es-303 economic environment policy 04.05.10

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IILM Institute for Higher Education

Course ManualECONOMIC ENVIRONMENT AND POLICY

ES-303

PGP 2010-12

ECONOMIC ENVIRONMENT AND POLICY

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PGP Batch [2010-12]

I. Course Facilitators

Facilitator Email-id

Prof. N. Chandra [email protected]

Mr. Abhijit Mukhopadhyay [email protected]. Rakhi Singh [email protected]. Deepa Bhaskaran [email protected]. Rachna Madaan [email protected]. Bhumika Kapoor [email protected]. Rajneesh Kler [email protected]. Course Overview

The overall macroeconomic situation in the economy affects the performance of a companyand subsequently the decision making of even a manager. This was amply demonstrated in

real life events after the recession, all around the world. The objective of this course is tofacilitate the learning of macro business environment for informed decision making. Thefocus of the course is on holistic understanding of the functioning of the economy andputting business in broader macroeconomic framework.

III. Course Topics

Macroeconomic Environment of Business: An Overview

National Income Accounting

Simple Keynesian Model of Output Determination

Hicksian-Hansen Extension of Keynesian Model (IS-LM Model)

Short Run Economic Fluctuations Monetary and Fiscal Policy

Inflation and Unemployment

Indian Economy: An Overview

External Sector

IV. Learning Outcomes

1. Students will be able to develop an understanding of the macroeconomic framework,national income and its components, key macro-economic variables, concepts, and

tools for business decision making.

2. Students will be able to develop a comprehensive understanding of the Indian andglobal economic environment, institutions and policies which affect corporateplanning, good governance and business prospects.

V. Pre-requisites

The course on Managerial Economics helps in understanding macroeconomic concepts.Completion of Managerial Economics course is a definite pre-requisite for this course. The

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students should also know fundamental concepts of algebra and two-dimensional geometryto understand the concepts in this course.

VI. Books and References

Main Textbook

Soumyen Sikdar:Principles of Macroeconomics, Oxford University Press

Additional Readings

N. Gregory Mankiw,Principles of Macroeconomics, Thomson Press.

Economic Survey, Government of India, Latest year

Macroeconomic and Monetary Developments, Reserve Bank of India, Latest

Issue

R. Dornbusch, S. Fischer and R. Startz,Macroeconomics, Tata McGraw Hill

Rakesh Mohan: Managing Monetary Policy An Inside View

Bimal Jalan- Indias Economic Policy: Preparing for the Twenty First Century,

Viking/ Penguin, 1997. T.N. Srinivasan- Eight Lectures on Indias Economic Reforms, Oxford University

Press.

Ernst and Young- Doing Business in India, Ernst & Young Private Ltd.

Reserve Bank of India- Latest Annual Report, RBI, Mumbai.

Uma Kapila:Understanding the Problems of Indian Economy, Academic

Foundation.

Justin Paul : Business Environment Text and Cases, Tata McGraw Hill

Richar T. Froyen :Macroeconomics, Pearson Education.

Mankiw, Gregory :Macroeconomics, Worth Publishers Inc.

Journals / Magazines / Newspapers

Economic and Political Weekly

The Economist

Business Today

The Economic Times

Important Websites:

www.indiabudget.nic.in

www.rbi.org.in www.ciionline.org

www.finmin.nic.in

www.ficci.com

www.planningcommission.nic.in

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http://www.indiabudget.nic.in/http://www.ciionline.org/http://www.ciionline.org/http://www.finmin.nic.in/http://www.ficci.com/http://www.planningcommission.nic.in/http://www.indiabudget.nic.in/http://www.ciionline.org/http://www.ciionline.org/http://www.finmin.nic.in/http://www.ficci.com/http://www.planningcommission.nic.in/


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VII. Assessment (Total 100 Marks)

Sl. No. Components Weight (%)

1 Test (MCQ) 20

2Individual assignment / Project

20

3 End-Term Test 60

Total 100

VIII Session Plan

Session

Topic Pre-Readings/Case Chapter / References

Module 1: The macroeconomic environment of business: An overview

1

Circular Flow of Income Study Material 1 Dernberg and Mcdougall,ch 1

Module 2 :National Income

2 Variants of National

Income

Study Material 2 Sikdar, ch 2

3 Measurement

Income Method

Expenditure methodValue Added


Module 3: Simple Keynesian Model

4 Aggregate Demand,

aggregate supply, andEquilibrium Output


5 The Consumption Function

and Aggregate Demand


6 Multiplier

The Government Sector


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Module 4: Hicksian-Hansen extension of Keynesian Model (IS-LM)

7 Goods Market Equilibrium

(IS)


8

Money Market Equilibrium(LM)


9 Equilibrium in the Goods

and Money Markets


Module 5: Short run economic fluctuations

10 Key facts about economic

fluctuations

newspaper articles Mankiw, ch 20

11 Explaining short run

economic fluctuations

newspaper articles Mankiw, ch 20

12 Causes of economic

fluctuations and recenteconomic recession in theworld

newspaper articles Mankiw, ch 20,

13 Mid Term Examination

Module 6: Monetary and Fiscal Policy

14 Monetary Policy Study Material 5 & 6 Sikdar, ch 5Economic Survey

15 Fiscal Policy and Crowding

Out

Study Material 5 & 6 Sikdar, ch 5

Economic Survey

16 Monetary Policy in India

Role of RBI

The Union Budget

Study Material 5 & 6 Sikdar, ch 6Economic Survey

17 Guest Lecture on the role of economic policies in Indian Economy

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Module 7: Inflation and Unemployment

18 Inflation: Meaning and

Types

The Anatomy of

Unemployment

Mankiw, ch 17 & 22 Sikdar, ch 8 & 9

19 Inflation in India Sikdar, ch 8 & 9 Economic Survey

20 Guest Lecture on inflation in India

Module 8: Indian Economy: An Overview

21 Economic Reforms Study Material 8 & 9Case Study :Economic Reformsand InclusiveGrowth in India

Economic SurveyMinistry of Industriesdocuments/website

22 Industry Study Material 8 & 9 Economic Survey

Ministry of Industriesdocuments/website

23

Agriculture Study Material 8 & 9 Economic Survey

Ministry of Industriesdocuments/website

24 Service Sector Study Material 8 & 9 Economic SurveyMinistry of Industriesdocuments/website

25 Guest Lecture on latest happenings in Indian Economy

Module 9: External Sector

26 Balance of payments

current account, capitalaccount

Exchange Rate

Dornbusch, Fischer& Startz, ch 12

Economic SurveyStudy Material 7Sikdar, ch 7Mankiw, ch 18 & 19

27 FDI in India Dornbusch, Fischer RBI documents

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& Startz, ch 12 Economic SurveyStudy Material 7

Session Details

Session 1:The students will be introduced to macroeconomics as a subject and subsequently relate it tobusiness environment. Subsequently then the basic flow of money/income in an economyshould be understood.

a) Pre-reading: Study Material 1b) Question for discussion in class:How does macroeconomic knowledge help in business decision

making?(c)Learning outcomes: Students should understand the distinction between macroeconomics andmicroeconomics very clear. The basic flow of money in an economy should also be understandable tothem.(d) Chapter: Dernberg & McDougall,Macroeconomics, ch 1

Session 2:

Like any individual or household, any nation also had its income and expenditure. There areconcepts and ideas which are well accepted worldwide to quantify or measure them. Thestudents would be introduced to all such relevant concepts of the economy.a) Pre-reading: Study Material 2b) Question for discussion in class: What are the ways by which any economy's health can be

judged?c) Learning outcomes: Students should learn different definitions of national incomemeasuring concepts.d) Chapter: Sikdar,Principles of Macroeconomics, ch 2

Session 3:

In this session, continuing with the concepts and measures of national income accounting, thestudents would be introduced to concepts like GDP, NI and the basic methodologies tomeasure them.

a) Pre-reading: Study Material 2b) Question for discussion in class: Why GDP is important as an indicator? Does it capture

all aspects of economic well-being?c) Learning outcomes: Students should get a feeling of real time GDP data on Indianeconomy.d) Chapter: Sikdar,Principles of Macroeconomics, ch 2

Session 4:

The concepts of aggregate demand and aggregate supply will be introduced to the students.After that, concept of equilibrium of an economy will be explained. In this session,preliminary concepts of Keynesian aggregate demand analysis will also be introduced.

a) Pre-reading: Study Material 3b) Question for discussion in class: What are the factors that change the pattern of aggregate

demand and supply; and what are the effects oneconomy?

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c) Learning outcomes: Students should be able to distinguish between the concept of demandin microeconomics and aggregate demand in macroeconomics.d) Chapter: Sikdar,Principles of Macroeconomics, ch 8 & 3

Session 5:

Determination of output under Keynesian demand analysis in simple closed economy andopen economy will also be done using this framework. The concept of multiplier will also be

introduced in this session.

a) Pre-reading: Study Material 3b) Question for discussion in class: What is a multiplier and how does it work?c) Learning outcomes: Students have to understand the mechanism of a multiplier. Wheneverinvestment or government expenditure rises, the mechanism of multiplier in the economy hasto be clear in their mind.d) Chapter: Sikdar,Principles of Macroeconomics, ch 3

Session 6:

This session would be utilized to facilitate an overall understanding of Keynesian aggregatedemand analysis in the simplest framework. If different components of aggregate demand

changes then the resultant changes in output need to be shown also in this session.

a) Pre-reading: Study Material 3b) Question for discussion in class: Why it was necessary to formulate an aggregate demand

analysis instead of regular demand-supply interaction?c) Learning outcomes: Students should be able to identify the nuances and contrasts ofdemand-side and supply-side oriented analysis.d) Chapter: Sikdar,Principles of Macroeconomics, ch 8

Session 7:

This session will be utilized to show the relationship between investment and rate of interest.After introducing investment function, the change in aggregate demand equation andsubsequently the derivation of IS curve will be done.

a) Pre-reading: Study Material 4b) Question for discussion in class: What is the relationship between investment and rate of

interest?c) Learning outcomes: Students should be able to understand the linkage between interestrate and investment. Subsequently, they have to appreciate the effect of a change ininvestment on aggregate demand.d) Chapter: Sikdar,Principles of Macroeconomics, ch 4

Session 8:

This session would be devoted to introduce money market to the students. The concepts ofmoney demand and money supply will be incorporated in this session. Different componentsof money demand will be explained in detail.

a) Pre-reading: Study Material 4b) Question for discussion in class: What are different components of money demand and

how money demand is linked to rate of interest?c) Learning outcomes: Students should be able to understand transaction and speculativedemand for money. Central Bank's role in the exogeneity of money supply has to beexplained along with the sense of opposing view of endogeneity.

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Session 14:

This session will be devoted to explain and analyse different tools and instruments ofmonetary policy. A special attention will be given to introduce the students to monetaryinstruments used in Indian economy.

a) Pre-reading: Study Material 5 & 6b) Question for discussion in class: What do you understand by monetary policy and what

are the standard monetary instruments?c) Learning outcomes: Basic instruments and mechanisms of monetary policy have to beknown. The working logic of such instruments have to be very clear also.d) Chapter: Economic Survey

Session 15:

This session will be devoted to explain and analyse different tools and instruments of fiscalpolicy. A special attention will be given to introduce the students to fiscal tools used inIndian economy.

a) Pre-reading: Study Material 5 & 6b) Question for discussion in class: What do you understand by fiscal policy and what are

the standard fiscal instruments?c) Learning outcomes: Basic instruments and mechanisms of fiscal policy have to be known.The working logic of such instruments have to be very clear also.d) Chapter: Economic Survey

Session 16:

This session will be a wrapping-up session to inculcate basic information on monetary andfiscal policies in India and their short term and long term implications.

a) Pre-reading: Study Material 5 & 6b) Question for discussion in class: What are the latest monetary and fiscal measures

undertaken by Indian government?c) Learning outcomes: The highlights of fiscal policies, as described in Union Budget andmonetary policy measures, as described in monetary and credit policy by the RBI, should beknown to the students.d) Chapter: Economic Survey

Session 17:

This session will be utilized for guest lecture on the relevance of economic policies with aspecial focus on Indian economy and business.

Session 18:

In this session the teacher will explain the implications and importance of learning the

phenomenon of inflation and unemployment.

a) Pre-reading: Mankiw, ch 17 & 22b) Question for discussion in class: Why high inflation and high unemployment are

detrimental to economic development?c) Learning outcomes: The students should understand and know the ills of high inflation andhigh unemployment scenario vis-a-vis economic development.d) Chapter: Sikdar, Principles of Macroeconomics, ch 8 & 9

Session 19:

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The teacher will delve into different causes and reasons for inflation to occur in an economy.Within mainstream theory, an emphasis has to be put on the relationship between inflation,money supply and subsequently unemployment.

a) Pre-reading: Mankiw, ch 17 & 22b) Question for discussion in class: How do you describe latest price and employment

situation in India?

c) Learning outcomes: The students should be aware of latest price level and unemploymentlevel prevailing in India.d) Chapter: Sikdar, Principles of Macroeconomics, ch 8 & 9

Session 20:

This session will be utilized for guest lecture on inflation and its implication on Indianeconomy and business.

Session 21:

This will be the first session in the series to introduce Indian economy with facts and figuresto the students. The basic fundamentals of India like GDP, growth, taxation etc. will beintroduced to the students with data and figures.

a) Pre-reading: Study Material 8 & 9b) Question for discussion in class: Do you know some of the latest economic fundamentals

of India?c) Learning outcomes: The students should come across the latest economic and standard ofliving indicators in India. They should be able to remember at least some of the basicindicators like GDP in real figures.d) Chapter: Economic Survey

Session 22:

In this session, the teacher will make students aware of the sectoral composition of Indianeconomy. A discussion will be ensued subsequently on the process of economic reformswhich started in the beginning of the 1990s.

a) Pre-reading: Study Material 8 & 9b) Question for discussion in class:How do you judge Indian economic reform?c) Learning outcomes: The circumstances under which economic reform was initiated, theactual reform process, a review of the reform process students should have some ideasabout all these.d) Chapter: Economic Survey

Session 23:

The teacher will initiate, facilitate and encourage a detailed discussion on main segments of

Indian economy agriculture, industry and services sector.a) Pre-reading: Study Material 8 & 9b) Question for discussion in class: How are Indian agriculture, industry and services

performing in the recent past?c) Learning outcomes: Students should know the sectoral composition of Indian GDP. Theyshould also be clear about the importance of all major sectors in the economy.d) Chapter: Economic Survey

Session 24:

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Analysis and evaluation of Indian economy in the last 15 years will be done to wrap up theseries of lectures based on Indian economy. Implications of Union Budget and Credit Policyhave to described in this session.

a) Pre-reading: Study Material 8 & 9b) Question for discussion in class: What are the policies taken by Central government and

the RBI in Union Budget and Credit policy? What will

be their implications?c) Learning outcomes: Students should be able to judge recent economic measures taken,comparing them with past policy measures.d) Chapter: Economic Survey

Session 25:

This session will be utilized for guest lecture on an overview of Indian economy.

Session 26:

In this session the teacher will introduce the basic concepts related to external sector likeBoP, foreign exchange depreciation and appreciation etc. to the students. The focus will be toemphasise the need to understand external sector in view of increasing global integration.

a) Pre-reading: Study Material 7b) Question for discussion in class: What are the major benefits of trade? How is India

placed in terms of export and import?c) Learning outcomes: Latest highlights of Indian export and import have to be understoodfully with their implications.d) Chapter: Economic Survey

Session 27:

This session will be utilized to conclude the discussion on external sector of India and globalcontext of business. Importance of FDI in India would be discussed in detail.

a) Pre-reading: Study Material 7b) Question for discussion in class:Has India benefited from foreign direct investment?c) Learning outcomes: Students should know the economic mechanisms by which foreigndirect investment helps Indian economy to grow. They should also be aware of certain perilsof foreign investments.d) Chapter: Economic Survey

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Study Material 1

The Circular Flow of Income

The five-sector circular flow modeldescribes the operation of the economy and the linkagesbetween the main sectors in the economy. The five-sector model is based on dividing the economyinto five sectors. A sector may be defined as a part of the economy where the participants areengaged in a similar type of economic activity.1. Individuals2. Businesses

3. Financial institutions4. Government5. International Trade

Individuals This sector consists of all individuals in the economy.

These individuals are the owners of productive resources, and the consumers in our economy.

Individuals supply factors of production (inputs) such as labour and enterprise to businesses,

which they use to produce goods and services. As a reward for supply resources such aslabour and enterprise to firms, individuals receive incomes rent, wages, interest and profit.

Businesses This sector consists of all the business firms engaged in the production and distribution of

goods and services (apart from financial services).

It concerns all their activities involved with buying factors of production and using them to

produce and sell goods and services.

Individuals and businesses are interdependent.

Financial Institutions

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Study Material 2

National Income: Concepts and Measurement

National Income: It is defined as the monetary value of all the final goods and servicesproduced in an economy in a financial year.

Final goods and Services:Those goods and services which are not further processed and converted into other goodsduring the period in which they are produced. These are used only for the final consumptionpurposes.It can be measured using three different methods corresponding to the three different phasesin the cycle of economic activity.

Production Value Added Method (Product Method)Distribution Income MethodDisposition Expenditure Method

Cycle of Economic Activity in any economy has three distinct phases: Production,Distribution, and Disposition. The Cycle of Economic Activity starts with the productionprocess in which goods are manufactured and/or services rendered. The factors of productionwhich contribute in the production process get factor payment for its services. This capturedby distribution phase. Once the factors of production gets the factor income, they spend inthe market to by the goods and services (i.e. they dispose off money in the market). Thisphase is termed as disposition.

Value Added Method (Product Method)

All the production units are considered separately in this method. For all the units, value

added is calculated and then they are aggregated to get the value of national income.

Value added = Gross Output Intermediate consumption

Gross output: Total Value of output produced by the production unit.Intermediate consumption: The inputs used by the production unit in manufacturing thegoods.

Let us consider the production of biscuits.Ghazala is running a bakery. She needs flour, labours, sugar, electricity and machines to bakethe biscuits. Ghazala buys flour for Rs. 200 from Robert. She buys electricity for Rs.300

from Haryana SEB. Raghu supplies her sugar and machine. She pays Rs. 100 in return. Shealso hires Sampat, Sabu, Akram and Ann as the laours and pays them Rs. 600. She, finally,bakes biscuits worth Rs. 10000.

Calculation of Value Added

Gross Output = Rs. 3000Intermediate Consumption= 200 + 300 + 100 + 600 = 1200

Value Added = 3000 1200 = Rs. 1800

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Similarly after calculating the value added for all the economic units we can sum them up toget the value of national income.

Income Method

If we add all the factor incomes we get national income. Precisely, national income is equalto Net Domestic Product at Factor cost (NDPFC)NDPFC = Wages and Salaries

+ Rent+ Interest+ Profit+ Mixed Income of the Self-Employed

All the factors incomes are considered for all the production units.

Expenditure Method

In this method, expenditures made by different economic agents are considered. This can betaken from Keynesian Model.

We wrote aggregate demand as follows

M-XGICAD +++=

C Private Final Consumption Expenditure (By the Household)

1

Production

Distribution

Disposition

Fig. 1 Cycle ofEconomic Activity

GrossOutputIntermeiateconsumtion

Wages andSalariesRentInterestProfit

ConsumptionexpenditureBy thehouseholdBy thegovernmentCapitalFormation byfirms

ExportImport


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I Gross Capital Formation (By the Firms)G Government Final Consumption Expenditure (By the Government)X Export (Expenditure made by foreigners on Indian products)M Import (Expenditure made by Indian on foreign products)

Adding them up we get

Gross Domestic Product at Market Price (GDPMP)Private Final Consumption Expenditure (By the Household)

+ Gross Capital Formation (By the Firms)+ Government Final Consumption Expenditure (By the Government)+ Export (Expenditure made by foreigners on Indian products)- Import (Expenditure made by Indian on foreign products)

Therefore we get two different variants of national income. Expenditure method gives usGDPMP , whereas income method gives us NDPFC .

There are eight variants of national income in all. The method to calculate different variantis given by the exhibit in the next page (Ref. Fig. 2).

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Definition of the Key terms

Net Factor Income from Abroad

= (Factor income Received by Indians while working abroad)- (Factor income Received by Foreigners while working in India)

Net Indirect Taxes

= Indirect Taxes- Subsidies

1

GNPMP

GDPMP

GNPFC

NDPFC

GDPFC

NNPFC

NDPMP

NNPMP

Fig. 2 Variants of National Income

- Dep- NFYROW

- NIT

- Dep

- Dep- NFYROW

- NFYROW- NFYROW- Dep

- NIT- NIT

- NIT

Legend

NFYROW Net Factor Income fromAbroadNIT Net Indirect TaxesDep Depreciation


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Depreciation

Wear and tear of machinery

Other Concepts Related to National Income

Base year

As price keeps changing all the time, the value of national income may also change only dueto change in price with no substantial change in total output. For example:

Assuming that only three goods are produced in the economy concerned, compare thenational income of a hypothetical economy no. 1 in 1993-94 and 2003-04

Table 1

1993-94 2003-04

Goods TotalOutput

Price TotalValue

TotalOutput

Price TotalValue

Rice 500 kg 30 1500 500 kg 60 3000

Cloth 200mts 40 8000 200mts 80 16000

House 40 1000 40000 40 2000 80000NationalIncome

49500 99000

Above table (Ref. Table 1) clearly brings out that the national income has doubledexclusively because of doubling up of price. Please note that the total output has remainedunchanged.

Therefore we need to introduce the concept of base year. Whenever we calculate the nationalincome of any economy we calculate it at two prices, one at the price of current year andsecond at the price of some year in the past which can be chosen as the base. At present

1993-94 is considered as the base year in Indian economy.Let us recalculate the national income given in the previous table. (Ref. Table 2)

Table 2

1993-94 (at current year price) 2003-04 (at base year price)

Goods TotalOutput

Price TotalValue

TotalOutput

Price TotalValue

Rice 500 kg 30 1500 500 kg 30 1500

Cloth 200mts 40 8000 200mts 40 8000

House 40 1000 40000 40 1000 40000

NationalIncome

49500 49500

Table 2 clearly reflects that the hypothetical economy no.1 has remained stagnant. Thereforethe significance of calculation at base year prices lies in giving the true picture of growth ofthe economy. Let us look at the data of hypothetical economy no. 2 (Ref. Table 3)

Table 3

1993-94 (at current year price) 2003-04 (at base year price)

Goods Total Price Total Total Price Total

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Output Value Output Value

Rice 500 kg 30 1500 1000 kg 30 30000

Cloth 200mts 40 8000 250mts 40 10000

House 40 1000 40000 45 1000 45000

NationalIncome

49500 85000

Table 3 shows that economy no. 2 has grown substantially. Its national income has grownfrom Rs. 49500 to 85000.Nominal Income, Real Income and Deflators

The national Income at current prices can be termed as Nominal GDP, whereas nationalincome at base year prices (Constant prices) Real GDP. Given these two we can define GDPdeflator

11

3

1

2

1

1..................,,

nQQQQ Quantities of final output in the current year of goods from 1

to n11

3

1

2

1

1 ...........,, nPPPP Prices of final output in the current year of goods from 1 to n003

0

2

0

1 ..................,, nPPPP Prices of final output in the base year of goods from 1 to n

Then the GDP deflator can be defined as

1

11

i

o

i

ii

QP

QP

eg Wholesale price index (WPI) and Consumer price index (CPI)CPI includes the goods which form the consumption basket of the typical family and it uses

the retail prices, whereas the WPI includes the industrial raw materials, fuels and machineryetc and it uses wholesale prices.

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Study Material 3

Simple Keynesian Model of Income Determination

Macroeconomics

Macroeconomics studies the economy as a whole. More specifically, it deals with thedetermination of the economys total output of goods and services, the price level and total

employment of resources.

Simple Keynesian Model

In the General Theory, Keynes proposed that an economys total income was in the short rundetermined largely by the desire to spend by the household, firms and the government. Themore people want to spend the more goods and services firms can sell. The more firms cansell the more output they will choose to produce and the more workers they will choose tohire.

Aggregate Demand

Let us try to derive aggregate demand in any economy. Sources of aggregate demand can be

Household Private Final Consumption Expenditure ( C )Firm Investment ( I )Government Government Expenditure (G)Rest of the world Export (X) and Import (M)

Therefore aggregate demand can be written as

M-XGICAD +++=

Please note that import has been subtracted from the aggregate demand as aggregate demand

gets reduced by the amount of import (as the economic agents demand shifts to the productfrom abroad)

In the formulation for AD, G is included as a separate component. It is so because factorsinfluencing other demand and the demand from government are quite different in nature.While government can go beyond its means the private sector can not do so.

Consumption FunctionC of AD represents consumption which is the function of income. This can be written as

cYCC +=where C minimum level of consumption even when income is zero.

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Differentiating the consumption function

cY

C=

c is termed as marginal propensity to consume. It may be defined as the incremental changein consumption level as a response to incremental change in income.

Savings Function

Saving is the difference between income and consumption. (Ref. Fig. 3)

2

Consumption

Income

Fig. 2 Consumption Function

)1(

,

)1(

)(

cs

CS

where

sYS

YcC

cYCYS

CYS

=

=

+=

+=

+=

=


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Graphically,

Using consumption function, Aggregate Demand can be rewritten as

M-XGIAD ++++= cYCwhere C , I , G , X , M are exogenous variablesExogenous variables can be rewritten asM-XGIA +++= C

ThencY+= AAD

Some key terminologies

Endogenous Variables: The variable, the value for which is derived from the system.Exogenous Variables: The variable for which the values are given.

For any economy to be in equilibrium,Y=AD

2

Savings

Income

Fig. 3 Savings Function


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( )

( )

( )

( )( )M-XGI

1

1*

Re

is1

1where,

A1

1*

A1

AY

AY

equlibriuminTherefore,

+++

=

=

=

=

+=

Cc

Y

wrting

multiplierc

cY

Yc

cY

cY

In differential

( )( )M-XGI*

1

1+++

= C

cY

Therefore, the same formulation can also be looked differently.We can say that if any of the endogenous variables changes, income in any economy can alsochange via multiplier effect.

Therefore 1/(1 c) is also called government expenditure multiplier and investmentmultiplier.

Let us now look at the same thing graphically.

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Alternative Formulation for equilibriumPlanned Investment = Planned Saving

Stability Analysis

2

AD

Income

Figure 4Income Determination in Keynesian System

AD = Y

Y*

H

Y*


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For any output above Y* there will be involuntary accumulation of inventories in theeconomy, whereas for any output below Y* there will be run down on the stocks.As a result of disequilibrium, the economy, will equilibriate through multiplier effect.

Concept of Multiplier

If the objective of the government is to raise the income of the economy it can be done byincreasing autonomous investment. Increase in investment would mean that there is increasein income through multiplier effect. The graphical representation is as following.

2

AD

Income

Figure 5Accumulation and Run down

AD = Y

Y1

Y* Y2

H


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2

AD

Income

Figure 6Change in autonomous investment

AD = Y

Y*

H

Y*


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Study material 4

Hicksian-Hansen Extension of Keynesian Model (IS-LM Model)

For a given price level, national income fluctuates because of shifts in the AD curve. The IS-LMmodel takes the price level as given and shows what causes income to change.

Keyensian model focuses only on IS-LM model, whereas IS-LM model takes into considerationmoney market as well.

We wrote aggregate demand in Keynesian model as follows

M-XGICAD +++=

where C was written as cYCC += , where as other components of AD were kept as exogenous

variable. Investment was taken as autonomous variable, whereas in real life, investment isfound to be affected by the interest rate. Therefore it can be made the function of interestrate. Symbolically

2

Income

Assets Market GoodsMarket

MoneyMarket

BondMarket

DD

SS

DD

SS

AggregateOutput

FiscalpolicyInterest

Rate

Monetarypolicy


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hiII =here h measures responsiveness investment spending to the interest rate and I isautonomous investment spending that is independent of both income and interest rate.

hdidI =

As the interest rate increases the firms incentive to invest decreases therefore there is lessinvestment. This gives rise to inverse relationship between interest rate and investment.

Aggregate Demand can, then, be rewritten as

M-XGhi-IAD ++++= cYCIn equilibrium we can rewrite it as

2

Investment

Rate ofinterest

Fig. 1 Investment Function


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( ) Ahi1

hi-AY

hi-AYequlibriuminTherefore,

AD

hi-AAD

=+

=

+=

=

+=

Yc

cY

cY

Y

cY

This is called goods market equilibrium

Now we have one equation in two variables. We need to look for another equation to solvethis equation system. This brings us to Money market equilibrium.

Before we go on to goods market equilibrium we should look at the graph of goods market.This graph will give us a locus where goods market is in equilibrium at various levels ofinterest and income (IS). (Ref. Fig. 2)

3

Rate ofinterest

I*

Income

Figure 2Goods Market equilibrium

Goods Market Equilibrium

Y*

T

I = S


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IS curve depicting goods market equilibrium is downwardly sloped. It means that when thereis rise in rate of interest there is less incentive for the firms to invest therefore there is a fall ininvestment which further leads to fall in output and finally income. This gives inverserelationship between income and interest rate.

YOIi

Money market equilibrium

Money market will be in equilibrium when there is equality of money demand and moneysupply.At any point of time, Money supply is given by the central bank of any country (In India,RBI). It may be written as

P

M

where M is nominal money supply and P is aggregate price. Therefore, M/P is real moneysupply.

Money DemandMoney demand in any economy can be for three distinct purposes.Transaction Demand for money (Mtd)Money demanded to carry out day today transactions. How much will be demanded for thispurpose will depend on the level of income of the household. Therefore,

( )YfMtd =

1..........................kYMTD =

Ref. Fig. 3

Precautionary Demand for money (Mpd)How much money do you keep aside for contingency purposes will also depend on income.Therefore

( )YfMpd =

3

YFig. 3

Transaction Demand for Money

MTD


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Speculative Demand for money (Msp)Households need money for investment purposes as well. This is the function of interest rate.If the interest is very high there will be lessMspand vice versa.Symbolically,

( )ifMsp =

2...........................biMSP =

Speculative demand for money depends on the cost of holding money. The cost of holdingmoney is the interest rate that is foregone by holding money rather other assets. The higherthe interest rate the more costly it is to hold money rather than other asset and accordinglythe less cash will be held at each level of income.

As Precautionary demand for money and Transaction demand for money are the functions of

income, therefore 1 and 2 can be clubbed together as follows.

( )YfMtd =

Total demand for money can be written as (Ref. Fig. 5)( ) bikYyigMMM sptdd ==+= ,

3

i Fig. 4Speculative Demand

for Money

Ms

p


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The demand function for real balances implies that for a given level of income, the quantitydemanded is a decreasing function of the real rate of interest. In equilibrium

( )

P

MbikY

Also

P

Myig

MMsd

=

=

=

,

,

Graphically it be shown as follows, (Ref. Fig 6)

For economy to be in equilibrium, money market and goods market should simultaneously be inequilibrium. Collecting the two equilibrium conditions we get,

Goods market Equilibrium( ) Ahi-1 = Yc

Money market Equilibrium

3

iFig. 5 Demand for Money

Msp

and

MD

MD

MSp

Rate ofinterest

I*

Income

Figure 6 Money Market equilibrium

Money Market Equilibrium

Y*

G

L=M


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( )P

Myig =,

These two are simultaneous equation in two variables. Solving this will give us the values of yand i. Graphically, it can be seen as follows (Ref. Fig 7).

The point where the two curves, IS and LM intersect each other is the point (G) where the

economy will be in equilibrium.

Fiscal Policy and Monetary Policy

Fiscal Policy is defined as tax and expenditure policy of the government, whereas monetarypolicy is defined as polices regarding money supply and interest rate.

With the expansionary fiscal policy government expenditure will go up leading to the upwardshift in IS curve, this will further lead to rise in income level and interest rate, whereas

contractionary fiscal policy will have the opposite effect. (Ref. Appendix Current Fiscal Trends2002-03)

With the expansionary fiscal policy IS will shift to IS and equilibrium will shift form G to H,thereby leading to rise in income from Y* to Y. (Ref. Fig. 8)

3

Rate ofinterest

I*

Income

Figure 7

Goods and Money Market equilibrium

Y*

G

I = S

L = M


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With the increase in money supply LM curve will shift downward leading to fall in interest rateand increase in income. (Ref. Fig. 9)

3

Rate ofinterest

I*

Income

Figure 9 : Expansionary Monetary Policy

Y* Y

G

I S

LM

F

LM

Rate ofinterest

I*

Income

Figure 8 : Expansionary Fiscal Policy

Y* Y

G

I S

L = M

H

I S


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Study Material 5

Monetary Policy

The Monetary policy is principally determined by the Reserve Bank of India (RBI), andusually it is announced through the Monetary and Credit Policy as the policy statement,traditionally announced twice a year, through which the RBI seeks to ensure price stabilityfor the economy as one of the main objectives.

The RBI also announces norms for the banking and financial sector and the institutionswhich are governed by it. They are the banks, financial institutions, non-banking financialinstitutions, primary dealers (money markets) and dealers in the foreign exchange (forex)market.

Objectives of the Monetary Policy

The objectives are to maintain price stability and ensure adequate flow of credit to theproductive sectors of the economy.

Stability for the national currency (after looking at prevailing economic conditions), growthin employment and income are also allied objectives of monetary policy. The monetarypolicy affects the real sector through long and variable periods while the financial marketsare influenced through short-term implications.

There are four main 'channels' which the RBI looks at:

Quantum channel: money supply and credit (affects real output and price levelthrough changes in reserves money, money supply and credit aggregates).

Interest rate channel.

Exchange rate channel (linked to the currency).

Asset price.

Instruments of Monetary Policy

The instruments can be broadly classified into direct and indirect ones.

Typically, direct instruments include cash reserve (CRR) and/or statutory liquidity ratios(SLR), directed credit and administered interest rates. The indirect instruments generallyoperate through repurchase (repos) and outright transactions in government securities (openmarket operations).

The reforms in the financial sectors have enabled RBI to expand the array of instruments atits command. While the prime target of Monetary Policy continues to be banks' reserves, theuse of the same is sought to be de-emphasised and the liquidity management in the system isbeing increasingly undertaken through open market operations (OMO), both outright andrepos.

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The CRR and SLR rates that peaked in the early 90's have now been considerably relaxedwith the RBI adopting other measures for controlling money supply. This has translated intobetter liquidity for the banking sector.

The following is a brief explanation of each of the aforementioned instruments.

CRR/SLR: Cash reserve ratio (CRR) determines the level of cash banks need to hold against

their net demand and time liabilities. Similarly, statutory liquidity ratio (SLR) requires banksto maintain a part of their liabilities in the form of liquid assets (e.g. government securities).

Bank rate: Bank rate is the rate at which RBI lends to the banking entities to meet theirliquidity requirements.

Interest rates: Credit and interest rate directives take the form of prescribed targets forallocation of credit to preferred sectors or industries and prescription of deposit and lendingrates.

OMO and LAF: Liquidity management in the system is carried out through open market

operations (OMO) in the form of outright purchases or sales of government securities anddaily repo and reverse repo operations under Liquidity Adjustment Facility (LAF).

To illustrate the main features of monetary policy, let us take (for example) the FirstQuarterly Review of Monetary Policy for the year 2006-07. The major highlights are asfollowing.

Highlights

Reverse Repo Rate increased to 6.0 per cent and Repo Rate to 7.0 per cent.

Bank Rate and Cash Reserve Ratio kept unchanged.

GDP growth projection for 2006-07 retained at 7.5-8.0 per cent.

Containing inflation within 5.0-5.5 per cent for 2006-07 warrants appropriate priority

in policy responses.

Money supply, deposit and credit growth above the indicative projections, warranting

caution.

Appropriate liquidity to be maintained to meet legitimate credit requirements,

consistent with price and financial stability.

Barring the emergence of any adverse and unexpected developments in various

sectors of the economy and keeping in view the current assessment of the economyincluding the outlook for inflation, the overall stance of monetary policy in the period

ahead will be:

To ensure a monetary and interest rate environment that enables continuation of the

growth momentum while emphasising price stability with a view to anchoringinflation expectations.

To reinforce the focus on credit quality and financial market conditions to support

export and investment demand in the economy for maintaining macroeconomic and,in particular, financial stability.

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To consider measures as appropriate to the evolving global and domestic

circumstances impinging on inflation expectations and the growth momentum.

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Study Material 6

Fiscal Policy

Fiscal policy is an important instrument of the general economic policy of a government. It isconcerned with the use of a governments taxation and expenditure powers to influence

economic activities in an economy at the aggregate level. It also deals with financial relationsbetween different tiers of government in a federal polity. Through the medium of budget,fiscal policy determines the level of taxation, public expenditure, and borrowings by agovernment and the issue of other additional expenditure by bodies like PlanningCommission.

Objectives of fiscal policy

The role of fiscal policy in developed economies is to maintain full employment andstabilize growth. In contrast, in developing countries, fiscal policy is used to create anenvironment for rapid economic growth. The various aspects of this are

1. Mobilisation of resources: Developing economies are characterized by low levels ofincome and investment, which are linked in a vicious circle. This can be successfully brokenby mobilizing resources for investment.

2. Acceleration of economic growth: The government has not only to mobilize moreresources for investment, but also to direct the resources to those channels where the yield ishigher and the goods produced are socially acceptable. Sectors to be focused have to beprioritized by the government.3. Minimization of the inequalities of income and wealth : Fiscal tools can be used to bring

about the redistribution of income in favor of the poor by spending revenue so raised onsocial welfare activities. Some argue that taxing the rich is also an integral part ofredistribution of wealth.

4. Increasing employment opportunities: Fiscal incentives, in the form of tax-rebates andconcessions, can be used to promote the growth of those industries that have highemployment-generation potential. Here also priority sectors come into importance as thegovernment has to identify the sectors where there are more potential to generateemployment.

5. Price stability: Fiscal tools like taxation and price control can be employed to contain

inflationary and deflationary tendencies in the economy.

The limitations of Fiscal Policy

Most of the developed countries benefited from active fiscal policy regime till 1960s and 70swhich has been a great success. Later fiscal policy became out of fashion and under neo-liberal economic policy less government intervention is prescribed. As a result in developingcountries also the role of fiscal policy became limited.

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The tax structure in the developing countries is often rigid and unnecessarily complex. Thus,conditions conducive to the growth of well-knit and integrated tax policies are absent andsorely missed. Following are some of the reasons that are hindrances for its implementationin developing countries.

1. A sizeable portion of most developing economies is non-monetized, rendering fiscal

measures of the government ineffective and self-defeating.

2. Lack of statistical information as regards the income, expenditure, savings, investment,employment etc. makes it difficult for the public authorities to formulate a rational andeffective fiscal policy.

3. Fiscal policy cannot succeed unless people understand its implications and cooperate withthe government in its implication. This is due to the fact that, in developing countries, amajority of the people is illiterate.

4. Large-scale tax evasion, by people who are not conscious of their roles in development,

has an impact on fiscal policy.

5. Fiscal policy requires efficient administrative machinery to be successful. Most developingeconomies have corrupt and inefficient administrations that fail to implement the requisitemeasures vis--vis the implementation of fiscal policy.

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Study Material 7

Balance of Payments

The Balance of Payments (BOP) is the financial statement of account for the whole country.It records economic transactions (i.e. financial relations) between the economy as a wholeand the rest of the world.

The BOP is the sum of two accounts:

1. The Current Account and2. The Capital Account

The Current Account involves the import and export of goods and services as well astransfer payments. It is the sum of:

1. Net of Trade2. Net of Remittances3. Net of Tourism4. Net of Services Payment5. Net of Interest6. Net of Profits

The Trade Account includes item 1. The Invisibles Account is named so because theseaccounts do not involve the physical movement of goods into and out of the country, and itincludes items 2 to 6. The Current Account is said to be in deficit when it is negative and in

surplus when it is positive.

The Capital Account deals with the movement of funds for investments and loans into andout of a country. It is the sum of:

1. Borrowings or Debt and2. Investment or Capital

Borrowings include:

1. Official Aid

2. External Commercial Borrowing3. Government Borrowing4. Foreign Currency Non-Resident accounts5. FII money in debt

Investments include:

1. FDI2. FII money in equity

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3. ADRs / GDRs4. Acquisition of shares in M & A5. Private Equity6. Venture Capital

The latest figures for each of the above items can be found on the Reserve Bank of Indiaswebsite.

Depreciation and appreciation of currency

Currency depreciation is the loss of value of a country's currency with respect to one ormore foreign reference currencies, typically in a floating exchange rate system. It is mostoften used for the unofficial increase of the exchange rate due to market forces, thoughsometimes it appears interchangeably with devaluation. Its opposite is called appreciation.

The depreciation of a country's currency refers to a decrease in the value of that country'scurrency. For instance, if the Indian rupee depreciates relative to the euro, the exchange rate

(the Indian rupee price of euros) rises - it takes more Indian rupees to purchase 1 euro.

The appreciation of a country's currency refers to an increase in the value of that country'scurrency. Continuing with the Indian rupee/euro example, if the Indian rupee appreciatesrelative to the euro, the exchange rate falls - it takes fewer Indian rupees to purchase 1 euro.

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Study Material 8

Indias Economic Reforms

Since 1991 there have been major changes in India's economic policies marking a

new phase in India's development strategy. The reforms were introduced in June 1991 in the wake a balance of payments crisis.The crisis erupted suddenly at the end of a period of apparently healthy growth in the1980s, when the Indian economy grew at about 5.5% per year on average

Aims of Reforms

Reduction of Government Control over various aspects of domestic economy Increasing the role of private sector Redirecting scarce public sector resources to areas where the private is unlikely to

enter Opening up the economy to trade and foreign investment

Pace of Reforms

Gradualism and evolutionary transition rather than rapid restructuring or "shocktherapy"

The reason behind gradualism is that the reforms were not introduced in thebackground of a prolonged economic crisis or system collapse of the type whichwould have created a widespread desire for and willingness to accept, radicalrestructuring. The crisis in 1991was not a prolonged crisis with a long period of non-performance

Reforms in the 80s

By the beginning of 80s - System of controls, with heavy dependence on the publicsector and highly protected inward oriented type of industrialization could not deliverrapid growth

Example of East Asian countries in 80s Second Half of 80s Reduction of control, lowering tax rate, expand the role of

private sector, and liberalize controls on both trade and foreign investment Acceleration in growth in 80s and it created climate for continuing in the direction of

reform

Reforms in June 1991

Fiscal Stabilisation Industrial Policy and Foreign Investment Trade and Exchange Rate Policy Tax Reforms Pubic Sector Policy Financial Sector Reforms Agricultural Sector Reforms

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Labour Market Reforms

Fiscal Stabilisation

Why Fiscal Stabilisation? Essential precondition of successful reforms. High fiscal deficit leads to inflation. Central Government fiscal deficit reached at 8.4% of GDP in 1990-91. Allowing for

deficits of the State Governments overall Government fiscal deficit reached 10%.This is high by any standard.

Reduction of Fiscal Deficit

Abolition of export subsidies in 1991-92 Partial restructuring of the fertilizer subsidy in 1992-93 (Rs. 6000 crores in 1991-92 ) Phasing out of budgetary support to loss-making public-sector enterprises Sharp reductions in capital expenditures and the transfers to the state governments State governments were unable to cut their recurrent expenditures and responded by

decreasing their own capital expenditures

Expenditure pattern of both central and state governments was biased in favour ofnon-capital (or revenue) expenditures

Retrospective of Fiscal Deficit (FD)

Central Government FD reduced from 8.4% of the GDP in 1990-91 to 5.9% in 1991-92.

FD in 1993-94 reached 7.3% of GDP due to reduction of tax. Customs revenue fall substantially due to fall in tariff Excise duty less collected because industrial production did not recover rapidly Higher government expenditure due to higher food subsidy in PDS and higher

developmental expenditure Willingness to accept expansionary fiscal policy due to existence of excess capacity

and reduction of inflation

FD after 1993-94

Target for FD in 1994-95 has been set at 6% of GDP In the 1994-95 Budget it was announced that there will be a pre-determined cap on

the extent of monetisation of the Government deficit.Industrial Policy and Foreign Investment

Industrial Policy Change Removing several barriers to entry in the earlier environment Abolition of erstwhile industrial licensing which required Government permission for

new investments as well as substantial expansion of existing capacity Licensing policy only for small list of industries, most of which are subject to

licensing primarily because of environmental and pollution consideration. Example:Coal and Lignite; petroleum; plywood and wood base products; industrial explosive;Drugs and Pharmaceuticals

Investment and expansion by large industrial houses through the Monopolies andRestrictive Trade Practices (MRTP) Act have also been eliminated

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Comprehensive restructuring of the Companies Act which aims at simplifying andmodernising the legal framework governing the corporate sector

Reservation of small scale industries continued due to social reasons but in caseswhere the products have export potential Government has modified policy to allowmedium scale units to enter such areas provided they export at least 50% ofproduction

Industries reserved for public sector has declined and in many critical areas have been

opened up to private sector participation including private participation. Example:Electric power generation; hydrocarbon sector; air transport; telecommunication

Foreign Investment Policy Change Earlier the percentage of equity allowed to foreign investors was generally restricted

to a maximum of 40%, except in certain high technology areas, and foreigninvestment was generally discouraged in the consumer goods sector unlessaccompanied by strong export commitments

The new policy is much more actively supportive of foreign investment Permission is automatically granted for foreign equity investment upto 51% in a large

list of 34 industries. For proposals involving foreign equity beyond 51%, or for

investments in industries outside the list, applications are processed by a high levelForeign Investment Promotion Board

Various restrictions earlier applied on the operation of companies with foreign equityof 40% or more have been eliminated by amendment of the Foreign ExchangeRegulation Act and all companies incorporated in India are now treated alike,irrespective of the level of foreign equity.

Trade and Exchange Rate Policy

Import Policy Import control on raw materials, other inputs into production and capital goods has

been virtually dismantled Imports for consumer goods remain restricted Lowering of customs duty, especially for capital goods. The customs duty has been

lowered from 90-100% in 1991 to a range between 20% to 40% in 1994. The peakrate of customs duty applicable to several items was over 200% in 1991. It has beenlowered to 65% in 1994.

Causes of BOP Crisis Even as exports continued to grow through the second half of the 1980s but by 1990-

91 the export growth slowed down due to slow growth in important trading partners.Export markets in Kuwait and Iraq were also lost

Interest payments and imports rose faster so that India ran consistent current accountdeficits.

There was also an exogenous shock to the economy. The Gulf War led to muchhigher imports bill due to the rise in oil prices.

Also remittances declined and additional burden on repatriation and rehabilitation.

Exchange Rate Policy BOP crisis in 1991. The foreign exchange reserves of India in June 1991 amounted to

little more than $1 billion, enough to finance about three weeks imports (the prudentlevel is generally accepted to be three months imports).

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Devaluation of about 24% in July 1991

India Borrowing from IMF Low reserves Indias recourse to commercial borrowing dried up as the credit rating

agencies down graded India Outflow of non-resident Indian deposits India approached IMF for an accommodation under the Compensatory and

Contingency Financing Facility (CCFF) and first credit tranche. Again higher amount of loan was taken with the promise of continued follow up,

policy reforms in the direction and to the degree required for upper credit tranchearrangements

Compensatory and Contingency Financing Facility The export compensatory element of the CCFF provides timely financing to members

experiencing a temporary shortfall in export earnings or an excess in cereal importcosts, attributable to factors largely beyond the members control. This element of thefacility has been used particularly by commodity exporters. The contingency elementhelps members with IMF arrangements keep their adjustment programs on track

when faced with unexpected adverse external shocks.

Credit TranchesIMF credit is subject to different conditionality and phasing, depending on whether it is madeavailable in the first credit tranche (or segment) of 25 percent of a members quota or inthe upper credit tranches (any segment above 25 percent of quota). For drawings in the firstcredit tranche, members must demonstrate reasonable efforts to overcome their balance ofpayments difficulties. Upper credit tranche drawings are made in installments, or phased, andare released when performance targets are met.

Policy Reform Due to IMF Loan

Macroeconomic StabilisationStructural Reforms

Structural Adjustment Programme (SAP)

Devaluation of rupee by 23%. New Industrial Policy allowing more foreign investments. Opening up more areas for private domestic and foreign investment. Part disinvestment of government equity in profitable public sector enterprises. Sick public sector units to be closed down.

Reforms of the financial sector by allowing in private banks. Liberal import and export policy. Cuts in social sector spending to reduce fiscal deficit. Amendments to the existing laws and regulations to support reforms. Market-friendly approach and less government intervention. Liberalization of the banking system. Tax reforms leading to greater share of indirect taxes

Other Policy Changes Devaluation was accompanied by an abolition of export subsidies

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Increase in export incentives in the form of special incentive licenses (Eximscrips)given to exporters which could be used to import items which were otherwiserestricted

Exchange Rate Policies in 92 and 93

In March 1992 the government decided to establish a dual exchange rate regime andabolish the EXIM scrip system. Under this regime, the government allowed importers

to pay for some imports with foreign exchange valued at free-market rates and otherimports could be purchased with foreign exchange purchased at a government-mandated rate

In March 1993 the government then unified the exchange rate and allowed, for thefirst time, the rupee to float. From 1993 onward, India has followed a managedfloating exchange rate system

Tax Reform

Changes in Tax Policy Maximum marginal rate of personal income tax was reduced from 56% in 1991 to

40% in 1993 Incentive structure for savings in the form of financial assets has been strengthened.

The Wealth Tax, which was earlier applicable to all personal assets, has beenmodified to exempt all productive assets including financial assets such as bankdeposits, shares and other securities .

The rates of corporate income tax, which were 51.75% for a publicly listed companyand 57.5% for a closely held company have been unified and reduced to 46%.

Customs duties were significantly reduced

Indirect Tax on Domestic Manufactured Goods Duties were specific rather than ad valorem Large Number of exemption A system of tax credit for taxes paid on inputs called Modified Value Added Tax or

MODVAT was in force but excluded important sectors such as textiles andpetroleum. Duty credit was also not available on excise duty paid on capital goods atthe time of investment

In Budget 1994 the bulk of the taxes shifted to an ad valorem basis The number of exemptions greatly reduced The coverage of the tax credit for taxes paid on inputs has been extended to include

petroleum and capital goods.

The number of excise duty rates has been reduced from 21 to 10 A start has also been made in extending indirect taxation to a few services by

imposing a 5% tax on telephone bills, premium payments for general insurance andstock brokers' commissions.

Public Sector Policy

Disinvestment of Government equity in public sector companies, with Governmentretaining 51% of the equity and also management control

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Non-inflationary resources for the Government Budget

The emergence of private shareholders in public sector units and trading of publicsector shares in the stock markets are both expected to make public sectormanagements more sensitive to commercial profitability. This is more as Governmenthas decided not to use budgetary resources to finance public sector investment inindustry

Policy for Loss Making Public sector Units

The Government has announced that budgetary support to finance losses will bephased out over three years

Active restructuring of these units wherever it is possible to make them economicallyviable, and with closure combined with adequate compensation for labour where it isnot

Objective process for determining whether a unit should be closed or not has beeninitiated by bringing sick public sector companies under the purview of the Board forIndustrial and Financial Reconstruction (BIFR)

Financial Sector Reforms

Banking System Reform Reduction of statutory liquidity ratio (SLR) and the cash reserve ratio (CRR) Interest rates on Government securities are increasing market determined Earlier the Reserve Bank of India prescribed a number of different interest rates on

deposits of different maturities and also a large number of prescribed lending rates fordifferent sectors and classes of borrowers. Deposit rates for different maturities havenow been freed subject only to a single ceiling. On the lending side the number ofprescribed interest rates for different types of borrowers has been reduced

The Government has announced a programme of contributing fresh capital to the

nationalised banks To mitigate the impact on the Budget it is envisaged that the relatively stronger

nationalised banks with good balance sheets will mobilise additional capital from themarket by issuing new equity to the public. This will improve the commercialviability of the banks

The banking system is also being opened up to competition from new private banks Debt Recovery Tribunal to help facilitate recovery by banks from defaulting

borrowers

Reform in Capital market The requirement of Government permission for companies issuing capital, as well as

the system of Government control over the pricing of new issues of equity by privatecompanies, has been abolished with the repeal of the Capital Issues Control Act inMay 1992.

The Securities and Exchange Board of India (SEBI) has been established as anindependent statutory authority for regulating the stock exchanges and supervising themajor players in the capital markets (brokers, underwriters, merchant bankers, mutualfunds, etc).

Portfolio Investment

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Capital market opened for portfolio investment Favorable tax treatment has been granted to Foreign Institutional Investors (FIIs) to

encourage capital inflows through these routes. Indian companies have been allowed to access international capital markets by

issuing equity abroad through the mechanism of Global Depository Receipts

Labour Market Reforms

Indian labour laws provide a high degree of protection to labour with retrenchment oflabour and closure of an unviable unit requiring prior permission of the StateGovernment for units employing more than 100 workers. So Indian firms lackflexibility. However larger flexibility in labour law may increase unemployment

National Renewal Fund (NRF) would finance compensation payments to labourrendered redundant in the course of public sector restructuring and closure ofunviable units. NRF would also finance retraining programmes to help redeploy oflabour. Finance for NRF would come from Central Government and other aid donors

Implication of Reforms on Agriculture All Central Government restrictions on domestic trade have been removed though

some State Governments restrictions remain Restrictions on agricultural exports have also been reduced significantly though not

as yet fully eliminated Reduction of subsidy in electric power and irrigation and increase in investment in

agricultural sector

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Study Material 9

Some data on Indian economyData and diagram Source: Economic Survey, 2007-08 (website:http://indiabudget.nic.in)

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es-303 economic environment policy 04.05.10

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