INTERMEDIATE COURSE

STUDY MATERIAL

PAPER : 8B
Economics for Finance

BOARD OF STUDIES
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

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This study material has been prepared by the faculty of the Board of Studies. The
objective of the study material is to provide teaching material to the students to
enable them to obtain knowledge in the subject. In case students need any
clarifications or have any suggestions to make for further improvement of the
material contained herein, they may write to the Director of Studies.
All care has been taken to provide interpretations and discussions in a manner useful
for the students. However, the study material has not been specifically discussed by
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may not be taken to necessarily represent the views of the Council or any of its
Committees.
Permission of the Institute is essential for reproduction of any portion of this
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© The Institute of Chartered Accountants of India

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Edition : September, 2021

Website : www.icai.org

E-mail : bosnoida@icai.in

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Institute of Chartered Accountants of India, ICAI
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BEFORE WE BEGIN….

Evolving Role of a CA - Shift Towards Strategic Decision Making

The traditional role of a chartered accountant restricted to accounting and

auditing, has now changed substantially and there has been a marked shift
towards strategic decision making and entrepreneurial roles that add value
beyond traditional financial reporting. The primary factors responsible for the
change are the increasing business complexities on account of a plethora of laws,
borderless economies consequent to giant leap in e-commerce, emergence of
new financial instruments, emphasis on corporate social responsibility, significant
developments in information technology, to name a few. These factors
necessitate an increase in the competence of chartered accountants to take up
the role of not merely an accountant or auditor, but a global solution provider.
Towards this end, the scheme of education and training is being continuously
reviewed so that it is in sync with the requisites of the dynamic global business
environment; the competence requirements are being continuously reviewed to
enable aspiring chartered accountants to acquire the requisite professional
competence to take on new roles.

Skill Requirements at Intermediate Level

At the Intermediate Level, you are expected to not only acquire professional
knowledge but also the ability to apply such knowledge in problem solving.
Learning outcomes which you need to demonstrate after learning each topic have
been detailed in the first page of each chapter/unit. Demonstration of these
learning outcomes would help you to achieve the desired level of technical
competence. The process of learning should also help you inculcate the requisite
professional skills, i.e., the intellectual skills and communication skills, necessary
for achieving the desired professional competence.

Economics for Finance : Dynamic & Interesting

The dynamic nature of the economic variables that influence decision making at
various levels necessitates a comprehensive understanding of the behavioural
patterns of economic entities. Therefore, of late, the tools of Economics have
gained wide application in nearly all areas of business and finance. It has thus
become increasingly important that our accounting and finance professionals be

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equipped with practical knowledge of the institutional framework and analytical

tools of Economics to enable them to make sense of the multitude of arguments
and information that emerge almost daily.

Framework of Chapters – Uniform Structure Comprising of Specific Component

The content of the course of study ‘Economics for Finance’ is devised by

incorporating the currently relevant subject matter of Macro Economics, Public
Finance, Monetary Theory and International Economics. Since this course is
framed to meet the functional requirements of accounting professionals, the
concepts and principles in this material are explained in a lucid and non-technical
manner with appropriate illustrations from the latest available sources relating to
the current economic and financial environment. The blend of theory and its
contextualization with stress on clarity of exposition intend to facilitate learners to
move beyond a mere understanding of the subject toward a level of analyzing
and evaluating current and future developments in the economy. From a
managerial perspective, this would provide coherent foresight and logical
judgment and contribute towards strategic policy formulation.
The study material is organized in four chapters. Chapter 1 explains in two units
the concept of National Income and its measurement and the conventional
Keynesian theory of determination of national income. Chapter 2 examines the
fiscal role of governments, the nature of market failures, the rationale of
government interventions to correct market failures and the application of fiscal
policy to ensure economic stability. Chapter 3 deals with the role of money in the
financial system, its demand and supply and governments’ use of monetary policy
to achieve and maintain economic stability. With the objective of enlightening
the students on the international economic phenomena emanating from global
integration and interdependence, chapter 4 is entirely devoted to International
Economics. The chapter begins with a discussion on popular theories of
international trade and then explores the use and welfare effects of various
instruments of trade policy. Separate units discuss trade negotiations and aspects
related to multilateral trade agreements and the exchange rate policies chosen by
national governments and their economic effects. An entire unit is devoted to
expound patterns of international capital movements and the outcomes of
foreign investments.
The learning outcomes put across at the beginning of each unit help orient the
learners to focus on key concepts. The end of the chapter summaries are intended
to integrate the discussions in the units. The sample questions appended with

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each chapter, though not exhaustive in coverage, are expected to provide crucial
guidelines for preparation for examinations. The glossary at the end of the book
intends to provide a quick review of the major concepts to the learners.
The learners are requested to keep themselves updated on the wide-ranging
changes that occur in the economic arena in view of the lack of feasibility of
instantly incorporating them in the study material. Your valuable suggestions to
improve the contents and /or use of pedagogical devices would be appreciated.

Happy Reading and Best Wishes!

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SYLLABUS
PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS
FOR FINANCE
(One paper – Three hours – 100 Marks)

SECTION B : ECONOMICS FOR FINANCE (MARKS: 40)

Objective:
To develop an understanding of the concepts and theories of Economics in the
context of Finance and acquire the ability to address application oriented issues.
1. Determination of National Income
(i) Macro Economic Aggregates and Measurement of National Income
(ii) The Keynesian Theory of Determination of National Income
2. Public Finance
(i) Fiscal functions: An Overview.
(ii) Market Failure
(iii) Government Interventions to Correct Market Failure
(iv) Fiscal Policy
3. The Money Market
(i) The Concept of Money Demand: Important Theories of Demand for
Money
(ii) The Concept of Money Supply
(iii) Monetary Policy
4. International Trade
(i) Theories of International Trade
(ii) Trade Policy – The Instruments of Trade Policy
(iii) Trade Negotiations
(iv) Exchange Rates and its economic effects
(v) International Capital Movements: Foreign Direct Investment

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CONTENTS
CHAPTER 1 – DETERMINATION OF NATIONAL INCOME

UNIT I - National Income Accounting ...................................................................................... 1.1

1.1 Introduction.............................................................................................................................. 1.2
1.2 Usefulness and Significance of National Income Estimates .................................. 1.2
1.3 Different Concepts of National Income ......................................................................... 1.4
1.4 Measurement of National Income in India ................................................................ 1.19
1.5 The System of Regional Accounts in India ................................................................. 1.32
1.6 GDP & Welfare ...................................................................................................................... 1.33
1.7 Limitations and Challenges of National Income Computation .......................... 1.34
Summary ................................................................................................................................. 1.35

UNIT II - The Keynesian Theory of Determination of National Income ...............1.51

2.1 Introduction............................................................................................................................ 1.51
2.2. Circular Flow in a Simple Two-Sector Model............................................................. 1.53
2.2. Basic Concepts & Functions ............................................................................................. 1.55
2.4 The Two-Sector Model of National Income Determination ................................ 1.61
2.5 The Investment Multiplier ................................................................................................. 1.72
2.6 Determination of Equilibrium Income: Three Sector Model ................................1.78
2.7 Determination of Equilibrium Income: Four Sector Model .................................. 1.85
2.8 Conclusion .............................................................................................................................. 1.93
Summary ................................................................................................................................. 1.93

CHAPTER 2 – PUBLIC FINANCE

UNIT I - Fiscal Functions: An Overview ...........................................................2.1

1.1 Introduction.............................................................................................................................. 2.2

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1.2 The Role of Government in an Economic System...................................................... 2.3

1.3 The Allocation Function ....................................................................................................... 2.4
1.4 Redistribution Function ....................................................................................................... 2.8
1.5 Stabilization Function ............................................................................................................. 2.10

1.6 Conclusion .............................................................................................................................. 2.12

Summary ................................................................................................................................. 2.12

UNIT II - Market Failure .................................................................................................... 2.22

2.1 Introduction ................................................................................................................ 2.23
2.2 The Concept of Market Failure ............................................................................... 2.24
2.3 Why Do Markets Fail................................................................................................ 2.25
2.4 Public Goods ............................................................................................................ 2.31
2.5 Incomplete Information ........................................................................................... 2.41
2.6 Conclusion .................................................................................................................. 2.44
Summary ..................................................................................................................... 2.44

UNIT III - Government Interventions to Correct Market Failure .............................. 2.60

3.1 Government Intervention to Minimize Market Power ........................................... 2.62
3.2. Government Intervention to Correct Externalities ................................................... 2.63
3.3 Government Intervention in the Case of Merit Goods .......................................... 2.71
3.4 Government Intervention in the Case of Demerit Goods ..................................... 2.73
3.5 Government Intervention in the Case of Public Goods ......................................... 2.75
3.6 Price Intervention: Non-Market Pricing...................................................................... 2.76
3.7 Government Intervention for Correcting Information Failure............................. 2.78
3.8 Government Intervention for Equitable Distribution.............................................. 2.79
Summary ................................................................................................................................. 2.79

UNIT IV - Fiscal Policy .................................................................................................................... 2.92

4.1 Introduction............................................................................................................................ 2.93

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4.2. Objectives of Fiscal Policy .................................................................................................2.94

4.3 Automatic Stabilizers Versus Discretionary Fiscal Policy....................................... 2.94
4.4 Instruments of Fiscal Policy .............................................................................................. 2.97
4.5 Types of Fiscal Policy ................................................................................................... 2.104
4.6 Fiscal Policy For Long-Run Economic Growth ...................................................... 2.109
4.7 Fiscal Policy for Reduction in Inequalities of Income and Wealth.................. 2.109
4.8 Limitations of Fiscal Policy ............................................................................................. 2.111
4.9 Conclusion ........................................................................................................................... 2.113
Summary .............................................................................................................................. 2.115

CHAPTER 3 – MONEY MARKET

UNIT I - The Concept of Money Demand: Important Theories ................................... 3.1

1.1 Introduction .................................................................................................................. 3.2
1.2 Functions of Money .................................................................................................... 3.3
1.3 The Demand for Money ............................................................................................ 3.6
1.4 Theories of Demand for Money ............................................................................... 3.7
1.5 Post-Keynesian Developments in the Theory of Demand for
Money .......................................................................................................................... 3.14
1.6 Conclusion .................................................................................................................. 3.18
Summary ..................................................................................................................... 3.19

UNIT II - The Concept of Money Supply ............................................................................... 3.30

2.1. Introduction............................................................................................................................ 3.31
2.2 Rationale of Measuring Money Supply ....................................................................... 3.32
2.3 The Sources of Money Supply ........................................................................................ 3.32
2.4 Measurement of Money Supply ..................................................................................... 3.33
2.5 Determinants of Money Supply...................................................................................... 3.36
2.6 The Concept of Money Multiplier .................................................................................. 3.36

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2.7 The Money Multiplier Approach to Supply of Money ........................................... 3.38

2.8 Effect of Government Expenditure on Money Supply ........................................... 3.44
Summary ................................................................................................................................. 3.48

UNIT III - Monetary Policy ........................................................................................................... 3.61

3.1. Introduction............................................................................................................................ 3.62
3.2 Monetary Policy Defined ................................................................................................... 3.62
3.3 The Monetary Policy Framework .................................................................................... 3.62
3.4 The Organisational Structure for Monetary Policy Decisions.............................. 3.74
3.5 Conclusion .............................................................................................................................. 3.76
Summary ................................................................................................................................. 3.79

CHAPTER 4 – INTERNATIONAL TRADE

UNIT I - Theories of International Trade ...................................................................... 4.1

1.1 Introduction .................................................................................................................. 4.2
1.2 Important Theories of International Trade............................................................. 4.6
Summary ..................................................................................................................... 4.16

UNIT II - The Instruments of Trade Policy ........................................................................... 4.28

2.1 Introduction............................................................................................................................ 4.29
2.2. Tariffs ........................................................................................................................................ 4.31
2.3 Non -Tariff Measures (NTMs) .......................................................................................... 4.36
2.4 Export-Related Measures .................................................................................................. 4.42
Summary ................................................................................................................................. 4.43

UNIT III - Trade Negotiations ..................................................................................................... 4.55

3.1 Introduction............................................................................................................................ 4.56
3.2. Taxonomy of Regional Trade Agreements (RTAs) ................................................... 4.56
3.3 The General Agreement on Tariffs and Trade (GATT) ............................................ 4.59
3.4 The Uruguay Round and the Establishment of WTO ............................................. 4.60

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3.5 The World Trade Organization (WTO) ......................................................................... 4.61

3.6 The Doha Round .................................................................................................................. 4.68
3.7 25 Years of the WTO Acheivements and Concerns................................................. 4.62
Summary ................................................................................................................................. 4.74

UNIT IV - Exchange Rate and Its Economic Effects ......................................................... 4.83

4.1 Introduction............................................................................................................................ 4.83
4.2 The Exchange Rate .............................................................................................................. 4.84
4.3 The Exchange Rate Regimes ............................................................................................ 4.85
4.4 Nominal Versus Real Exchange Rates .......................................................................... 4.90
4.5 The Foreign Exchange Market......................................................................................... 4.91
4.6 Determination of Nominal Exchange Rate ................................................................. 4.93
4.7 Changes in Exchange Rates.............................................................................................. 4.94
4.8 Devaluation Vs Depreciation ........................................................................................... 4.97
4.9 Impacts of Exchange Rate Fluctuations on Domestic Economy ........................ 4.97
Summary .............................................................................................................................. 4.103

UNIT V - International Capital Movements ...................................................................... 4.115

5.1 Introduction ............................................................................................................ 4.116
5.2 Types of Foreign Capital .................................................................................... 4.116
5.3 Foreign Direct Investment (FDI) ...................................................................... 4.117
5.4 Foreign Portfolio Investment (FPI) ................................................................. 4.119
5.5 Reasons for Foreign Direct Investment ........................................................ 4.120
5.6 Modes of Foreign Direct Investment (FDI) .................................................. 4.124
5.7 Benefits of Foreign Direct Investment .......................................................... 4.124
5.8 Potential Problems Associated with Foreign Direct Investment ......... 4.115
5.9 Foreign Direct Investment in India (FDI) .................................................... 4.130
5.10 Overseas Direct Investment by Indian Companies ................................... 4.132
Summary .................................................................................................................. 4.133
GLOSSARY ............................................................................................... I.1 - I.21

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