Macroeconomic environment ppt babasab patil

Macroeconomic
Environment of Business

Introduction to Macroeconomics

Definitions:
 In the words of Boulding, " Macroeconomics is
that part of economics which studies the overall
averages and aggregates of the system."
 According to Shapiro, "Macroeconomics deals
with the functioning of the economy as a
whole."

Scope & Importance of Macroeconomics
 To understand the working of the
Economy
 Framing Economic Policies
 Study of Unemployment
 National Income
 Economic Growth
 Monetary Problems
 Business Cycles

Objectives of Macroeconomic Policy
 High level of output (GDP)
 Full employment
 Price stability
 Sustainable balance of Payments
 Rapid Economic Growth

Instruments of Macroeconomic
Policy
 Fiscal Policy
 Monetary Policy
 Exchange Rate Policy
 Trade Policy
 Price and Income Policies

Objectives Instruments/Tools
High output level Monetary Policy
Low unemployment rate Fiscal Policy
Stable price level Exchange rate Policy
Maintenance of Balance
of Payments
International Trade Policy
Steady economic growth Price and Income Policy

Basic Concepts in Macroeconomics
 Stock and Flow Concepts:
 A stock variable is measured at a specific point in time
–it signifies the level of a variable at a point in time
 Money supply, consumer price index, unemployment
level and foreign exchange reserves are examples
 A flow variable is measured over a specific period of
time- it represents the change in the level of a variable
over a period of time
 GDP, inflation, exports, imports, consumption and
investments are examples

Economic Environment
Economic stages that exists at a given time in a country
Economic system that is adopted by a country for example.
Capitalistic, Socialistic or Mixed Economy
Economic planning, such as five year plans, budgets, etc.
Economic Indices such as National Income, Per Capital
Income, Disposable Income, Rate of growth of GNP,
Distribution of Income, Rate of savings, Balance of
Payments etc.
Economic policies for example, monetary, industrial and fiscal
policies
Phases of business cycle
Structure of economy

Types of Economic System
Capitalism
Communism/Socialism
Mixed Economy

What is Capitalism?
"Capitalism is a system of economic
organization featured by private ownership
and its use for private profit of man-made and
nature-made capital."

Features of Capitalism
Right to Private Property
Freedom of Enterprise
Freedom of Choice by Consumer
Profit Motive
Competition
Importance of Price System

Socialism
"the important essentials of socialism are
that all the great industries and the land
should be public or collectively owned, and
that they should be conducted (in
conformity with a national economic plan)
for the common good instead of private
profit."

Features of Socialism
Social Ownership of Means of Production
No Private Enterprise
Economic Planning
Classless Society
Consumer is not sovereign

Mixed Economy
Co- Existence of Public and Private Property
Price System and Government Directives
Government Regulates and Controls the
Private Sector
Consumers' sovereignty is protected
Government Protects Labor Interest

Objectives of Five Year Plans
1st Plan (1951-56)
It gave importance to agriculture, irrigation and power projects
to decrease the countries reliance on food grain imports,
resolve the food crisis The focus was to maximize the output
from agriculture, which would then provide the impetus for
industrial growth.
2nd Plan (1956-61)
The second five year plan mainly focused on hydroelectric
projects, steel Mills, production of coal, railway tracks.

Contd..
8th Plan (1992-97)-Post Economic Reforms
The eighth plan was initiated just after a severe balance of
payment crisis, which was intensified by the Gulf war in
1990.several structural modification policies were brought in to put
the country in a path of high growth rate. They were devaluation of
rupees, dismantling of license prerequisite and decrease trade
barriers.
The plan targeted an annual growth rate of 5.6% in GDP and at
the same time keeping inflation under control.

Contd..
9th Plan (1997-2002)
It was observed in the eighth plan that, even though the
economy performed well, the gains did not percolate to the
weaker sections of the society. The ninth plans therefore laid
greater impetus on increasing agricultural and rural incomes
and alleviate the conditions of the marginal farmer and
landless laborers.
The main objectives of the ninth five year plan were
agriculture and rural development, food and nutritional
security, empowerment of women, accelerating growth rates,
providing the basic requirements such as health, drinking
water, sanitation etc.

Contd..
10th Plan (2002-2007)
The aim of the tenth plan was to make the Indian economy the
fastest growing economy in the world, with a growth target of
10%.It wanted to bring in investor friendly market reforms and
create a friendly environment for growth. It sought active
participation by the private sector and increased FDI's in the
financial sector. Emphasis was also on improving the
infrastructure.

Eleventh Five-Year Plan- (2007-
12)
The major objectives of the eleventh five year plan are
income generation, poverty alleviation, education, health,
infrastructure, environment , agriculture etc.
The chief thrust of the plan, that will run from 2007-08 to
2011-12, will be agriculture, education and infrastructure
-- all areas that remain a concern in a rapidly growing
economy.
‘Towards Faster and More Inclusive Growth’ is the
central theme of the plan that seeks to lower poverty by
10%, generate 70 million new jobs, and reduce
unemployment to less than 5%.

What is Union Budget?
The Union Budget gives the details of income and
expenditure planned by the government of India.
Income are those that will be generated by taxation and
expenditure is which that the government is going to make.
Government's expenditure includes money spent on
running various government services, subsidies, interest
charges etc..
The union budget also announces policies and it tells about
the government's economic thinking. It also determines
activities such as exports and foreign direct investment.
The Union Budget has both short and long term effect.

What is an Economic Indicator???
An economic indicator is a statistic about the
economy.
Economic indicators allow analysis of economic
performance and predictions of future
performance.
Nature of Economic indicators can be described in
two ways:
Relation with the economy
Timing

Nature of Economic indicators
Relation to the Business cycle or Economy
Procyclic: A procyclic economic indicator is one that moves in
the same direction as the economy. So if the economy is doing
well, this number is usually increasing, whereas if we're in a
recession this indicator is decreasing. The Gross Domestic
Product (GDP) is an example of a procyclic economic
indicator.
Countercyclic: A countercyclic economic indicator is one that
moves in the opposite direction as the economy. The
unemployment rate gets larger as the economy gets worse so
it is a countercyclic economic indicator.

Nature of Economic indicators
Timing: Economic Indicators can be leading, lagging, or coincident which
indicates the timing of their changes relative to how the economy as a whole
changes.
Leading: Leading economic indicators are indicators which change before the
economy changes. Stock market returns are a leading indicator, as the stock
market usually begins to decline before the economy declines and they
improve before the economy begins to pull out of a recession. Leading
economic indicators are the most important type for investors as they help
predict what the economy will be like in the future.
Examples
Stock price
Housing Markets
Inflation
Interest rates

Contd…
Lagged: trail behind the general economic
activity. Example: Unemployment rate GDP
(sometimes)
Coincident: A coincident economic indicator is
one that simply moves at the same time the
economy does. The Gross Domestic Product is a
coincident indicator.

General Economic Indicators
Total Output, Income, and Spending (GDP, Consumer
Spending)
Employment, Unemployment, and Wages
Production and Business Activity (Index of Industrial
production)
Prices (Inflation rate)
Money, Credit, and Security Markets (Interest rates)
Federal Finance (Fiscal deficit)
International Statistics (BOP status, Exchange rate)

What is National Income??
 It represents the total income accrued to
all factors of production
 Wages + Interest + Rent + Profit

Measures of Aggregate Income
 Gross Domestic Product (GDP)
 Gross National Product (GNP)
 Net National Product (NNP)

Calculating Aggregates
At Market Price
At Factor Cost
Factor costs are really the costs of all the factors of
production such as labor , capital, energy, raw materials like
steel etc that are used to produce a given quantity of output
in an economy.
Factor costs are also called factor gate costs since all the
costs that are incurred to produce a given quantity of goods
and services take place behind the factory gate ie within the
walls of the firms, plants etc in an economy.

Gross Domestic Product
The GDP of a country is defined as the market value of all final
goods and services produced within a country in a given
period of time usually a year
Includes only goods and services purchased by their final
users, so GDP measures final production.
Counts only the goods and services produced within the
country's borders during the year, whether by citizens or
foreigners.
Excludes transfer payments since they do not represent current
production.
It provides the measure of aggregate output and its comparison
over time enables us to calculate the rate of growth (usually
calculated both at current and constant prices)

GDP at Market Price
GDP@ market price = GNP@ factor cost –
Subsidies + Indirect Taxes
GDP@ market price refers to the total final output of
all final goods and services produced within the
national frontiers of a country by its citizens and the
foreign residents who reside within those frontiers that
are sold at market prices in various markets.

GDP at factor Cost
GDP@ factor cost = GDP@ market price + Subsidies -
Indirect Taxes
GDP@ factor cost refers to the total final output of all final
goods and services produced within the national frontiers of a
country by its citizens and the foreign residents who reside
within those frontiers that are assessed at production or
factor cost prior to leaving the irrespective factory gates for
various markets where they are bought and sold.

IMF's GDP forecast same as Govt's:
Arvind Virmani
The International Monetary Fund’s (IMF) recent 9.4% GDP
growth forecast for the current year surprised economy
watchers as its far upbeat version of what the traditionally
pessimistic fund has had to say for the growth of the Indian
economy. The government reacted with caution and said India
would be happy with 8.5% growth.
Explaining the difference Arvind Virmani, India's Executive
Director at the fund said these forecasts were for the calendar
year. “Our forecasts are for GDP at market prices as against
the official forecasts which are for GDP at factor cost,” he said
adding, a 9.4% GDP at market price implies a 8.5% GDP at
factor cost.

Nominal GDP
Nominal GDP is the value of the total flow of
goods and services produced in an economy over
a specified period of time (usually a year] at
current market price
At current prices, GDP growth is partly due to
increase in output and partly due to increase in
prices so that GDP at current prices can give
misleading conclusions on growth

Real GDP
GDP data is also calculated at constant prices
taking the year in the past as base year to filter
our the impact of current prices.
Real GDP is the physical quantity of goods and
services produced in a given period changes in
real GDP measure changes in living standard

Example
Assume economy only produces apples and pears. The
price for an apple is $2 in 2000, whereas the price for a
pear is $3. Same year we produce 100 apples and 50
pears. In 2005, because of the inflation the price for an
apple goes up to $3, whereas the price for a pear is $4 at
the same production levels.
The nominal GDP in 2000 is $350 and the nominal GDP in
2005 is $500. However real GDP did not change, because
real GDP only changes with the changing production level
and therefore is a better size measure for economy.

Gross National Product (GNP)
 Total market value of all final goods and services produced by
citizens of a country no matter where they are residing
 Is total Income received by residents for their contributions as
factors of production anywhere in the world
 GDP measures output within the borders of a country no matter
regardless of citizenship of the producer, GNP measures output of
the country’s citizens regardless where they live
 GNP at factor cost =GDP at factor cost + Net
Income from abroad

Examples - GNP
The income of an Indian working in Bahrain is part of Bahrain's
GDP as well as India's GNP
Suppose Toyota owns a plant in Bahrain to produce Camry's
using Bahraini workers. How to count the product of this plant in
the GDP and GNP of Bahrain and Japan?
With GDP, Bahrain gets all of it, because the plant and the
workers are all located in Bahrain.
With GNP, the capital share goes to Japan

Net National Product
 NNP equals GNP less replacement investment
 NNP = GNP – Depreciation
 This is an estimate of how much the country has to
spend to maintain the current GNP
 If the country is not able to replace the capital stock
lost through depreciation, then GNP will fall.

Contd….
 In addition, a growing gap between GNP and
NNP indicates increasing obsolescence of
capital goods, while a narrowing gap would
mean that the condition of capital stock in the
country is improving.
 NNP at factor cost = GNP at factor
cost- Depreciation which is accurate
measure of National Income

Approaches used to calculate GDP
Production Approach
Income Approach
Expenditure Approach

Expenditure Approach
 Considers total spending on all final goods &
services during the year
 It is a demand based concept
 Includes:
 Personal Consumption
 Durable Goods & Non-Durable Goods and Services
 Gross Private Investment
 Government Consumption and Gross Investment
 Net Exports of Goods and Services
 So, GDP = C + I + G + (X-M)

Income Approach
 Measures by summing the following
components
 Employee Compensation
 Proprietor’s Income
 Corporate Profits
 Rent
 Interest Income
 Indirect Business Taxes
 Net Income from foreigners

Major Limitations of GDP
The GDP fails to measure or express changes in
a nation's:
Quality of life
Unpaid labor
Wealth distribution
Underground economy
Externalities

Money Supply
Money supply is another important indicator of
macroeconomic environment
This refers to the total volume of money circulating in
the economy, and conventionally comprises
currency with the public and demand deposits
(current account + savings account) with the
public.
Money supply in an economy determines liquidity
conditions in the market, which in turn impacts
interest rate structure and hence the cost of capital
to the firms.

Contd..
Money supply is basically determined by the central
bank of a country (e.g. Reserve Bank of India) and
the commercial banking network.
RBI has adopted four measures of money supply viz.-
Ml, M2, M3 and M4 .
M3 (broad money) is most popular from operational
point of view. M3 includes time deposits (fixed
deposits), savings deposits with post office saving
banks and all the components of M1.

Factors affecting Money supply
Bank credit
Deficit financing
Foreign exchange reserves

Inflation
A sustained increase in the general level of prices
so that a given amount of money buys less and
less.
Reasons of inflation
1. inflation caused by monetary expansion
(monetary inflation)
2. inflation caused by real demand expansion
3. inflation caused by aggregate supply
contraction

Money supply & Inflation – Monetary
inflation
It was Milton Friedman who famously
quipped, “Inflation is always and everywhere a
monetary phenomenon.” If the quantity of money
grows at a pace greater than warranted by the
growth of the economy, then the excess money
supply drives up prices.

Types of Inflation
Demand pull inflation: Arises when aggregate demand
outpaces aggregate supply in an economy. It involves inflation
rising as the real gross domestic product rises and
unemployment falls
Cost Push inflation: This is because of large increases in the
cost of important goods or services where no suitable
alternative is available. A situation of this kind has been cited
during oil crisis in 1970s
Hyperinflation: Hyperinflation is also known as runaway
inflation or galloping inflation. This type of inflation occurs
during or soon after a war

Remedies - Real Demand Inflation
If inflation is caused by strong real demand, the best response
may be to support aggregate supply growth. Part of the solution
may be to let prices rise. Suppliers need incentives to invest in
new capacity.
Stimulating aggregate supply include encouraging business
investment; reducing input costs; and increasing competitive
intensity.
If aggregate supply is sufficiently stimulated, inflation may be
converted into balanced economic growth:
If instead money supply is tightened in the face of strong
real demand, the result will be a surge in interest rates,
which may be counterproductive in this case, as it will be
harder for aggregate supply to expand when borrowing

Remedies – Monetary Inflation
If the cause of inflation is instead monetary
expansion, aggregate supply should still be
stimulated, but the focus of effort should be
constraining further monetary expansion.

Real v/s Money Inflation
To distinguish real demand inflation from
monetary inflation is to look at interest
rates. When inflation is caused by strong
real demand, interest rates will tend to be
high. When inflation is caused by excessive
monetary growth, in contrast, interest rates
will tend to be low.

Measurement of Inflation
Inflation is measured by the
Wholesale Price Index (WPI)
Consumer Price Index (CPI)
A Wholesale Price Index (WPI) is the price of a
representative basket of wholesale goods.
Some countries use the changes in this index to
measure inflation in their economies, in particular
India – The Indian WPI figure is released weekly

WPI as a measure of inflation in
India
WPI is preferred to CPI
wider commodity coverage
available on weekly basis
computed at all-India basis
WPI Inflation is divided into three broad categories
Primary Articles
Fuel Products and
Manufacturing Items.

Headline inflation
Headline inflation is a measure of the total inflation within
an economy and is affected by certain components which
may experience sudden inflationary spikes such as food or
energy. As a result, headline inflation may not present an
accurate picture of the current state of the economy.
WPI is the measure of headline inflation in India

Core inflation
Core inflation has emerged as an alternative for measuring
inflation. In this, volatile items like food prices and fuel
items are excluded.
The first two categories include food articles and fuel items
which can be excluded. The third category –
Manufacturing also includes food products which tends to
be volatile as well and moves in line with prices of primary
articles. So after excluding food products from
manufacturing sector, we get non-food manufactured
products inflation. This can also be called as core inflation
for India

Consumer Price Index
CPI, also retail price index is a statistical
measure of a weighted average of prices of a
specified set of goods and services purchased
by wage earners in urban areas. It is a price
index which tracks the prices of a specified set
of consumer goods and services, providing a
measure of inflation.

CPI in India based on different
economic groups.
CPI UNME (Urban Non-Manual Employee)
CPI AL (Agricultural Labourer)
CPI RL (Rural Labourer)
CPI IW (Industrial Worker).
While the CPI UNME series is published by the
Central Statistical Organization, the others are
published by the Department of Labor.

Effects of inflation
Wealth costs – inflation affects those on fixed incomes
and redirects wealth to other (physical) assets
Planning costs – businesses uncertain about future price
changes may be reluctant to invest – hits economic
growth
Competitiveness – inflation at a higher rate in the UK
than elsewhere hits domestic competitiveness and affects
the balance of payments
Social stability - At very high rates, confidence in the
currency is eroded and production and exchange can be
stifled – can lead to food riots, looting and violence

Real & Nominal Interest rates
Real Interest Rate = Nominal Interest Rate –
Inflation
Real interest rate, is one where the effects of
inflation have been factored in. A nominal variable
is one where the effects of inflation have not been
accounted for.

Economic Policies
Monetary Policy
Fiscal Policy
Industrial Policy
Foreign Trade Policy

Monetary policy
Monetary policy is one of the tools used to
influence its economy. Using its monetary
authority to control the supply and availability of
money, a government attempts to influence the
overall level of economic activity in line with its
political objectives. Usually this goal is
"macroeconomic stability" - low unemployment,
low inflation, economic growth, and a balance of
external payments. Monetary policy is usually
administered by a Government appointed "Central
Bank“.

What is Monetary Policy??
It is the process by which the central bank
or monetary authority of a country regulates
(i) the supply of money (ii) availability of
money and (iii) cost of money or rate of
interest in order to attain a set of objectives
oriented towards the growth and stability of
the economy

Monetary policy provides
a) an overview of economy
b) specifies measures that RBI intends to
take to influence such
key factors like…money supply….interest
rates….inflation
c)lays down norms for financial institutions
like banks, financial companies etc. relating
to CRR, capital adequacy

Monetary policy & Inflation
When inflationary pressures build up:
raise the short-term interest rate (the policy
rate)
which raises real rates across the economy
which squeezes consumption and
investment.

Monetary Policy Instruments
Open Market Operations
Bank rate
Cash Reserve Ratio
Statutory Liquidity Ratio
Repo rate
Reverse Repo rate

Open Market Operations
OMOs are the means of implementing
monetary policy by which a central bank
controls the nation’s money supply by
buying and selling government securities, or
other financial instruments

What is the outcome on account of OMO?
When the RBI buys bonds from the market and infuses liquidity,
the consequences are:
It tends to soften the interest rates
It enables corporates to borrow at favorable interest rates
It prevents the rupee from strengthening unnecessarily and
thereby protects the interest of exporters
It may tend to increase inflation
Consequently… If the RBI were to sell bonds
instead and suck in liquidity, the effect
would exactly be the opposite!!

Bank rate
Rate at which Central Bank lends money to
commercial Banks
The bank rate signals the central bank's long-term
outlook on interest rates. If the bank rate moves up,
long-term interest rates also tend to move up, and
vice-versa.
Any increase in Bank rate results in an increase in
interest rate charged by Commercial banks which in
turn leads to low level of investment and low inflation

Cash Reserve Ratio
It refers to the cash which banks have to
maintain with RBI as certain percentage of their
demand and time liabilities
An increase in CRR reduces the cash with
commercial banks which results in low supply of
currency in the market, higher interest rate and
low inflation

Statutory Liquidity Ratio
Commercial Banks have to maintain liquid assets
cash, gold and approved securities equal to not
less than 25% of their total demand and time
deposit liabilities
Objectives of SLR
To restrict expansion of Bank credit
To augment bank’s investment in government
securities
To ensure solvency of banks

Meaning of Repo
 The term Repo is used as an abbreviation for
Repurchase Agreement or Ready Forward. A
Repo involves a simultaneous "sale and
repurchase" agreement.
 It enables collateralized short term borrowing and
lending through sale/purchase operations in debt
instruments

Repo Rate
In current monetary policy RBI raised repo rate by
25 basis points to 5.75%
Repo rate is the interest rate charged by the Central
bank when banks borrow money from it against
pledging its securities
If the RBI wants to make it more expensive for the
banks to borrow money, it increases the repo rate;
similarly, if it wants to make it cheaper for banks to
borrow money, it reduces the repo rate.

Reverse Repo
The rate at which RBI borrows money from the banks (or banks lend
money to the RBI) is termed the reverse repo rate.
If the reverse repo rate is increased, it means the RBI will borrow
money from the bank and offer them a lucrative rate of interest. As a
result, banks would prefer to keep their money with the RBI (which is
absolutely risk free) instead of lending it out (this option comes with a
certain amount of risk)
Consequently, banks would have lesser funds to lend to their
customers. This helps stem the flow of excess money into the
economy
Reverse repo rate signifies the rate at which the central bank
absorbs liquidity from the banks, while repo signifies the rate at
which liquidity is injected.

Importance of Repo & Reverse Repo
 It helps borrower to raise funds at better rates
An SLR surplus and CRR deficit bank can use
the Repo deals as a convenient way of adjusting
SLR/CRR positions simultaneously.
 RBI uses Repo and Reverse repo as instruments
for liquidity adjustment in the system
 Reverse Repo is undertaken to earn additional
income on idle cash.

Major Players in Repos/Reverse Repos
 The major players in the repo and reverse repurchase
market tend to be banks who have substantially huge
portfolios of government securities as approved by
RBI (Treasury Bills, Central/State Govt securities).
 Besides these players, primary dealers who often hold
large inventories of tradable government securities are
also active players in the repo and reverse repo
market.
 DFHI is very active in the Repo Market. It has been
selling and purchasing on repo basis T-Bills and
eligible dated Government Securities.

Call Rate – Short term Inter bank rate
Call rate is the interest rate paid by the banks for
lending and borrowing for daily fund requirement.
Since banks need funds on a daily basis, they lend
to and borrow from other banks according to their
daily or short-term requirements on a regular
basis.

Liquidity Adjustment Facility
A tool used in monetary policy that allows banks to
borrow money through repurchase agreements. This
arrangement allows banks to respond to liquidity
pressures and is used by governments to assure
basic stability in the financial markets.
Liquidity adjustment facilities are used to aid banks in
resolving any short-term cash shortages during
periods of economic instability or from any other form
of stress caused by forces beyond their control.
Various banks will use eligible securities as collateral
through a repo agreement and will use the funds to
alleviate their short-term requirements, thus remaining

Liquidity Adjustment Facility
Objective : The funds under LAF are used by the banks for their day-to-day mismatches in liquidity.
Tenor :Under the scheme, Reverse Repo auctions (for absorption of liquidity) and Repo auctions (for injection
of liquidity) are conducted on a daily basis (except Saturdays).
Eligibility : All commercial banks (except RRBs) and PDs having current account and SGL account with RBI.
Minimum bid Size : Rs. 5 cr and in multiple of Rs.5 cr
Eligible securities: Repos and Reverse Repos in transferable Central Govt. dated securities and treasury
bills.
Discretion to RBI : Under the revised Scheme, RBI will continue to have the discretion to conduct overnight
everse repo or longer term reverse repo auctions at fixed rate or at variable rates depending on market
conditions and other relevant factors. RBI will also have the discretion to change the spread between the repo
ate and the reverse repo rate as and when appropriate. (As per an IMF 1997 publication, “the sale and
epurchase transactions (reverse repo), are sales of assets by the central bank under a contract providing for
heir repurchase at a specified price on a given future date; they are used to absorb liquidity”. On the contrary,
prior to above change, in the Indian context, “repo” denotes liquidity absorption by the Reserve Bank and
reverse repo” denotes liquidity injection).

Highlights of RBI Monetary Policy Review for
first quarter of the financial year FY2010-11
The Bank Rate has been retained at 6.0%
Repo rate increased by 25 bps from 5.5% to 5.75% with
immediate effect
Reverse repo rate increased by 50 bps from 4.0% to 4.50% with
immediate effect
Cash Reserve Ratio (CRR) of scheduled banks has been
retained at 6.0% of their net demand and time liabilities (NDTL)
The projection for WPI inflation for March 2011 has been raised
to 6.0% from 5.5%
Baseline projection of real GDP growth for FY2010-11 is revised
to 8.5%, up from 8.0% with an upside bias

Contd..
The move was aimed to moderate inflation by reining in
demand pressures and reduce the volatility of short-term
rates, RBI governor Subbarao was quoted as saying.
"Inflation is now being significantly driven by demand-side
factors," Subbarao said. "It is imperative that we continue in the
direction of normalizing our policy instruments to a level
consistent with the evolving growth and inflation scenarios."
The RBI said that the Monetary Policy actions are expected
to:
Moderate inflation by reining in demand pressures and inflationary
expectations.
Maintain financial conditions conducive to sustaining growth.
Generate liquidity conditions consistent with more effective transmission
of policy actions.

Public Finance
and
Fiscal Policy

Public Finance
 Study of State Finance is called Public Finance
 Deals with the income and expenditure of central, state
and local governments.
 Raising of necessary funds for incurring expenditure for
public goods constitutes the subject matter of Public
Finance
 Components of Public Finance
 Public Revenue
 Public Expenditure
 Public Debt
 Fiscal Policy

Meaning of Fiscal Policy
 Fiscal policy is also called Budgetary policy. It is
primarily concerned with the receipts and
expenditures of the Central government; it also
relates to the study of economic effects of these
receipts and expenditures
 Fiscal policy refers to government policy that
attempts to influence the direction of the economy
through changes in taxation, public borrowing and
public expenditure with specific objectives in view.

Contd..
 Changes in the level and composition of taxation
and government spending can impact on the
following variables in the economy:
 Aggregate Demand and the level of
economic activity
 The pattern of resource allocation
 The distribution of income.

Importance of Fiscal Policy –Post Great
Depression
 The ineffectiveness of monetary policy as a means of
overcoming the severe unemployment of the Great
Depression
 The development of the new economics by Keynes with
its emphasis on aggregate demand. Fiscal policy is
based on the theories of British economist John Maynard
Keynes. Also known as Keynesian Economics, this theory
basically states that governments can influence
macroeconomic productivity levels by increasing or
decreasing tax levels and public spending. This influence, in
turn, curbs inflation (generally considered to be healthy
when at a level between 2-3%), increases employment and
maintains a healthy value of money.

Main Concern of Fiscal Policy in
LDCs
 Development
 Allocation of resources for development
 Reduction in economic inequality
 Inducing savings and investment
 Control of inflation
 Reduction in regional inequalities

Budget
 The main instrument of fiscal policy is the budget,
presented annually by the Minister of finance to
Parliament.
 Budget means ‘plans of government finances submitted
for the approval of the Legislature’
 It is a time bound financial program systematically
worked out and ready for execution in the ensuing
fiscal year. It is a comprehensive plan action which
brings together in one consolidated statement all
financial requirements of the government.

Budget has four major Functions-
Prof Musgrave
 Proper allocation of resources or the
provision of social goods
 Equitable distribution of income and wealth
 Securing economic stability or full
employment
 Long term economic growth

Public Revenue :Major Sources For
Centre
Revenue Receipts Capital Receipts
Tax revenue: Direct Taxes
 Income Tax
 Corporate Tax
 Wealth Tax
Indirect Taxes
 Customs
 Excise
 Others
 Market Borrowing-internal debt
 Disinvestment of PSUs
 Recoveries of loans
 Borrowing from external markets
External loans/Debts from world
institutions
Non tax Revenue
 Interest receipts
 Dividend
 Profits of PSUs
 Revenue from social services like
education and hospitals
 External Grants

Public Revenue :Major Sources For
States
Revenue Receipts Capital Receipts
Tax revenue
 land revenue,
 stamp duties and registration fees,
 Urban immovable property tax
Indirect Taxes
 Sales tax on goods
 Entertainment tax
 Luxury tax
 Market Borrowing
 Loans which flow from Centre
 Interest receipts
 Dividend from state enterprises
 Share in Central taxes
 Grants in aid from Centre
 And other contributions from Centre
Like those given for central schemes

Public Expenditure
Revenue Expenditure Capital Expenditure
Plan Expenditure
Central Plan such as agriculture,
rural development, social service
and others
Central Assistance for plans to
States and UTs
Plan Expenditure
Developmental Projects
Non – Plan Expenditure
Interest Payments
Subsidies
Debt relief to farmers
Grant to states and UTs
Others
Non – Plan Expenditure
Loans to PSUs
Loans to states and UTs
Defense

Meaning of Public Debt
 It represents government borrowing from public.
 Government debt can be categorized as internal debt,
owed to lenders within the country, and external debt,
owed to foreign lenders.
 Internal Debt is comprised of market borrowings,
special securities issued to RBI, Provident funds, Small
savings collections, Treasury bills, Ways and Means
Advances
 Government Borrowing leads to Crowding out effect

Crowding out Effect
 In economics, when the government expands its borrowing to
finance increased expenditure, crowding out occurs of
private sector investment by way of higher interest rates
 If increased borrowing leads to higher interest rates by
creating a greater demand for money and loanable funds and
hence a higher "price" (ceteris paribus), the private sector,
which is sensitive to interest rates will likely reduce investment
due to a lower rate of return. This is the investment that is
crowded out.
 More importantly, a fall in fixed investment by business can
hurt long-term economic growth of the supply side, i.e., the
growth of potential output.

Features of Public Debt
 Size of debt has been on increase
 Internal debt constituted a larger
proportion in first and Second Plans and
position was reversed in Third Plan
where external loans contributed to a
larger proportion
 However from 4th
till 10th
plans greater
reliance has been placed on internal
borrowings
 Market Borrowings form a significant

Indicators of Fiscal Imbalances
 Revenue Deficit
 Fiscal Deficit

Revenue Deficit
 Current revenue expenditure of the central
government is composed of plan and non-
plan expenditure of the government.
Revenue expenditure is met out of current
revenue receipts
Revenue Deficit = Revenue expenditure –
Revenue receipts

Fiscal Deficit
 It is the difference between the
government's total receipts (excluding
borrowing) and total expenditure. Fiscal
deficit gives the signal to the government
about the total borrowing requirements
from all sources.
 Components of fiscal deficit
 revenue deficit and
 capital expenditure.

Fiscal Deficit
In India, the fiscal deficit is financed by
obtaining funds from Reserve Bank of India,
called deficit financing. The fiscal deficit is
also financed by obtaining funds from the
money market (primarily from banks)

Methods of raising funds or
financing Deficit
 Borrowing from market or external
sources
 Government may print currency or govt
issue adhoc treasury bills to RBI(deficit
financing)

Ad hoc Treasury bills
 Under this old system started in 1955 government was
allowed to draw money from RBI automatically and to
an unlimited extent
 It stipulated that whenever the government’s cash
balances with went below Rs 50 crore adhoc treasury
bills would be issued to raise the cash balance Rs 50
crore. It became an attractive source of financing since
it was available at interest rate of 4.6% since 1974
 However over a period of time the limit got extended to
an ever increasing amount
 According to C.Rangarajan this operational
arrangement opened up the floodgates of automatic
monetization which changed the entire course of
monetary history for the next 40 years

Monetized Deficit
 It is net increase in net Reserve Bank
credit to Central government which is
sum of increase in RBI’s holdings of govt
of India dated securities, treasury bills,
rupee coins and loans and advances
from Reserve Bank to Centre since April
1, 1997

Ways and Means Advances-New
Scheme
 Under the new scheme RBI provides facilities for
temporary accommodation up to a ceiling fixed
in advance
 The limit for WMA and rate of interest on WMA
will be mutually agreed to between the Reserve
Bank and govt from time to time
 The credit thus drawn has to be repaid or in
technical language Govt vacates WMA from time
to time.
 As a result WMA will be reduced to zero at the
end of financial year

 Scheme of Ways and Means Advances (WMA) to
State Governments for the fiscal year 2007-08
On a review of the State-wise limits of Normal Ways
and Means Advances for the year 2006-07, the
Reserve Bank of India has decided to keep these limits
unchanged for the year 2007-08. Accordingly, the
aggregate Normal WMA limit would be retained at
Rs.9,875 crore in 2007-08. Other terms and conditions
of the Scheme would also continue to remain
unchanged for 2007-08.

Deficit Financing in India
 In first plan it was modest at Rs 333 crore
 Second Plan to Rs 954 crore
 Third- 1,133 crore
 Fourth – 2060
 Fifth- 15684 crore
 Eight plan – 33,037 crore

The FRBM Act, 2003
It became effective from July 5, 2004
eliminate revenue deficit by March, 2009
and
to reduce fiscal deficit to an amount
equivalent to 3 per cent of GDP by
March,2008.

BUDGET ESTIMATES 2010-11
The Gross Tax Receipts are estimated at Rs. 7,46,651 crore
The Non Tax Revenue Receipts are estimated at Rs. 1,48,118 crore.
The total expenditure proposed in the Budget Estimates is Rs.
11,08,749 crore, which is an increase of 8.6 per cent over last year.
The Plan and Non Plan expenditures in BE 2010-11 are estimated at
Rs. 3,73,092 crore and Rs. 7,35,657 crore respectively. While there is
15 per cent increase in Plan expenditure, the increase in Non Plan
expenditure is only 6 per cent over the BE of previous year.
Fiscal deficit for BE 2010-11 at 5.5 per cent of GDP, which works out
to Rs.3,81,408 crore.
Taking into account the various other financing items for fiscal deficit,
the actual net market borrowing of the Government in 2010-11 would
be of the order of Rs.3,45,010 crore. This would leave enough space
to meet the credit needs of the private sector.

Fiscal Consolidation- Budget
-2010 -11
With recovery taking root, there is a need to review public
spending, mobilize resources and gear them towards
building the productivity of the economy.
Fiscal policy shaped with reference to the
recommendations of the Thirteenth Finance Commission,
which has recommended a calibrated exit strategy from
the expansionary fiscal stance of last two years.
It would be for the first time that the Government would
target an explicit reduction in its domestic public debt-GDP
ratio.

Meaning of Business Cycle
 The business cycle or economic cycle refers to the
fluctuations of economic activity about its long term growth
trend.
 The cycle involves shifts over time between periods of relatively
rapid growth of output (recovery and prosperity), and periods of
relative stagnation or decline (contraction or recession).
 Phases of Business Cycle
 Prosperity
 Recession
 Depression
 Recovery

Prosperity Phase
 Unemployment rate declines
 Income tends to rise
 Investment increases
 Investors become more optimistic
 Consumption tends to rise
 Share price index tends to rise
 Money Supply increases

Recessionary Phase
 Recession is turning point ie when
prosperity ends recession begins
 Liquidation in stock market, fall in prices
are symptoms
 Banks & People try to gain greater
liquidity so credit sharply contracts
 Business expansion stops

Depression Phase
 Shrinkage in volume output
 Rise in level of unemployment
 Fall in aggregate demand
 Contraction of Bank credit
 Fall in prices

Recovery Phase
 Rise in demand for consumption goods
which in turn lead to demand for capital
goods and new investment is induced
 This will give rise to increase in income
and employment

Macroeconomic environment ppt babasab patil

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