the capital account. If
exports are equal to imports, there will be no other transaction but if they are not equal, it will
lead to short term capital movements in the form of international borrowing and lending. These
capital movements are undertaken for bridging he deficit in the balance of trade. Since the short-
term capital flows are accommodating or compensatory in nature, they are called induced
transactions. Induced transactions include borrowing from the International Monetary Fund or
Central Banks of other countries, drawings from Special Drawing Rights account. Induced
transactions are excluded from the concept of basic balance. Thus when autonomous
transactions are equal and there is no need for induced transactions, the balance of payment is in
equilibrium. This equilibrium in the balance of payment is a state of balance which can be
sustained without government intervention. The concept of basic balance therefore can be stated
as:
(X – M) + LTC = 0
Where, X stands for exports.
M stands for imports, and
LTC stands for long term capital movements.
If exports are greater than imports (X > M), long term capital movement will be negative and
equal to net exports (Xn) which means there will be net capital outflow. Similarly, if exports are
less than imports (X < M), long term capital movement will be positive and equal to net imports
(Mn) which means there will be an inflow of capital to bridge the deficit in the current account.
TYPES OF DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS.
The balance of payment is unfavorable when a country’s autonomous payments are greater than
its autonomous receipts. Autonomous payments arise out of import of goods and services and
export of capital, whereas autonomous receipts result from the export of goods and services and
import of capital. Thus the balance of payment is unfavorable when total imports are greater
than total exports. However, imports and exports are determined by a number of factors.
Imports of a country depend upon domestic demand for foreign goods, the prices of imports and
the prices of their domestic substitutes and people’s preference for foreign goods. Exports of a
country depend upon foreign demand for its goods and services, price competitiveness and
quality and exportable surplus. As all economies operate under dynamic conditions, factors
which determine imports and exports keep changing and the changes differ in their duration and
intensity from time to time and form country to country. The changes which occur as a result of
disturbances in the domestic economy and other economies create conditions of disequilibrium
in the balance of payment. There are different reasons for different disequilibria, and these are
given below.
72
Cyclical Disequilibrium.
Business cycles or fluctuations in the economic activities of trading nations are the cause of
cyclical disequilibrium in the balance of payments. These fluctuations occur in prices,
production, employment and incomes which causes periodic fluctuations in international trade.
During the prosperity phase of the business cycle, prices of goods rise, and incomes fall which
affects international trade and balance of payments. A country with elastic demand during the
prosperity phase will experience fall in imports. Conversely, if the demand is inelastic, demand
for imports will rise during prosperity. Further, during depression, when prices decline and
incomes rise, countries with elastic demand for imports will experience rise in imports and those
with inelastic demand will experience a fall in imports. A country in the prosperity phase will
thus experience a surplus and that of a country in depression will experience deficit.
Structural Disequilibrium.
Structural disequilibrium occurs due to structural changes taking place in certain sectors of the
economies of the trading countries. Structural changes may change the demand and supply of
imports and exports. For example, on account of a fall in the foreign demand for Indian
garments, garment production will fall in India. If there is a freedom of exit, the resources
employed in garment industry can be redirected to other profitable avenues. In the absence of
freedom of exit, exports will fall and if there is no matching fall in the imports, there will be
disequilibrium in the balance of payments. Export demand remaining constant there may be fall
in the exportable surplus or supply of exports on account of industrial fictions or some other
extraneous factors resulting in structural disequilibrium in the balance of payments.
Increase in the marginal propensity to import on account of increasing domestic incomes will
have a two-fold adverse effect on the balance of payments. First the import demand will rise and
second the demand for domestic goods will also increase leading to a fall in the exportable
surplus. According to RagnerNurkse, international demonstration effect can lead to structural
disequilibrium in balance of payments. On account of growing contact of the developing
countries with the advanced countries, developing countries try to imitate the consumption
pattern of the advanced countries. As a result, the demand for imports rises without a matching
rise in exports. This also results in a change in the production pattern of poor countries resources
are diverted to manufacture import substitutes of consumer goods by adopting sophisticated
production methods and imported technology. Capital imports compounds the problem of
foreign exchange outflow creating structural disequilibrium.
Short Run Disequilibrium.
Short run disequilibrium in the balance of payments refers to temporary deficit or surplus lasting
for a short period. It is caused by unexpected contingencies such as favorable or unfavorable
monsoons, industrial peace or disharmony, short term borrowing and lending in the internal
market. For instance, failure of monsoons in a rain fed agricultural country like India would
necessitate large scale import of food grains leading to unfavorable balance of trade. However,
the situation may be corrected in the subsequent year if the monsoon is normal. Hence, the
disequilibrium is temporary for that period. A temporary disequilibrium may also be caused on
73
account of bumper agricultural crop leading to higher exports and a surplus on the merchandise
account. Similarly, wide-spread industrial disharmony in a country which is involved in the
exports of manufactured goods would experience a decline in the exportable surplus and thus
face a deficit in the balance of payments. In the same manner, short term borrowing or lending
in the international market may cause a short period disequilibrium in the capital account.
However, short period deficits and surpluses are subject to automatic correction because of the
operation of market forces and the international payment mechanism.
Long Run Disequilibrium.
Long run disequilibrium in the balance of payments is also known as secular or fundamental
disequilibrium. It refers to persistent deficit or surplus in the balance of payment of a country. If
there is a persistent deficit, it would lead to progressive depletion of the stock of gold land
foreign exchange reserves o the country leading to exchange instability and foreign exchange
crisis. For example, the foreign exchange crisis of 1991 in India was a case of long run or
fundamental disequilibrium in the balance of payments. The International Monetary Fund has
used the term ‘fundamental disequilibrium’ to describe a long run disequilibrium caused by
persistent deficit in the balance of payment of a country. Fundamental or secular disequilibrium
is caused by unchecked persistent short run disequilibrium in the balance of payments. The
causes of fundamental disequilibrium are deep seated in the economy. Some of the causes are
persistent rise in population, low rate of capital formation, technological changes, instability in
the export prices of primary goods and import restrictions by advanced countries. The IMF
expects a member country facing secular disequilibrium to consult the Fund so that it can advise
or assist in taking appropriate measures to correct the situation. It is important to correct
fundamental disequilibrium immediately in order to ensure one’s survival in the international
economy.
THE FOREIGN EXCHANGE MARKET.
The foreign exchange market is the international market in which foreign currencies are bought
and sold. It is an arrangement for buying and selling of foreign currencies in which exporters
sell the foreign currencies and importers buy them. The players in the foreign exchange market
are exports and importers, travelers land investors, traders, speculators and brokers and
commercial banks and central banks of different countries of the world. The US Dollar was
exchanged for 49.25 Indian rupees on 09th May 2009. The rupee – dollar exchange rate was
therefore Rs.49.25 for one US Dollar or One Indian rupee would fetch 0.02 US Dollars. The
Rupee – Pound Sterling exchange rate on 09th May 2009 was Rs.74.07 which means the Pound
Sterling – Rupee exchange rate would be UK Pound Sterling 0.013 for one Indian rupee. One
Euro was exchanged for Rs.66.08 on the same day. In the foreign exchange market, there are two
different rates for buying and selling of foreign currencies. This difference arises due to
transaction cost in dealing with foreign currencies.
Broadly there are two systems of exchange rate determination. They are known as fixed and
flexible or floating exchange rate systems. Under the fixed exchange rate system, the foreign
exchange rate is fixed by the government. The fixed exchange rate was established in the year
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1944 under an agreement reached at Bretton Woods in New Hampshire, USA. Under this
system, at the fixed exchange rate if there is disequilibrium in the balance of payments giving
rise to either excess demand or supply of foreign exchange, the Central Bank of the country has
to buy and sell the required quantities of foreign exchange to eliminate the excess demand or
supply. The system of exchange rate in which the exchange value of a currency is determined by
the market forces of demand and supply of foreign exchange is known as flexible or floating
exchange rate system. The flexible exchange rate system came into existence after the fall of the
fixed exchange rate system in 1977. The changes in the exchange value of a currency in the
foreign exchange market are known by the terms: appreciation and depreciation. For instance, if
the rupee – dollar exchange rate becomes Rs.50.00 in a few days hence, the rupee would be said
to have depreciated against the dollar. Conversely, if the rupee – dollar exchange rate becomes
Rs.46.05 then the rupee would be said to have appreciated against the dollar. The changes in the
exchange rate are determined by the market forces in a flexible exchange rate system. In the
case of fixed exchange rate system, the central bank has to buy or sell foreign exchange so that
the exchange rate is maintained at the pegged or fixed level. However, the fixed exchange rate
could be changed through devaluation or revaluation only with permission from the International
Monetary Fund (IMF) in case of fundamental disequilibrium in the balance of payments. Thus,
if a country was running large and persistent deficit in her balance of payments, it was allowed to
devalue its currency in order to improve the balance of payment position. Conversely, if a
country was running large and persistent surpluses in the balance of payments, it was allowed to
revalue its currency so that correction is made. The IMF maintains funds which are contributed
by member countries and gives loans to member countries from its reserves when they face
temporary deficit in the balance of payments. If a member country has a persistent deficit in the
balance of payment, the IMF would permit such a country to devalue its currency in order to
correct the deficit so that a relatively stable or fixed exchange rate system was maintained for the
promotion of world trade. In order to maintain the exchange rate at a given level, the central
banks of different countries were required to maintain reserves of foreign currencies. The
international reserve currencies are the US dollar, UK Pound Sterling, German Deutsche marks
and the Japanese Yen.
FREE MARKET EXCHANGE RATE DETERMINATION.
The free market exchange rate of a currency is determined by the market forces of demand for
and supply of foreign exchange. Assuming that there are two countries, India and the USA, the
exchange rate of their currencies (rupee and dollar) will be determined by American demand for
Indian exports and Indian demand for American exports. Indian demand for American exports
actually means Indian demand for US dollars. Similarly, American demand for Indian exports
means American demand for Indian rupees.
Demand for Foreign Exchange (US Dollars). The demand for US dollars in India is a
function of the demand for US goods and services by Indian firms and individuals. There is a
direct relationship between demand for US exports from India and the demand for US dollars.
The demand for dollars may also arise due to Indian citizens and firms wanting to purchase
assets in the United States give loans or send gifts to friends in the United States. The demand
for dollars can be realized by exchanging rupees for dollars with the central bank. The demand
curve for US dollars will be downward sloping as the demand for US dollars will be inversely
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proportionate to the rupee dollar exchange rate. Higher the exchange rate, lower will be demand
for US dollars and vice versa. The demand for US dollars is shown by the demand curve DD in
Fig.4.1 below.
Supply of Foreign Exchange (US Dollars). The supply of US dollars results from the demand
for Indian exports from USA. The supply of US dollars will be directly proportional to the
supply of exports from India to the United States. The supply of US dollars may also arise from
the demand for US citizens and firms to purchase assets in India or to give loans and gifts to
people in India. The supply of US dollar is derived from the demand for Indian rupees or the
demand for Indian exports. The supply curve of dollars in terms of rupees is positively sloping
as shown in Fig.17.1 below. Higher the rupee dollar exchange rate, higher will be the supply of
US dollars and vice versa.
The Equilibrium Exchange Rate (Re/$). The equilibrium exchange rate will be determined by
the intersection of demand for and supply curve of dollars. Such an equilibrium point in Fig.17.1
is point ‘E’ and the equilibrium exchange rate is OR with OQ quantity of demand and supply of
US dollars. At a higher price of dollars i.e. OR1 the quantity supplied of dollars is greater than
the quantity demanded by ‘ab’. Excess supply of dollars will push the prices down back to the
equilibrium level. Similarly, if the exchange rate is OR2, there will be excess demand for US
dollars and demand for dollars will exceed its supply by ‘cd’ causing the exchange rate to go up
and stabilize at the equilibrium exchange rate OR.
a b
E
c d
Fig.4.1: Equilibrium Exchange Rate
O Q
D
D
S
S
R
R2
R1
Y
X
Exch
ange
Rat
e o
f D
olla
rs (
Rs/
$)
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Appreciation and Depreciation in the Exchange Rate. The changes in the exchange rate are
caused by changes in the factors that determine the demand for and supply of foreign exchange.
For example, an increase in US national income will cause an increase in the demand for Indian
exports which will lead to an increase in the supply of dollars in the foreign exchange market.
The supply curve will shift as a result to the right as S1S1 as shown in Fig. 4.2 below. The
increase in the supply of dollars on account of an increase in the demand for Indian exports will
lower the exchange rate of dollars in terms of rupees from OR to OR1. Thus the dollar will
depreciate and to that extent the rupee will appreciate. The new equilibrium exchange rate will
be determined by point E1. The depreciation of dollar by RR1 is caused by the excess supply of
dollars equal to EF.
S
S1
E
E1
S1
Q1
Fig.4.2: Appreciation of Exchange Rate
Further, an increase in the national income of India may cause an increase in the demand for US
exports to India. Such an increase will lead to increase in demand for dollars. The increase in
demand for dollars is shown by a rightward shift of the demand curve in Fig.4.3. On account of
excess demand for dollars over supply at the equilibrium exchange rate OR, the dollar price rises
or appreciates and the new equilibrium exchange rate OR1 is determined.
O Q
D
D
S
R
R1
X
Exch
ange
Rat
e o
f D
olla
rs (
Rs/
$)
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D1
E1
E F
D1
D
Q Q1
Fig.4.3: Depreciation of Exchange Rate
CONCEPT OF FOREX AND ITS COMPONENTS.
The foreign exchange reserve of a country consists of foreign currency assets held by the Central
Bank, Gold holdings by the Central Bank and Special Drawing Rights (SDRs). For instance,
India’s foreign exchange reserve also consists of gold, SDRs and foreign currency assets. Gold
is not used for current transactions. It does not say anything about the balance of payment
situation of the country. The net result of the external transactions of a country is indicated by
changes in the foreign currency reserves and special drawing rights.
GOLD.
As on 30th October 2015, the value of gold was USD 18,152 million. On 28th October 2016, the
value of gold went up to USD 21,406 million. In percentage terms, gold reserves went up by
17.92% during the year.
O
D
S
S
R
R1
Y
X
Exch
ange
Rat
e o
f D
olla
rs (
Rs/
$)
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SPECIAL DRAWING RIGHTS.
In the 1960s, the need to increase international monetary reserves was felt by the advanced
capitalist countries. In 1968, the leading nations agreed to give the IMF the power to create
SDRs or new international reserves or paper gold. In 1969, the SDR was created by the IMF to
supplement the reserve assets of member nations. Between 1970 and March 2016, the IMF has
created 204.1 billion SDRs which are equal to USD 285 billion. These SDRs have been allocated
to member countries. SDRs can be exchanged for freely usable currencies. The value of the
SDR is based on a basket of five major currencies, namely; the US dollar, Euro, the Chinese
Renminbi RMB), the Japanese Yen and pound sterling as of October 1, 2016. Unlike regular
IMF loans, the SDRs drawn by member nations need not be paid back to the Fund. The basket
of currencies is reviewed every five years to ensure that the constituent currencies are
representative of those used in international transactions and that the weights given to the
currencies reflect their relative importance in the world’s trading and financial system. The
allocation of SDRs to member countries is done in proportion to their quotas in the IMF and the
quota of each member nation is determined by its share of national income in the world. Every
member of the IMF is required to subscribe to the fund an amount equivalent to its quota. Each
member is assigned a quota in terms of SDRs. Quotas are used to determine the voting power of
members, their contribution to the Fund’s resources and their share in the allocation of SDRs. A
member’s quota reflects its economic size in relation to the total membership of the Fund. Each
member pays a subscription to the IMF equal to its quota and the IMF decides on the amount of
SDRs to be paid. A member nation is required to pay about 25 per cent of its quota in SDRs or
in currencies of other members selected by the IMF and the remaining contribution can be paid
in the home currency of the member. The IMF ;holds huge resources in members’ currencies
and SDRs which are available to meet countries’ temporary balance of payments requirements.
The SDR holdings of India as on 30th October 2015 were 2889 million SDRs or USD 4036
million. As on 28 October 2016, SDR holdings went down to 1066 million or USD 1462
million.
FOREIGN CURRENCY ASSETS.
In 1991, the foreign currency reserves were at the decadal low of USD 2.236 billion. By 1993-
94, the foreign currency assets reached ten times the figure of 1990-91. The rise was due to
drawings from the IMF. Net foreign investment in India thereafter contributed to the increasing
trend in foreign currency assets. On 29th March 2002, the foreign currency assets were USD
51.093 billion. The same rose to USD 330.14 billion on 30th October 2015 and further to 341.94
billion on 28th October 2016. On 25th January 2019, the foreign exchange reserves were of the
order of USD 398 billion. The country has come a long way from the foreign currency crisis of
1991 i.e., from a mere 2.23 billion reserves to 398 billion USD (See Table 4.4).
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Table 4.4 – Foreign Exchange Reserves of India
S.No. Item Unit As on
30.10 2015
As on
28.10. 2016
As on 25 Jan
2019
1. Foreign Currency
Assets
USD Million 330,141.00 341,945.00 372,149.20
2. Gold USD Million 18,152.00 21,406.00 21,921.30
3. SDRs SDR Million 2889.00 1066.00 1464.50
USD Million 4036.00 1462.00
4. Reserve Tranche
Position in IMF
USD Million 1308.00 2345.00 2643.4
Total USD Million 353,637.00 367,157.00 398,178.4 Ref. Table 32, p39, RBI Bulletin November 2016.
SOURCES OF DATA.
1. www.rbi.org.in (RBI bulletins and Reports).
2. Indian Economic Survey various years http://indiabudget.nic.in
3. http://finmin.nic.in
Questions.
1. Explain the concept and usefulness of the study of Balance of Payments.
2. Explain the structure of balance of payments.
3. The balance of payments always balances. Explain.
4. Explain the types of disequilibrium in the balance of payments.
5. Explain how free market exchange rates are determined.
6. Explain the concept of foreign exchange reserves and its components.