MACROECONOMICS

UNIT 1

ISSUES IN MACROECONOMICS
Macroeconomic seeks to analyze those problems that affect eh economy as a whole; such
problems cannot be adequately studied with reference to an individual product, firm or
industry. For example, the effect of introduction of new technology (say computers) is not
limited to a single product or industry also, it will affect the structure of economic activity in
the economy as a whole; it will affect the rate of economic growth; it will affect the level of
employment (or unemployment); it will affect the general price level; it will affect the country’s
balance of payments, etc. All those problems and issues that affect the economy as a whole are
studied in macroeconomics.

We present a brief view of the major macroeconomic issues as follows:

Economic Growth
Although traditionally macroeconomics has focused on output gap and has sought to explain
the factors that cause divergence between potential GDP and actual GDP (i.e. GDP gap), in
more recent times, macroeconomics has also sought to identify the forces that help an economy
raise the level of potential output. Increase in the level of potential output constitutes economies
growth, and forms an important issue in macroeconomics.
Business Cycles
Macroeconomic activity, in the long history of nations, has never followed a smooth trend;
economic activity faces uptrends and downtrends, almost in a cyclical regularity.
These cyclical uptrends and downtrends are known as business cycles. The various phases of
a business cycle are identified as (1) boom, (2) recession, (3) depression, and (4) slump.
The various phases have been illustrated in. AB lime shows the normal trend line. A movement
from A to C takes the economy away from its normal trend. This constitutes boom. When
recession sets in, economy moves down-hill (from C to D); if the downtrend is not arrested,
economy may get caught in slump (or what is also called depression). E to F represents the
recovery phase.
This cyclical behavior of economic activity has always attracted the attention of practitioners
of macroeconomics. As a matter of fact, it was the great depression of 1930s that gave birth to
modern macroeconomics, in a form that came to be known the Keynesian Revolution.
Inflation
Inflation can be defined as a sustained rise in the general price level. It has been the experience
the world over that a rise in GDP has generally been accompanied by an increase in the general
price level. Normally, a moderate inflation has been consider a necessary condition of
economic growth. But frequently rising general price level went out of control and reached
astonishing limits. The phenomenon of inflation (and its converse deflation) is conventionally
analyzed in macroeconomics.
Unemployment
Another experience common to most of the economies in the world, developed and developing
alike, has been that the rate of creation of new job opportunities has lagged behind the demand
for jobs. As a result, apart of the labour force remains unemployed. This non-utilization of
available resources in the economy represents a deadweight loss. Macroeconomics ahs been
trying to seek a lasting solution to this perennial problem.
Government Budget Deficits
Government has been traditionally spending more than what they could earn by way of taxes
and sale of economic goods and services produced by them. The resultant deficit (variously
known as budget deficit or fiscal deficit) could be financed by mobilization of capital by way
of loans. An excess of government expenditure over revenue enabled it to create more jobs and
thereby help the economy generate more income. But this way of financing government
expenditure has many other implications, many of these may prove adverse: (i) budget deficit
may prove inflationary, especially if the economy fails to generate more output; (ii) a large part
of domestic savings may be cornered by the government; adequate savings may not be
available for private investment; and (iii) this may put pressures on market rates of interest.
Macroeconomics has been paying more attention to these issues in recent years.
Interest Rates
In the globalizing world of today, interest rates have come to occupy centre stage. Globalization
implies cut-throat competition. Successful globalization requires that all the actors work to
their best efficiency; none of them would like to be competed out because they have to pay
high rates of interest. Therefore, how to keep interest rates low is the issue that has attracted
the attention of economists.
Balance of Payments
Again, in the globalizing, increasingly free market economies, goods, services and capital are
flowing across national borders as never before. The cross-border transactions in goods,
services and capital given rise to payments and receipts in foreign exchange. Exchange rates,
wherever they are left to be determined by market forces, exert their own influence on
international economic reactions. Therefore, a proper analysis of balance of payments has been
a core issue in macroeconomics.
GNP
Gross national product (GNP) is an estimate of the total value of all the final products and
services turned out in a given period by the means of production owned by a country's residents.
GNP is commonly calculated by taking the sum of personal consumption expenditures, private
domestic investment, government expenditure, net exports, and any income earned by
residents from overseas investments, minus income earned within the domestic economy by
foreign residents. Net exports represent the difference between what a country exports minus
any imports of goods and services.
GNP is related to another important economic measure called gross domestic product (GDP),
which takes into account all output produced within a country's borders regardless of who owns
the means of production. GNP starts with GDP, adds residents' investment income from
overseas investments, and subtracts foreign residents' investment income earned within a
country
GNP measures the total monetary value of the output produced by a country's residents.
Therefore, any output produced by foreign residents within the country's borders must be
excluded in calculations of GNP, while any output produced by the country's residents outside
of its borders must be counted.1 GNP does not include intermediary goods and services to
avoid double-counting since they are already incorporated in the value of final goods and
services
he Difference Between GNP and GDP
GNP and GDP are very closely related concepts, and the main differences between them come
from the fact that there may be companies owned by foreign residents that produce goods in
the country, and companies owned by domestic residents that produce goods for the rest of the
world and revert earned income to domestic residents.
For example, there are a number of foreign companies that produce goods and services in the
United States and transfer any income earned to their foreign residents. Likewise, many U.S.
corporations produce goods and services outside of the U.S. borders and earn profits for U.S.
residents. If income earned by domestic corporations outside of the United States exceeds
income earned within the United States by corporations owned by foreign residents, the U.S.
GNP is higher than its GDP.
GNP In India: In financial year 2021, the gross national income at current prices in India was
estimated to amount over 190 trillion Indian rupees, a decrease from the previous year. It was
the first time during the last decade, that the gross national income decreased. Nevertheless, its
value was still higher than in 2019.
CONCEPT OF MACROECONOMICS
Macroeconomics is the study of the behavior of the economy as a whole. This is different from
microeconomics, which concentrates more on individuals and how they make economic
decisions. While microeconomics looks at single factors that affect individual
decisions, macroeconomics studies general economic factors.
Macroeconomics is very complicated, with many factors that influence it. These factors are
analyzed with various economic indicators that tell us about the overall health of the economy.

GROSS DOMESTIC PRODUCT (GDP)

Output, the most important concept of macroeconomics, refers to the total amount of goods
and services a country produces, commonly known as the gross domestic product (GDP).
This figure is like a snapshot of the economy at a certain point in time.
When referring to GDP, macroeconomists tend to use real GDP, which takes inflation into
account, as opposed to nominal GDP, which reflects only changes in price. The nominal GDP
figure is higher if inflation goes up from year to year, so it is not necessarily indicative of higher
output levels, only of higher prices.
The one drawback of GDP is that information has to be collected after a specified time period
has passed, a figure for the GDP today would have to be an estimate. GDP is nonetheless a
stepping stone into macroeconomic analysis. Once a series of figures is collected over a period
of time, they can be compared, and economists and investors can begin to decipher business
cycles, which are made up of the periods alternating between economic recessions (slumps)
and expansions (booms) that occur over time.
From there we can begin to look at the reasons why the cycles took place, which could be
government policy, consumer behavior, or international phenomena among other things. Of
course, these figures can be compared across economies as well. Hence, we can determine
which foreign countries are economically strong or weak.
Based on what they learn from the past, analysts can then begin to forecast the future state of
the economy. It is important to remember that what determines human behavior and ultimately
the economy can never be forecasted completely.
India's economy expanded by 8.4 percent year-on-year in July-September 2021, following a
record 20.1 percent growth in the previous three-month period and matching market
expectations. The reading marked a fourth straight quarter of expansion, as coronavirus-related
disruptions continued to ease and as the economic activity rebounded helped by a faster pace
of vaccinations and a drop in cases. By sectors, service activity growth was supported by
increases in trade, hotels, transport & communication (8.2% vs 34.3%), financial, real estate &
professional services (7.8% vs 3.7%), and public administration, defense & other services
(17.4% vs 5.8%). In addition, output rose for manufacturing (5.5% vs 49.6%), mining &
quarrying (15.4% vs 18.6%), utilities (8.9% vs 14.3%), construction (7.5% vs 68.3%), and
agriculture (4.5%, the same as in July-September). The Reserve Bank of India has forecast
annual growth of 9.5 percent in the current
THE UNEMPLOYMENT RATE
The unemployment rate tells macroeconomists how many people from the available pool of
labor (the labor force) are unable to find work.
Macroeconomists agree when the economy witnesses growth from period to period, which is
indicated in the GDP growth rate, unemployment levels tend to be low. This is because with
rising (real) GDP levels, we know the output is higher and, hence, more laborers are needed to
keep up with the greater levels of production.
Inflation as a Factor
The third main factor macroeconomists look at is the inflation rate or the rate at which prices
rise. Inflation is primarily measured in two ways: through the Consumer Price Index (CPI) and
the GDP deflator. The CPI gives the current price of a selected basket of goods and services
that is updated periodically. The GDP deflator is the ratio of nominal GDP to real GDP.
If nominal GDP is higher than real GDP, we can assume the prices of goods and services has
been rising. Both the CPI and GDP deflator tend to move in the same direction and differ by
less than 1%.
India Inflation Rate Lower than Expected
The annual inflation rate in India edged up to 4.91% in November of 2021 from 4.48% in
October, below forecasts of 5.1%, but stayed within the RBI's target range of 2%-6% for a 5th
straight month. Food inflation jumped to a 3-month high of 1.87%, with oil and fats recording
the biggest price increase (29.67%) while prices of vegetables declined (-13.62%). Cost also
accelerated for housing (3.66% vs 3.54% in October) but slowed for fuel and light (13.35% vs
14.35%), namely transport and communication (10.02% vs 10.9%) and health (7.33% vs
7.57%).

Demand and Disposable Income

What ultimately determines output is demand. Demand comes from consumers (for investment
or savings, residential and business-related), from the government (spending on goods and
services of federal employees), and from imports and exports.
Demand alone, however, will not determine how much is produced. What consumers demand
is not necessarily what they can afford to buy, so to determine demand, a consumer's disposable
income must also be measured. This is the amount of money left for spending and/or
investment after taxes.
To calculate disposable income, a worker's wages must be quantified as well. Salary is a
function of two main components: the minimum salary for which employees will work and the
amount employers are willing to pay to keep the employee. Given demand and supply go hand
in hand, salary levels will suffer in times of high unemployment, and prosper when
unemployment levels are low.
Demand inherently will determine supply (production levels) and an equilibrium will be
reached. But in order to feed demand and supply, money is needed. A country's central bank
(the Federal Reserve in the U.S.) typically puts money in circulation in the economy. The sum
of all individual demand determines how much money is needed in the economy. To determine
this, economists look at the nominal GDP, which measures the aggregate level of transactions,
to determine a suitable level of the money supply.

What the Government Can Do

There are two ways the government implement macroeconomic policy. Both monetary and
fiscal policy are tools to help stabilize a nation's economy. Below, we take a look at how each
works.
Monetary Policy
A simple example of monetary policy is the central bank's open market operations. When there
is a need to increase cash in the economy, the central bank will buy government bonds
(monetary expansion). These securities allow the central bank to inject the economy with an
immediate supply of cash. In turn, interest rates—the cost to borrow money—are reduced
because the demand for the bonds will increase their price and push the interest rate down.3 In
theory, more people and businesses will then buy and invest. Demand for goods and services
will rise and, as a result, the output will increase. To cope with increased levels of production,
unemployment levels should fall and wages should rise.
On the other hand, when the central bank needs to absorb extra money in the economy and
push inflation levels down, it will sell its T-bills. This will result in higher interest rates (less
borrowing, less spending, and investment) and less demand, which will ultimately push down
the price level (inflation) and result in less real output.2
Fiscal Policy
The government can also increase taxes or lower government spending in order to conduct
a fiscal contraction. This lowers real output because less government spending means less
disposable income for consumers. And, because more consumers' wages will go to taxes,
demand will also decrease.
A fiscal expansion by the government would mean taxes are decreased or government spending
is increased. Either way, the result will be growth in real output because the government will
stir demand with increased spending. In the meantime, a consumer with more disposable
income will be willing to buy more.
A government will tend to use a combination of both monetary and fiscal options when setting
policies that deal with the economy.
The Bottom Line
The performance of the economy is important to all of us. We analyze the economy by
primarily looking at the national output, unemployment, and inflation. Although it is
consumers who ultimately determine the direction of the economy, governments also
influence it through fiscal and monetary policy.
UNEMPLOYMENT RATE
The unemployment rate is the percent of the labor force that is jobless. It is a lagging indicator,
meaning that it generally rises or falls in the wake of changing economic conditions, rather
than anticipating them. When the economy is in poor shape and jobs are scarce, the
unemployment rate can be expected to rise. When the economy is growing at a healthy rate and
jobs are relatively plentiful, it can be expected to fall.
3 Negative Effects That Affect A Countrys Economy
1.Low unemployment makes recruitment and retention more difficult
This first negative impact that can result from low unemployment is a bit more obvious than
the others: When jobs are plentiful and more employees are finding stable work, the pool of
candidates applying for open positions shrinks.
At the same time, organizations may see an increase in employee turnover when workers have
ample opportunities at their fingertips. Simply put, employees can afford to be choosey when
it comes to finding new positions that might better suit their wants and needs.
2.Low unemployment often results in lost productivity
Economists have determined that when unemployment reaches unprecedented lows, the labor
market can reach a point where each additional job added doesn’t generate enough productivity
to cover its cost. Every subsequent job will contribute to a scenario where what an economy
actually produces diverges from what it has the potential to produce — known by many as the
“output gap.”
The output gap rises and falls alongside the economy. In simple terms, a negative output gap
means the economy’s resources are being underutilized. Conversely, a positive output gap
means the market is over-utilizing resources, and the overall economy becomes inefficient.
Productivity can also take a hit if employers aren’t offering competitive wages in the midst of
the tight labor market. This inevitably results in hiring teams filling vacancies with less-
qualified candidates.
3.Low unemployment could mean another recession is coming
The last time we saw unemployment rates as low as they are today was in 1969, when President
Richard Nixon was still in office. While unemployment fell to 3.5 percent in December 1969,
it shot back up to 6.1 percent a year later. The conditions back then, many note, closely mirror
what we’re seeing now. After a historically long economic expansion, the American economy
fell into a recession — although a mild one.
Unemployment Rate In India
India's unemployment rate reached a four-month high of 7.91% in December as compared to
7% and 7.75 per cent in November and October 2021. The unemployment rate hit its highest
rate since 8.3% in August.
The urban unemployment rate rose to 9.30% in December while rural employment stood at
7.28%. Both urban and rural unemployment saw significant rise from 8.21% and 6.44%,
respectively, in the previous month.
The rise in unemployment has been attributed to muted economic activity and consumer
sentiment, which has been dented due to the rise of Covid-19 cases after the emergence of
Omicron variant across the world.
Meanwhile, a study conducted recently has revealed that unemployment and coronavirus are
the top worries among urban Indians. Around 70% urban Indians also believe the country is
moving in the right direction, according to findings of the Ipsos What Worries the World global
survey for December. Indians, however, worry about unemployment with concerns around job
security topping their list.
CIRCULAR FLOW

 Real Flow

Real flows depict the way that commodities and products & services are produced and
consumed in the economy.

 Money Flow

Money flows depict the way that money and credit circulate in the economy as
income turns into savings and investment and back again
Example
Suppose a person provides 5 acres of land on rent to a company, for which he receives ₹
1,00,000 every month as rent. It indicates a money flow of ₹ 1,00,000 as factor income, from
the company to the person, and at the same time there is a flow of factor of production (land)
of the equal amount from the person to the company, indicating the real flow. So, we can say
that the situation prevails in the whole economy.
From slide 36 its consumer price index

GROSS NATIONAL SAVINGS

Gross national saving is gross disposable income less final consumption expenditure after
taking account of an adjustment for pension funds. [SNA 1993] For many countries, the
estimates of national saving are built up from national accounts data on gross domestic
investment and from balance of payments-based data on net foreign investment.
The national savings rate is the GDP that is saved rather than spent in an economy.
It is calculated as the difference between a nation's income and consumption divided by
income.
The national savings rate is an indicator of a nation's health as it shows trends in savings, which
lead to investments.
Household savings can be a source of borrowing for governments to provide funds for public
works and infrastructure needs.
Calculating the National Savings Rate
The first factor in calculating the national savings rate is the national income and product
accounts. This is provided by the Bureau of Economic Analysis, which categorizes the private
and public sector's money as income, consumption, and savings.

FACTORS AFFECTING THE NATIONAL SAVINGS RATE

The collective spending behaviors of households and public and private entities can swiftly
affect the direction of the national savings rate. Even if incomes rise, if the consumption rate
also increases, the savings rate will not improve, and in some cases, it may even decline.
Retirement plans, such as 401(k)s and IRAs, represent a large portion of savings that contribute
to investments. These are not considered cost outlays and are thus included in the national
savings rate. A negative perception can occur among individuals that the overall returns
generated by retirement programs will generate more than enough income for their retirement,
leading to households not saving more of their income, which would, in turn, reduce the
potential of a higher national savings rate.
There may also be government-backed pension programs for retirement, paid for through
taxation of those who currently work. This can contribute to a trend of less money being saved
by households in anticipation of benefiting from such programs.
In instances where households do not have access to subsidized retirement funds, they must
focus on setting aside more of their own money for retirement, which would subsequently
elevate the national savings rate.
When measured as a percentage of the gross domestic product saved by households, the
national savings rate can be used as a barometer for growth in a country.

GROSS CAPITAL FORMATION

As per RBI, Gross capital formation refers to the ‘aggregate of gross additions to fixed assets
(that is fixed capital formation) plus change in stocks during the counting period.’ Fixed asset
refers to the construction, machinery and equipment.
Capital formation is a term used to describe the net capital accumulation during
an accounting period for a particular country. The term refers to additions of capital goods,
such as equipment, tools, transportation assets, and electricity. Countries need capital goods
to replace the older ones that are used to produce goods and services. If a country cannot
replace capital goods as they reach the end of their useful lives, production declines.
Generally, the higher the capital formation of an economy, the faster an economy can grow
its aggregate income.
How Capital Formation Works
Producing more goods and services can lead to an increase in national income levels. To
accumulate additional capital, a country needs to generate savings and investments from
household savings or based on government policy. Countries with a high rate of household
savings can accumulate funds to produce capital goods faster, and a government that runs
a surplus can invest the surplus in capital goods.
Example of Capital Formation
As an example of capital formation, Caterpillar (CAT) is one of the largest producers of
construction equipment in the world. CAT produces equipment that other companies use to
create goods and services. The firm is a publicly traded company, and raises funds by issuing
stock and debt. If household savers choose to purchase a new issue of Caterpillar common
stock, the firm can use the proceeds to increase production and to develop new products for
the firm’s customers. When investors purchase stocks and bonds issued by corporations, the
firms can put the capital at risk to increase production and create new innovations for
consumers. These activities add to the country's overall capital formation.
Gross Capital Formation In India
Gross capital formation (% of GDP) in India was reported at 29.28 % in 2020, according to the
World Bank collection of development indicators, compiled from officially recognized
sources. India - Gross capital formation (% of GDP) - actual values, historical data, forecasts
and projections were sourced from the World Bank on January of 2022. Gross capital
formation (formerly gross domestic investment) consists of outlays on additions to the fixed
assets of the economy plus net changes in the level of inventories. Fixed assets include land
improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases;
and the construction of roads, railways, and the like,including schools, offices, hospitals,
private residential dwellings, and commercial and industrial buildings. Inventories are stocks
of goods held by firms to meet temporary or unexpected fluctuations in production or sales,
and "work in progress." According to the 1993 SNA, net acquisitions of valuables are also
considered capital formation.

Leading Indicators
Leading indicators are a heads-up for economists and investors who hope to anticipate trends.
Bond yields are thought to be a good leading indicator of the stock market because bond traders
anticipate and speculate about trends in the economy. However, they are still indicators, and
are not always correct.
New housing starts also are a leading indicator. If housing starts rise, it means builders are
optimistic about the demand in the near future for newly constructed homes. If housing starts
fall, builders are getting cautious. That's a sign that home sales are slowing, or at least that
builders fear they soon will.
The overall money supply, which is tracked by the federal government, is a more complex
leading indicator. Generally, if there is plenty of money out there, in consumers' pockets, in
bank accounts, and in bank vaults ready to be invested in business expansion, it's a signal that
the economy will be strong.
for example; the percentage of people wearing hard hats on a building site is a leading safety
indicator. A lagging indicator is an output measurement, for example; the number of accidents
on a building site is a lagging safety indicator. The difference between the two is a leading
indicator can influence change and a lagging indicator can only record what has happened.

Lagging Indicators
Lagging indicators can only be known after the event, but that doesn't make them useless. They
can clarify and confirm a pattern that is occurring over time. The unemployment rate is one of
the most reliable lagging indicators. If the unemployment rate rose last month and the month
before, it indicates that the overall economy has been doing poorly and may well continue to
do poorly.
The Consumer Price Index (CPI), which measures changes in the inflation rate, is another
closely watched lagging indicator. There are few events that cause more economic ripple
effects than price increases. Both the overall number and prices in key industries like fuel or
medical costs are of interest.
If we want to know how many sales have been made this month, we simply count them. If we
want to know how many accidents have occurred on the factory floor, we consult the accident
log. These are lag indicators. They are an after-the-event measurement, essential for charting
progress but useless when attempting to influence the future.
COINCIDENT INDICATORS
Coincident indicators are analyzed and used as they occur. These are key numbers that have a
substantial impact on the overall economy.
Personal income is a coincident indicator of economic health. Higher personal income numbers
coincide with a stronger economy. Lower personal income numbers mean the economy is
struggling. The gross domestic product (GDP) of an economy is also a coincident indicator.
Coincident indicators define the business cycles of the economy. This means that they are the
primary indicators that are used to define whether the economy is in a recession or expansion
in a given quarter, a process known as business cycle dating.
Coincident indicators do not typically reflect present economic conditions but report on data
from the recent past. Different coincident indicators may have a long or short lag time between
the reported indicator and the real underlying phenomenon that the indicator is meant to
measure. These lags occur because it takes time to collect, tabulate and report the data, and can
range from anywhere between one day and up to one year (for final or revised data).
For example, if an upsurge in solar panel manufacturing is reported, it may show the effect
that incentive programs for alternative energy sources are having. Payroll data can show the
kind of recent demand companies have had for employees and their levels of productivity. If
salaries have increased from a comparable period, it may indicate that companies are lately
engaging in more business, seeing increased revenue, and can afford to pay higher salaries to
attract skilled workers.
Referring to current payroll data as a coincident indicator can also show the capacity that
employees have to spend money back into the economy. Increases in salary could allow
for flexible expenses to increase, as well as create the potential for luxury expenditures. This
would show that the economy has been robustly productive recently and which segments of it
are expressing the most strength and stability.
Difference between the indicators
 Leading indicators are considered to point toward future events.
 Lagging indicators are seen as confirming a pattern that is in progress.
 Coincident indicators occur in real-time and clarify the state of the economy.

IIP

Index of Industrial Production (IIP) is an index that shows the performance of different
industrial sectors of the Indian economy.
The IIP is estimated and published on a monthly basis by the Central Statistical Organisation
(CSO). As an all-India index, it gives general level of industrial activity in the economy.
According to the CSO. “It is a composite indicator that measures the short-term changes in the
volume of production of a basket of industrial products during a given period with respect to
that in a chosen base period.”
Importance of Index of Industrial Production
The IIP is used by public agencies including the Government agencies/ departments including
that in the Ministry of Finance, the Reserve Bank of India etc. for policy purposes. The all-
India IIP data is used for estimation of Gross Value Added of Manufacturing sector on quarterly
basis.
Similarly, the data is also used extensively by analysts, financial intermediaries and private
companies for various purposes.
Data collection for IIP
The IIP is constructed by the CSO using secondary data. Data is sourced from 14 source
agencies in various Ministries/Departments. But the major source of data for IIP is the
Department of Industrial Policy and Promotion that supplies data for 322 out of 407 item
groups with a weight of 47.54% in overall IIP.
IIP is released every month in the form of Quick Estimates with a time-lag of 6 weeks as per
the norms of IMF.
Components of IIP
The IIP is basically divided into three sectors though a use-based classification is also provided
by the CSO.
The UNSD recommends inclusion of Mining & Quarrying; Manufacturing; Electricity, Gas
steam and Air-conditioning supply; as well as Water supply, Sewerage, Waste management
and Remediation activities in IIP. But due to constraints of the data availability on monthly
basis, the modified IIP has been limited to Mining, Manufacturing and Electricity sectors only.
Following are the three sectors of the IIP as per the revision based on 2011-12 series.
(i) Mining,
(ii) Manufacturing and
(iii) Electricity
Besides the main classification of the index into three sectors ie., mining, manufacturing and
electricity sectors, the IIP is also prepared based on Use based classification. Here, the
industries are divided into six use-based sectors:

 Primary Goods,
 Capital Goods,
 Intermediate Goods,
 Infrastructure/ Construction goods,
 Consumer durables and
 Consumer nondurables.
Core industries in the IIPThe Eight Core Industries comprise 40.27 % of the weight of items
included in the Index of Industrial Production (IIP). These industries are: Coal, Crude Oil,
Natural Gas, Refinery Products, Fertilizers, Steel, Cement and Electricity.
 MANUAL ON COMPILATION OF
INDEX NUMBER OF WHOLESALE PRICES IN INDIA

About the Price Index

The price index is an indicator of the average price movement over time of a fixed basket of
goods and services. The constitution of the basket of goods and services is done keeping in to
consideration whether the changes are to be measured in retail, wholesale, or producer prices
etc. The basket will also vary for economy-wide, regional, or sector specific series. At present,
separate series of index numbers are compiled to capture the price movements at retail and
wholesale level in India. There are four main series of price indices compiled at the national
level. Out of these four, Consumer Price Index for Industrial Workers (CPI-IW), Consumer
Price Index for Agricultural Labourers/Rural Labourers (CPI-AL/RL), Consumer Price Index
for Urban Non-Manual Employees (CPI-UNME) are consumer price indices. The Wholesale
Price Index (WPI) number is a weekly measure of wholesale price movement for the economy.
Some states also compile variants of CPI and WPI indices at the state level
WPI is also compiled by many states covering state level wholesale transactions. Presently
WPI series compiled are Assam (base 1993-94),Bihar (1991-92), Haryana (1980-81),
Karnataka (1981-82), Punjab (1979-82), U.P.(1970-71) and West Bengal (1980-81). Most of
the state series are cover agricultural commodities only
Step-wise introduction to compilation of WP
Like most of the price indices, WPI is based on Laspeyres formula for reason of practical
convenience. Therefore, once the concept of wholesale price is defined and the base year is
finalized, the exercise of index compilation involve finalization of item basket, allocation of
weights (W) at item, groups/ sub-groups level. Simultaneously, the exercise to collect base
prices (Po), current prices (P1), finalization of item specifications, price data sources, and data
collection machinery is undertaken. These steps are discussed in detail in the following
sections:
1)Concept of Wholesale Prices:
Wholesale price has divergent connotations adopted by the different departments using them.
There is no uniform definition for agricultural and non agricultural commodities as all the
wholesale prices can not be collected from the established markets

Agricultural commodities: In practice, there are three types of wholesale markets viz.,
primary, secondary and terminal in the agricultural sector. The price movements and price
levels in all three vary. Price movement in the terminal market may tend to converge toward
the retail prices Option o collect the wholesale prices for these three different stages of
wholesale transactions exists for agricultural commodities though the primary market is
prepared.
Ministry of Agriculture has defined wholesale price as the rate at which relatively large
transaction of purchase, usually for further sale, is effected. Various state agencies concerned
with the collection of wholesale prices of agricultural commodities are following the concept
of Ministry of Agriculture. However, there are certain variation with regard to inclusion or
exclusion of incidental charges, duties and taxes, For e.g., in Andhra Pradesh, the wholesale
prices include incidental charges such as weighment charges, cost of bags and sales tax. In
Gujarat, the wholesale prices are inclusive of packing charges and taxes. In Punjab and Tamil
Nadu. the wholesale prices are inclusive of incidentals. In Haryana, the wholesale prices for
agriculture commodities exclude taxes but include arat, weighment and the lorry charges,
whereas, non-agricultural products include sales tax, etc.
Non-agricultural commodities: For non-agricultural commodities, which are predominantly
manufacturing items, the problem arises, as there are no established sources in markets. This
is true of mining and fuel items also. The issue of ex-factory vis-à-vis wholesale prices for non-
agriculture items have been discussed by the successive Working Groups set up for the revision
of WPI and all have reached the conclusion that in practice, it is not feasible to collect wholesale
prices for most of the manufacturing items It has also been observed that the margin of
wholesalers in case of non-agricultural commodities remains unchanged for over a long period
of time. As a result, it is felt that the trends in the index compiled on the basis of ex-factory
prices would not be much different from the index if compiled on the basis of wholesale prices
if it were feasible to get these prices The last Working Group has recommended collecting
wholesale prices from the markets as far as possible, because the economy is moving towards
globalisation and open trade with inputs increasing in the commodities set
The wholesale price as defined for WPI: The concept of wholesale price adopted in practice
represent the quoted price of bulk transaction generally at primary stage. The price pertaining
to bulk transaction of agricultural commodities may be farm harvest prices, or prices at the
village mandi market of the Agricultural Marketing Produce Committeel procurement prices,
support prices. For manufactured goods the wholesale prices are administered prices, ex-
factory gate/ex-mill, ex-mine level. Ex-factory prices exclude rebate if any, other taxes and
levies are excluded though excise duty is currently included.
Wholesale price and producer price: The wholesale price as defined above differs from
producer (output) prices as the latter excludes all kind of taxes and transport charges. In 1993
SNA, Producer(output) price is defined as the amount receivable by the producer from the
purchaser for a unit of a good or service produced as output minus VAT or similar deductible
tax, invoiced to the purchaser. It excludes any transport charges invoiced separately. It excludes
any transport charges invoiced separately by the producer. However, the producer (input)
prices include retail or wholesale margins
2) Choice of Base
Year The well known criteria for the selection of base year are (i) a normal year ie. a year in
which there are no abnormalities in the level of production, trade and in the price level and
price variations, (ii) a year for which reliable production price and other required data are
available and (iii) a year asrecent possible and comparable with other data series at national
and state level. The National Statistical Commission has recommended that base year should
be revised every five year and not later than ten years.
3) Selection of Items, Varieties/ Grades, Markets:
To ensure that the items in the index basket are as best representatives as possible, efforts are
made to include all the important items transacted in the economy during the base year. The
importance of an item in the free market will depend on its traded value during the base year.
At wholesale level, bulk transactions of goods and services need to be captured. As the services
are not covered so far, the WPI basket mainly consists of items from goods sector, in the
absence of single source of data on traded value, the selection procedures followed for
agricultural commodities and non-agricultural commodities have also been different.
Agricultural commodities: As there is a little scope of emergence of new commodities in the
agriculture, the selection of new items in the basket is done on the basis of increased importance
in wholesale markets, Varieties, which have declined in importance, need to be dropped in the
revised series. Final inclusion or exclusion of an item in the basket is based on the process of
consultation with the various departments. The exercise of adding /deleting commodities,
specifications and markets is completed once the consultation process is over. In the existing
WPI series, items, their specifications and markets have been finalized in consultation of with
the Directorate of E&S (M/O Agriculture), National Horticulture Board, Spices Board, Tea
board, Coffee Board and Rubber Board, Silk Board, Directorate Of Tobacco, Cotton
Corporation of India etc.
Mining Items: For deciding on the inclusion and exclusion of mineral items, their grades,
market centers etc. suggestions of Indian Bureau of Mines are taken into account.
Specifications of coal, coke and lignite have been decided in consultation with the Department
of Coal. Likewise for selection of petroleum products the Ministry of Petroleum is consulted
and for electricity suggestions are taken from Central Electricity Authority.
Manufactured Products: Selection of items from manufacturing sector, as a whole is the most
tedious and time taking process. To ensure complete coverage, selected items have to represent
not only the organized manufacturing sector but also vast informal sector

1. Organized Manufacturing Sector Regular time series data on value of production are
available through Annual Survey of Industries covering factory sector. The criterion for
selection of items has been based on the cut off traded value of a product during the
base year. The traded value of a product is the sum total value of output as per ASI base
year+ Excise duty+ Imports during base year- Exports during the base year. WPI 1993-
94 adopted a cut off traded value of Rs. 120cr. All possible efforts are made to establish
a proper concordance between the NIC classification adopted in ASI and ITC (HS)
classification for imports and exports quantum. The problem of concordance arises in
case of textile items and for this segment, the selection of items has been done with the
help of Office of the Textile commissioner. Some of the items may not feature in the
final basket even though the traded value is above the cut off point. This may be due to
poor specifications or non-availability of regular deta source for continuous pricing
2. Unregistered/unorganized manufacturing sector: Units falling in this sector add
substantial portion to the total manufacturing production in the economy. Unorganized
manufacturing sector covers traditional sectors like handlooms, sericulture, coir, khadi
and village industries and modem segments like SSI and power looms. Further the
small-scale sector encompasses both organized and unorganized segments of the
 manufacturing sector. But for informal sector, all encompassing time series data on
value of production are not available. In the past, Working groups have made efforts to
pool value of production data from disparate sources like results of surveys on Own
Account Enterprise (OAE),Directory Manufacturing Establishment (DME) and Non-
Directory Manufacturing Establishment (NDME), Economic Census and its follow up
surveys and Census of Registered SSI units. The last Working group could not use these
data sources mainly because it found the data available either farther from the chosen
base year or were incompatible. However, some items from silk coir, power looms and
handlooms based were included on the suggestions of agencies responsible for these
segments.
The selection of specification/ grade variety in respect of manufactured products as also
the selection of sources for supplying regular price data is done with help of production
data. Selection of data sources is done on subjective sampling basis. For each item, a
list of 10 major manufacturers/ producers is prepared and efforts are made to seek
willing cooperation from the top five manufacturers for regular supply of weekly
wholesale price quotations. Data collection is done on conditions of confidentiality. At
least five price quotations in respect of representative grades are included in the index.
In case there are less then five manufacturers of an item, then all the units are raped in
to furnish the price date
4) Derivation of Weighting Diagram:

Weights used in the WPI are value weights not quantity weights as its difficult to assign
quantity weights. Distribution of the appropriate weight to each of the item is most important
exercise for reliable index. Unlike consumer price indices, where weights are derived on the
basis of results of Expenditure Surveys, several sources of data are used for derivation of
weights for WPI
Because of non-availability of updated Supply and Use Table (SUT), the approach, finding
favour with the successive Working groups, is based on top down stratified compartmentalized
system. Under this approach, weights are first assigned at Major group level from outside with
due account made for exclusion of services from the total value of transactions in the economy.
This method for weighting diagram represents more accurately structural changes at higher
level of aggregation. Further, compartment system also ensures that wherever data for a more
recent year are available they can be used, while in other compartments data from more distant
year can be achieved. This has also made it possible to use different sets of data sources for
agricultural and manufacturing items.
Weights of Agriculture commodities: For building of the weights of agricultural
commodities, the data on sale of agricultural commodities is not available as there is large
number of markets. Therefore, to arrive at the approximate traded value of agricultural
commodities; an indirect method of arriving such estimates is used. These weights are based
on the Marketed value (MV) arrived at by multiplying Marketed Surplus Ratio (MSR) to the
estimates of Value Of Production (VOP) of agricultural commodities. The estimates of VOP
are based on the estimates of quantity of production, as brought out by the Directorate of
Economics and Statistics(DES), and an average price of a commodity
The ratio of quantity marketed to quantity produced gives the MSR.

The estimates of MSRS are based on the results of Comprehensive Scheme on Cost of
Cultivation of DES and other sources. The Directorate of Marketing and Inspection, MO
Agricultural, is also responsible to generate MSRs
In practice MSRS are worked out on the basis of production value of three years average
production to remove the bias on account of fluctuation in individual commodity and over all
production. No estimates of MSRS are available in the case of new items of fruits, vegetables
and flowers, and these are finalized separately by the working group, based on the related crops.
MSRs of flowers and meat items are kept 100 considering that production of these is mainly
for market sale
Manufactured items: As discussed above, the traded value of manufactured products ie, total
production excise duty- imports - exports value for the year are worked out from various
sources. Final weights of each item is based on its traded value plus pro rata imputed traded
value of items which need to be excluded from the basket due to various reasons.

In the current series traded value of items falling under 'Other manufacturing' have been
imputed amongst other items in the remaining sub-groups of 'Manufactured products' as there
was only one item featuring above the cut-off mark. Retaining it would have led to extreme
fluctuations. Similarly weight of crude petroleum was distributed pro rata amongst fuel items,
as procuring its wholesale prices was not possible.
5) Collection of Prices;
In WPI pricing methodology used is specification pricing. Under this, in consultation with the
identified source agencies, precise specifications of all items in the basket are defined for repeat
pricing every week. All characteristics like make, model, features along with the unit of sale,
type of packaging, if applicable, etc are recorded and printed in the price collection schedule.
At the time of scrutiny of price data all these are kept in mind. This pricing to constant quality
technique is the cornerstone of Laspeyres formula. In case of changes in quality and
specifications, due adjustments are made as per the standard procedures.
The collection of base prices is done concurrently while the work on finalisation of index basket
is on. Therefore, price collection is normally done for larger number of items pending
finalisation. Once the basket is ready, current prices are collected only as per the final basket
from the designated sources. Weekly prices need to be collected for pre-determined day of the
week. For the current senes prices are quoted on the basis of the prevailing prices of every
Friday. Agricultural wholesale prices are for bulk transactions and include transport cost. Non-
agricultural prices are ex-mine or ex-factory inclusive of excise duty but exclusive of rebate if
any.
6) Treatment of prices collected from open market & administered prices:
There are some items which constitute part of index baskets but the prices for these items are
either totally administered by the Government or are under dual pricing policy The issue of
using administered prices for index compilation is resolved by taking into account appropriate
ratio between the levy and non-levy portions. Where these ratios are not available, the issues
can be resolved through taking the appropriate number of price quotations of the administered
prices and the open market prices after periodic review:
Due to variation in quality and different price movements of the commodities belonging to
unorganized sector, separate quotations from organized and unorganized units have to be taken
and merged based on the turnover value of both the sectors at item level. For pricing from
unorganized sector, adequate number of price quotations has to be drawn out of the list of units
by criteria of share of production as far as possible
7) Classification structure
The Working Groups over the period have been suggesting to bring the classification of various
items under different groups and sub-groups as per the latest revised National Industrial
Classification (NIC) which in turn is comparable to International Standard Industrial
Classification (ISIC). The classification based on NIC renders the WPI data amenable to
comparison with the Index of Industrial Production (IP) and National Income data.

The grouping and classification of WPI is also useful for in depth analysis as separate inflation
rates can be worked out for groups with items whose prices are given to extreme fluctuations,
affected by international prices or have administered prices. Apart from the headline inflation
based on WPI, core inflation, manufactured products inflation, primary articles inflation etc.
can be easily computed. The classification structures adopted in the WPI (1993-94) series is as
below:
The classification of manufactured products' is similar to the classification adopted in the index
of Industrial Production (IP) except that the sub group of Other Manufacturing has not been
retained and its traded value has been imputed in to remaining sub-groups
8) Methodology of Index Calculation
Actual index compilation is done in stages, though due to computerization now, the machines
do all complex calculations. In the first stage, once the price data are scrutinized, price relative
for each price quote is calculated Price relative is calculated as the ratio of the current price to
the base price multiplied by 100 ie. (P₁/P0)X100. Assigning weights at quotations level is
difficult, as it needs detailed data
In the next stage, commodity item level index is arrived at as the simple arithmetic average of
the price relatives of all the varieties (each quote] included under that commodity. An average
of price ratio relative is used under implicit assumption that each price quotation collected for
an item/commodity index compilation has equal importance ie the shares of production value
is equal Where as if the ratio of average prices is adopted instead, the implicit assumption
would be that importance of each price quotation depends on its price level in the base period
and all the quantities produced are equal. Since quantities produced at unit level are not equal
the average of price relatives method is preferred to arrive at tem level index in WPI
Next the indices for the sub groups/groups/ major groups are compiled and the aggregation
method is based on Laspeyres formula as below:

The e weights are value weights. Aggregation is first done at sub-group and group level. All
commodities index is compiled by aggragating Major group indices
9) Handling of the Seasonal Commodities
There are number of agriculture items, especially some fruits and vegetables, which are of
seasonal nature. When a particular seasonal item items on pro rata basis with in the sub-group
of vegetables or fruits. The underlying assumption is that if the items remained available, the
prices of these items would have moved in the same proportion as the prices of the other items
in the sub-group, which did remain available. This is equivalent to giving a greater weight to
the remaining items. The seasonality problem can be sorted by adopting other mathods like, i)
prices of unavailable disappears from the market and its prices are not available because of its
being out of season, the weights of such item is imputed amongst the other tems can also be
extrapolated forward from the period of availability or ii) if such seasonal Item has insignificant
weight it can be taken permanently from the basket etc.
10) Procedure for Estimation for Non-response and Data Substitution
As the series grow older, many of the items in the basket tend to disappear from the market, or
item specification may change or the source agency may no longer manufacture the item
 a. If the source agency stops manufacturing and the item is still available in the market,
then efforts are made to locate and fix another representative source producing item
with matching specification.

b. In case no suitable substitute is available, the weight of the item is imputed to similar
other item or among other items of the sub-group/group. The criterion for imputation
is that the price movement of the outgoing item and the item to which weight is
imputed similar. Imputation of weight is not a long-term solution and ultimately
replacement has to be effected
c. .In case item with different specifications need to be taken in the basket as a substitute
then the new price and old price is linked by splicing

Substitution and replacement: First of all it should be ensured that the prices of both the price
quotations, outgoing quotation (old price) and incoming quotation (new price) are collected
concurrently for some time and respective price movements observed for any extreme variation
Splicing is done by working out a ratio (linking coefficient) of concurrent price quotations and
multipled by the base price as below:

Price relatives and worked out by dividing the current price with the updated base price.
Splicing can be done other way round, wherein, linking coefficient can be worked out by
dividing old price (outgoing quote) with the new price (incoming quote) and multiplied by the
current price
In WPI the substitution is effected from the date final indices are compiled. The effective date
and the splicing ratio are documented properly.
11) Provisional Vs Final:
Primary objective of WPI is to bring out an estimate of headline inflation for the economy.
Because of late receipt of price data part of the price data cannot be utlized as the WPI is
released on weekly basis. The weekly indices are compiled after a short gap of two weeks only
as compared to other Indices, indices, which are compiled on monthly basis. The WPI are,
therefore released provisionally and final revised indices, incorporating all possible quotations,
are released after a gap of two months.
12) Data collection mechanism
At present data collection for WPI is solely based on voluntary basis, Price data pertaining to
'Primary articles and Fuel & petroleum products are mainly collected through administrative
Ministries/Departments PSUs and state government Departments For Manufactured products,
apart from some government sources, data collection is done through Chambers of Commerce.
Trade Associations, Business Houses and leading Manufacturing Units
13) Linking Factor:

In order to maintain continuity, the time series data on wholesale price index, it is important to
provide inking factor so that new series when released may be compared with the outgoing
one. It provides a basis for determination of cost escalation and wage settlement and secondly,
generates a lang time series data for analytical purposes
There are three commonly used methods for linking new series with old one ie (1) arithmetic
conversion method (ii) ratio method and (iii) regression method. In arithmetic linking method
the relationship between the indices in the old series (y) and those in the new series (X) is
assumed to be linear Le y = cx, where c is the conversion factor given by

The linking factor for the WPI, which has been published officially, has been based on
arithmetic conversion method. The linking factor is worked out only at aggregate level for all
commodities. Because of the vast changes in the commodity baskets, it has not been found
feasible to compile linking factor at group/ sub-group level. Even though for analytical purpose,
it would be very useful to have linking factor at desegregated level.
14) Approval and Release of revised Series
As per the established practice, a Working Group is set up for revision of existing WPI series
with the approval of the Minister in-charge of the Department of Industrial Policy & Promotion.
Detailed deliberations on all aspects including methodological issues are held first at the level
of sub groups and thereafter in the Working Group. The views expressed at both the levels and
recommendations based thereon are incorporated in the report of the Working Group
The Report of the Working Group is first placed before the Technical Advisory Committee on
Statistics of Prices & Cost of Living (TAC on SPCL) in Central Statistical Organisation (CSO)
and thereafter before the Committee of Secretaries (COS). It is only after acceptance of the
report by the TAC on SPCL and its subsequent approval and appropriate direction of the COS:
the Office of the Economic Adviser through press release introduces the revised series of WPI

15) Data Management and Dissemination System

The ultimate use of the index compilation will depend upon the quality of data management
and data dissemination. Though due to improved computer facilities it has now become easier
to compile store and transmit WPi data. As SDDS norms of IMF are applicable to WPI, every
effort is made to ensure timeliness and transparency in release of the indices. Weekly WPI are
released to the press on every Friday. Dissemination of Weekly press release is also done
through official website simultaneously. Time series data are also made available to users
through print and electronic media on request Report of the last Working Group is also placed
on the office website Le. http://www.eaindustry.nic.in/

HDI
What is the Human Development Index (HDI)?
The HDI serves as a frame of reference for both social and economic development. It is a
summary measure for monitoring long-term progress in a country’s average level of human
development in three basic dimensions: a long and healthy life, access to knowledge and a
decent standard of living. The HDI was introduced in 1990 to emphasize that people and their
capabilities should be the ultimate criteria for assessing the development of a country, not just
economic growth.
History of the human development concept
For decades, the economic growth paradigm dominated the national development discourse.
However, in the 1980s unemployment levels escalated; and access to social services
deteriorated in many countries including some industrialised countries while at the same time,
economic production was expanding. In other words, high rates of economic growth did not
automatically translate into improved human well-being. During the same period, some
countries were registering improvement in human well-being with modest economic growth.
These raised questions around the nature, distribution and quality of economic growth. It
became clear that economic growth alone is not an adequate yardstick for a country’s level of
development. The need for a conceptual shift and alternative policy options that create a
balance between economic growth and protection of the interest of poor and marginalised
members of society became imperative. The HDI, which was introduced in the first Human
Development Report published in 1990, was a response to this demand. The idea of a composite
index that measures socio-economic progress was conceived by Mahbub ul Haq arenowned
economist, whose vision was to come up with one measure which is as crude as the GDP, but
“not as blind to social aspects of human lives as the GNP is
Importance of Human Development Index
It is necessary to determine social measures of development for calculating the overall
development of a nation. Human Development Index measures the socio economic factors and
therefore, is considered very effective in measuring the performance of a country in terms of
these factors.
HDI acts as a tool in evaluating the socio-economic status of nations around the world every
year and as such acts as a reliable indicator of the development of the nations.
How Is the HDI Measured?
The HDI is a summary measurement of basic achievement levels in human development. The
computed HDI of a country is an average of indexes of each of the life aspects that are
examined: knowledge and understanding, a long and healthy life, and an acceptable standard
of living. Each of the four components is normalized to scale between 0 and 1, and then the
geometric mean of the three components is calculated.2
The health aspect of the HDI is measured by the life expectancy, as calculated at the time of
birth, in each country, normalized so that this component is equal to 0 when life expectancy is
20 and equal to 1 when life expectancy is 85.2
Education is measured on two levels: the mean years of schooling for residents of a country
and the expected years of schooling that a child has at the average age for starting school. These
are each separately normalized so that 15 mean years of schooling equals one, and 18 years of
expected schooling equals one, and a simple mean of the two is calculated.2
The metric chosen to represent the standard of living is GNI per capita based on purchasing
power parity (PPP), a common metric used to reflect average income. The standard of living is
normalized so that it is equal to 1 when GNI per capita is $75,000 and equal to 0 when GNI
per capita is $100. The final Human Development Index score for each country is calculated
as a geometric mean of the three components by taking the cube root of the product of the
normalized component scores.
Limitations of the HDI
Human Development is a broad concept which cannot be captured in one composite. The HDI
suffers Data availability influences what is captured in the HDI. Other important dimensions
of human development such as political freedom, environmental sustainability and degree of
people’s selfrespect are not currently measured. The HDI also is not designed to assess progress
in human development over a short-term period because some of its component indicators are
not responsive to short-term policy changes. Thus, the index partially measures past
achievements as the components are made up of both stock and flow variables. This is a source
of frustration for many governments
Future Possibilities Since its introduction in 1990, the HDI’s analytical framework,
methodology and data have been subjected to rigorous scrutiny. Some of the major criticisms
have led to major refinements of the methodology and component indicators but limitations
still remain. The measures of human development will depend on availability of social
indicators measuring political freedom and gender disaggregated indicator of wealth and other
economic well-being
 UNIT 2
MULTIPLIER PRINCIPLE
The cumulatively reinforcing induced interaction between consumption, production, factor
payments, and income that amplifies autonomous changes in investment, government
spending, exports, taxes, or other shocks to the macroeconomy. The multiplier principle is so
named because relatively small autonomous changes generate relatively larger, or multiple,
induced changes in aggregate production. This principle is commonly represented by a
multiplier, which is a specific number with a value greater than one.
The essence of the multiplier principle is that relatively small changes in autonomous
expenditures or other shocks cause relatively large overall changes in aggregate production and
income. The multiplier principle works because a change in autonomous expenditures triggers
a change in aggregate production, factor payments, and income, which then induces changes
in other expenditures, especially consumption. These induced expenditures then cause further
changes in aggregate production, factor payments, and income, when then induce further
changes in expenditures. The process is cumulative and reinforcing.

The multiplier principle is a direct implication of Keynesian economics. The key to the
multiplier principle is induced expenditures, expenditures that depend on aggregate production
and income, especially induced consumption expenditures. Induced consumption
expenditures, as captured by the marginal propensity to consume, are the cornerstone of
Keynesian economics.

A Circular Flow Injection

The multiplier principle is best illustrated using the circular flow model of the economy. The
circular flow is a model of the continuous production, factor payment, income, and expenditure
interaction among the four major sectors (household, business, government, and foreign), that
takes place through the three aggregated macroeconomic markets (product, resource, and
financial). A simplified circular flow model is presented in the exhibit to the right. The four
key parts of this circular flow are the business and household sectors at the right and left, and
the product and resource markets at the top and bottom. This model can be used to illustrate
the multiplier principle.
To get the flow moving, let's see what would happen with a $1 trillion change in autonomous
investment expenditures, a injection of investment into the circular flow. Click the [Inject
Investment] button to illustrate this. What happens?
Circular Flow
  First, $1 trillion enters into the product markets for the purchase of $1 trillion worth
of capital goods.
 Second, this $1 trillion is revenue received by the business sector as payment for this
production.
 Third, this $1 trillion revenue is then used by te business sector as factor payments to
the resources that produce the capital goods.
 Fourth, this $1 trillion of factor payments becomes income of the household sector.
 Fifth, the $1 trillion of income received by the household sector is then divided between
consumption ($750 billion) and saving ($250 billion), based on the marginal propensity
to consume (and save).
Of some importance, this $250 billion of saving is a leakage out of the circular flow. Also of
some importance, the $750 of consumption expenditures remains in the circular flow and is
used to purchase additional production.

Another Round
The $750 of consumption expenditures remaining in the circular flow generates another round
of aggregate production, factor payments, income, and consumption.
The new exhibit to the right presents the circular flow model as it stands with the $750 billion
of consumption expenditures poised to enter the production markets for the payment of
aggregate production. Click the [Induced Consumption] button to illustrate the results of this
additional round of expenditures.
Circle flow

While the numbers are a bit different, the process is much the same.
 First, $750 billion enters into the product markets for the purchase of $1 trillion worth
of consumption goods.
 Second, this $750 billion is once again revenue received by the business sector as
payment for the production.
 Third, this $750 billion revenue is then used by te business sector as factor payments to
the resources that produce this round of consumption goods.
  Fourth, this $750 billion of factor payments becomes additional income of the
household sector.
 Fifth, the $750 billion of income received by the household sector is once again divided
between consumption ($563 billion) and saving ($187 billion), based on the marginal
propensity to consume (and save).
With this round, a portion of the $750 billion household sector is leaked out of the circular flow
as saving and a portion remains as consumption expenditures, which will generate another
round of aggregate production, factor payments, income, and then even more consumption
expenditures. And so it goes.

A Bunch of Rounds
The circular flow is likely to experience several additional rounds of aggregate production,
factor payments, income, and consumption expenditures. Each subsequently round, however,
is smaller than the previous round, meaning that the process eventually winds down to infinitely
small values.
But with each round, additional aggregate production is generated. The first round generates
$1 trillion of capital goods production. The second round generates $750 billion of
consumption goods production. The third round adds another $563 billion of consumption
goods production to the total.
The first three rounds has a total of $2.313 trillion, almost 2 1/2 times the initial injection of
investment expenditures. How much higher will it go?
A Bunch of Rounds

The answer is given by the exhibit to the right, which summarizes several rounds of the circular
flow.
 The first round generates $1 trillion in production, $750 billion in consumption, and
$250 billion in saving. This round is triggered by the initial $1 trillion investment in
capital.
 The second round generates $750 billion in production, $563 billion in consumption,
and $187 billion in saving. This round is triggered by the $750 billion of consumption
from the first round.
 The $563 billion of consumption from the second round then generates $563 billion in
production, $422 billion in consumption, and $141 billion in saving in the third round.
  The values for production, consumption, and saving are also presented for rounds four
through six. The first six rounds combine for $3,288 billion in production, $2,466
billion in consumption, and $822 billion in saving.
In these first six rounds, the increase in aggregate production of $3,288 billion generates an
identical $3,288 billion of income. This income is divided between consumption and saving
based on the marginal propensity to consume (0.75) and the marginal propensity to save (0.25).
The $2,466 billion in consumption is 75% of the income ($2,466 = $3,288 x 0.75). The $822
billion in saving is 25% of the income ($822 = $3,288 x 0.25).

 The totals for remaining rounds of activity beyond round six (seven through infinity)
are also listed in the table. These rounds generate and additional $712 billion in
production, $534 billion in consumption, and $178 billion in saving. Once again the
production (and income) total is divided between consumption and saving based on the
marginal propensities to consume and save.
 The grand totals of all rounds are presented at the bottom of the table, which are $4
trillion in production, $3 trillion in consumption, and $1 trillion in saving. As might be
expected the grand total of production (and income) is also divided between
consumption and saving based on the marginal propensities to consume and save.
The overall change in aggregate production ($4 trillion) is a multiple of the initial change in
investment that triggered the process ($1 trillion). In this case the multiple is four times --
aggregate production increases by four times the increase in investment. The change in
aggregate production and income is divided between consumption ($3 trillion) and saving ($1
trillion) based on the marginal propensity to consume (0.75) and marginal propensity to save
(0.25). The overall change in saving ($1 trillion) is exactly the same as the initial change in
investment ($1 trillion). Using other terminology, injections equal leakages.

The Keynesian Cross

The multiplier principle is commonly illustrated as a shift of the aggregate expenditures line in
the Keynesian model. The exhibit to the right presents a standard Keynesian cross. The
existing equilibrium is $12 trillion, given by the intersection of the aggregate expenditures line
(AE) and the 45-degree line (Y = AE). This equilibrium, however, is about to change.
Suppose, for example, that autonomous investment expenditures increase by $1 trillion, which
is just the thing to shift the aggregate expenditures line and trigger the multiplier.
To display the shift of the aggregate expenditures line, click the [$1 Trillion More] button. This
reveals a new aggregate expenditures line that is $1 trillion higher than the original line.
The new equilibrium is found at the intersection of the 45-degree line and the new aggregate
expenditures line, which is $16 trillion of aggregate production. The difference between the
original equilibrium and the new equilibrium is $4 trillion. This is four times the initial change
in investment, which implies a multiplier of 4.
 The Keynesian Cross

Let's examine this adjustment process a little more closely.

The initial change in investment causes a vertical shift of the aggregate expenditures line that
disrupts the existing equilibrium. In particular, aggregate expenditures exceed aggregate
production, which creates an economy-side shortage in the product markets and causes a
decrease in business inventories. Click the [Autonomous Investment] button to highlight this
initial disequilibrium gap between point A and point B. The business sector responds to this
shortage and decrease in business inventories by increasing production.
This boost in production means an increase in income to the household sector. The household
sector is induced by this additional income to increase consumption expenditures. Click the
[Induced Consumption] button to highlight this adjustment. This is the movement along the
aggregate expenditures line from point B to point C. Because consumption is the only induced
expenditure in this particular model, the slope of the aggregate expenditures line is equal to the
marginal propensity to consume. The movement along the aggregate expenditures line is what
restores balance between aggregate expenditures and aggregate production.
The movement along the aggregate expenditures line not only restores equilibrium it also
generates the multiplier process. Each change in aggregate production on the supply side of the
economy induces a change in consumption and aggregate expenditures on the demand side.
The process of closing one gap between production and expenditures ends up creating another
gap.
For example, the initial investment creates a $1 trillion imbalance between production and
expenditures. This gap is closed with $1 trillion of production. However, this production
induces $750 billion of consumption, which creates a new $750 billion gap. Closing this gap
with $750 billion of production induces another $563 billion in consumption, which creates
another new gap.
Fortunately the gaps grow smaller until they are inconsequential and can be ignored. The
multiplier process ends when these gaps become infinitesimally small.
The Simple Expenditures Multiplier
The multiplier principle is commonly represented by the multiplier, a measure of this
cumulatively reinforcing induced interaction that is greater than one. The simplest multiplier,
which is often used to illustrate the basics of the multiplier process, is the simple expenditures
multiplier.
The simple expenditures multiplier is the ratio of the change in aggregate production to an
autonomous change in an aggregate expenditure when consumption is the only induced
expenditure. This simple expenditures multiplier is typically used to analyze shocks caused by
changes in investment expenditures.
This simplest version of the simple expenditures multiplier comes from the two-sector
Keynesian model that has nothing but induced consumption from the household sector and
autonomous investment from the business sector. However, while this simple expenditures
multiplier is derived from the basic two-sector Keynesian model, it works equally well for other
models as long as consumption is the only induced expenditure.
This version is as simple as it gets while capturing the fundamentals of the multiplier.
Autonomous investment triggers the multiplier process and induced consumption provides the
cumulatively reinforcing interaction between consumption, aggregate production, factor
payments, and income.
The formula for this simple expenditures multiplier, m, is:

1 1
m= =
(1 - MPC) MPS

Where MPC is the marginal propensity to consume and MPS is the marginal propensity to
save.
If, for example, the MPC is 0.75 (and the MPS is 0.25), then an autonomous $1 trillion change
in investment expenditures results in a change in aggregate production of $4 trillion.
While the simple expenditures multiplier can be derived from the basic two-sector Keynesian
multiplier, it also works for models with more sectors, as long as consumption is the only
induced expenditure. If, for example, autonomous government purchases change by $1 trillion,
then the change in aggregate production is $4 trillion, the same as with a $1 trillion change in
investment expenditures. Moreover, the same change in aggregate production is realized if
autonomous exports or consumption expenditures change by $1 trillion.

Paradox of Thrift
The Paradox of Thrift is the theory that increased savings in the short term can reduce savings,
or rather the ability to save, in the long term. The Paradox of Thrift arises out of the Keynesian
notion of an aggregate demand-driven economy.
An increase in the rate of saving reduces consumption in the economy which, in turn, reduces
total output (via Keynesian consumption). According to British economist John Maynard
Keynes, when people save during a recession, the level of consumer spending decreases, which
eventually slows down economic growth.

Background of the Paradox of Thrift

In 1936, Keynes wrote a controversial book called “The General Theory of the Economy” in
which he declared that spending and investment in the economy were the keys to increasing
economic growth. He believed that the level of output and employment did not rely on the
capacity of production, but rather on the decisions taken by individuals in society to spend and
invest their money. Additionally, it was the role of the central bank to reduce interest rates and
encourage greater investment.
In congruence with spending in the economy, Keynes also said that saving money would reduce
the amount of money that people spend and invest. The resulting loss of business would cause
high unemployment and eventually, lower economic growth. He called it the “Paradox of
Thrift.”
Keynes did not view saving as its own entity but rather as an excess of what is spent. Investment
is the acquisition of capital goods. While consumption of goods and services helps increase
national aggregate income, saving is just an element of income that leaked out of the circular
flow of income. The economist defined saving with the formula S = Y(1–t) – C. That is, savings
is a part of the income that is taken out of total consumption.

Line I shows the relationship between investment spending and Gross Domestic Product
(GDP). Line S shows the correlation between savings and GDP. When people wish to increase
savings from S to S1, it leads to a fall in real investment (OH to OT) and income (OY to OY1).
Criticisms of the Paradox of Thrift
The Paradox of Thrift, while practical in its reasoning, attracted numerous criticisms from neo-
classical economists. The neo-classical economists argue that a consumer saving is viewed by
the market as a signal of supply-side inefficiency. A consumer saving sends the signal that the
consumer DOES NOT WANT to consume any of the goods in the market at the prevailing
market price.
Therefore, producers should either lower the price or change the goods and services being
produced. Thus, the action of not consuming does not reduce future output but merely forces
the market to optimize.
Under standard neo-classical economic growth theory, saving is essential to economic growth
and technological innovation. Most modern theories of innovation argue that a threshold level
of capital needs to be reached before innovation can occur. Technological innovation can
significantly raise the total amount of output in an economy.

ACCERALTOR THEORY
There are two fundamental macro-economic principles viz., the multiplier and the acceleration.
J.M. Keynes who developed the multiplier, ignored the effects of induced investment.
According to Paul Samuelson, in the long run, the effect of an increase in spending world not
stop with the effect of an increase in spending world not stop with the multiplier expansion of
income, as Keynes has pointed out, for this higher income level would, in turn, have
implications for other parts of the economy. An increase in national output or income will lead
to an increase in investment. Such investment, which depends on national income or its rate of
change, is called induced investment.
In reality, we observe that a business firm’s decision to make new investment depends on the
rate of change of sales (demand for its product) or of output, because the demand for capital
goods is a derived demand.
Thus, anything, which increases consumer demand (or demand for consumption goods like
textiles) such an increase in per capita income will always be beneficial to the capital goods
producing industry (such as textile producing machineries). In other words, aggregate
investment depends not on the absolute level of output but on the rate of change of national
income or output.
Let us suppose an investment of Rs 100 crore leads to an increase in national income of Rs 500
crore. However, with this multiple increase in income, business firms might very well decide
to proceed with another round of increased investment spending, that they could supply the
output needed by an economy in which national income has just increased.
This is the process of induced investment, which depends on the rate of change of output or of
sales: Ip = f (ΔY), where Ip is induced private investment which depends on (i.e., is a function
of) change(s) in national income (ΔY).
The Acceleration Principle
The implications of induced investment become very clear when we study the acceleration
principle. The principle refers to the relationship between increase in total output (income) and
the additional investment spending that occurs due to such output (income) increase.
In short, the acceleration principle explains why the increase in national income often results
in a more than proportionate increase in investment spending and why the amount of
investment studying depends not on the absolute level of business activity but on whether that
level is increasing or decreasing.
So, a change in national income or output induces (or leads to) a change in investment.
However, a small change in national income or output leads to an accelerated change in
investment. The accelerator principle, developed by J.M. Clark, refers to the accelerated effect
on investment of a small change in the demand for or output (sales) of consumption goods.
Assumptions
The acceleration principle is based on three main consumptions:
1. First, investment has both autonomous and induced components.
2. Investment depends not on the absolute level of output or demand but on the rate of
increase in NNP or in total demand. If the rate of increase is growing, investment
spending will increase; if the rate of income is stable, investment will be constant; if
the rate of increase declines, investment will fall.
3. The acceleration principle also emphasises the extreme volatility of investment as
compared with other components of aggregate demand. It suggests that any percentage
change in aggregate demand may result in much larger percentage changes in
investment spending.
Illustration of the Principle:
In producing output (whether shoes or cars or clothing) firms seek to use that stock of capital
(machines, inventories, plants) that allows the most profitable operation of the firm. The
acceleration principle is based on the idea that an increase in demand for consumer goods (food,
clothing, furniture) produces a far greater increase in demand for producer or capital goods
(food processing equipment, looms, and lathes).
Net investment in the addition to the stock of capital, but the stock of capital needs to grow
only if the level of output or sales increases. The relationship between capital and output
illustrates this point. For example, if for every Re 1 of output the economy requires 50 paise
worth of capital, the capital/output ratio would be 2.
The capital/output ratio (K/Y) is the value of capital (K) needed to produce a given level of
output divided by the value of that output (Y).
If the capital/output ratio remains steady (and capital is fully utilised), capital must increase for
the economy to produce more output. With a capital/output ratio of 2, for example, a Rs 10
crores increase in output would require a Rs 20 crores increase in capital. Because investment
in the increase in capital (I = DK), investment must also depend upon the rate of increase in
output.
With a fixed capital/output ratio of 2, the relationship between investment and output is:
1 = 2 ΔY
or I = K/Y × Δ Y
This equation illustrates the accelerator principle of investment: investment will increase only
if the national income or output increases. If output is high but fails to increase in a particular
year, investment will fall to zero. If output declines, there will be net disinvestment as business
firms will allow their capital stock to depreciate without replacement.
Thus, investment in an economy depends not on the level of income but on how fast output —
or the level of business sales — is rising or falling. To raise investment, output not only has to
grow; it has to grow by increasing rate.
The accelerator principle of investment is that investment depends upon the growth of output
and implies that investment will be unstable. Investment will fall simply because output grows
at a slower rate. For investment just to remain stable, output growth must be constant rate.
The Accelerator:
We assume that the capital-output ratio is 2:1, i.e., two units of capital are required to produce
one unit of output. The name acceleration principle is given since net investment depends upon
the acceleration or deceleration of output.
Importance:
The acceleration principle can work in both directions.
The acceleration principle makes the following two predictions:
1. Investment spending will fluctuate more sharply (widely) than demand for consumer
(final) goods.
2. Investment spending can start to decline even when sales are rising (though at a slower
rate that before).
These two phenomena contain the seeds of business cycles. They together explain why a
private enterprise economy is inherently unstable. When an industry gradually reaches its
capacity level of output, a continued increase in aggregate demand will bring about an
accelerated increase in investment spending.
Even before capacity output is reached, the continuation of that condition can set the
acceleration principle in motion. The enlarged induced investment spending adds to aggregate
effective demand and causes a further rise in national income through the multiplier.
However, like the multiplier the accelerator can work in both the directions. Thus, once a rise
in aggregate demand begins to slacken, however, the operation of the acceleration principle
can cause investment spending to decline. This, in its turn, will slow the growth of aggregate
demand still further and can set the stage for a general downturn in business activity.
Qualifications:
The acceleration principle, however, only provides a partial explanation of investment demand.
Investment is also governed by present and future profits. Future profits are the main rationale
for investment and they figure extensively in the evaluation of investment projects. It seems
that any analysis of investment demand must include both profits and the acceleration principle,
or some variant of it.
Certain qualifications will have to be introduced in the simple acceleration theory:
 1. Lags:
Investment lags behind the change in income. That is, planned investment for the third quarter
(made in the second quarter) is based on the actual change between the first and second
quarters, rather than the forecast change between the second and third quarters
2. Business outlook:
Secondly, if the general business outlook is optimistic, businesses will be more inclined to
think that an output increase will be permanent so they will more inclined to invest, than if the
business outlook is pessimistic.
3. Capacity limits:
When a rapid rise in output leads to large planned investment, there are often physical limits to
the rate at which actual investment can take place. The industries which produce capital goods
themselves have capacity limitations.
4. Profile:
Business firms usually prefer to expand internally, by using their own funds. Therefore, we
could expect profits to be a factor in the determination of investment. Investment usually varies
directly with profits.
5. Inventories:
Business investment in plant and equipment mainly depends on profit prospects and the rate of
interest at which money is borrowed to purchase an asset. Usually, inventory investment (i.e.,
investment in stocks of goods held by business to even out delivery and sales) varies
proportionately with sales and output and, thus, fits the simple accelerator model.

TOBINS Q THEORY:
****Write the ppt content first and continue with this****
The firm needs money for investment. This money can be raised either by borrowing or by
selling shares, equity, etc. When the firm sells the share, the buyer buys the share to earn a
capital gain from the increase in the market value of the shares.
The purchaser of share, therefore, purchases shares when he expects a high capital gain. This
is because:
During boom:
The share price is high. The firm by selling only few shares can raise a lot of money. Thus
when stock markets are high, firms are willing to sell equity to finance investment than when
the stock market is low. James Tobin was the first person to explain this relation between the
stock market and investment and that is why it is also referred as “Tobin’s q” theory.
q = market value of the firm/ Replacement cost of capital
Or
q = Value the stock market places on the firm’s asset /Cost of producing those assets
(i) If q ratio is high → it means the price of share is high.
... Firms will invest more.
(ii) If q > 1 → Firm will buy physical capital, that is, add to the capital stock.
Reason
for every Rupee worth of new machinery, the firm can sell the stock for q rupee and earn a
profit = q – 1.
In other words, when q > 1, firms find it profitable to acquire additional capital because value
of capital exceeds the cost of acquiring it.
Thus, when q > 1 → Investment will increase.

(a) Initial capital stock → K0 (Fig. 20.4a)

Pk → P0
Investment → I0 (Fig. 20.4b)
(b) In the Short run:
Assume demand for desired capital increases from K0 to K1. Demand curve of capital shifts
to the right from DD0 to DD1.
Due to increase in demand for capital, price of capital increases from P0 to P1 (Fig. 20.4a)
Although, desired capital stock is K1 and Investment is I1, but, actual capital stock is K0
Therefore, in the short run there exists a gap between the Actual Capital stock (K0) and the
desired Investment (I1, that is K1).
Reason:
Factors of production and other inputs required to produce additional capital are in short supply.
Therefore, capital stock cannot be increased immediately in short run.
(c) In the long run:
The gap between the capital stock (K0) and Investment flow (I1) is filled in long run such that:
Desired capital stock (K1) = Actual capital stock (K1)
The speed at which the firms plan to adjust their capital stock over time can be explained with
the help of Flexible Accelerator Model.
The Model shows that Investment contains dynamic behaviour which depends on the values of
the economic variables in different time periods.
The firm wants to bridge the gap between the existing capital stock and the desired capital
stock. If the gap is large, firm’s investment will be greater. In each period the firm tries to
bridge a fraction of the gap.

Thus, in next period, increase in investment will be I1

... K0 < K1
... Investment in period 1 (I0) < Investment in period 2 (I1).
Increase in Investment will continue till Actual capital Stock reaches desired capital stock.
However, the speed with which the gap is reduced depends on (λ).
Greater the λ, lesser will be the time period required to fill the gap and thus, faster will be the
capital accumulation. Thus, greater the λ, faster the gap will be reduced.
Conclusion:
Thus, current Investment depends on: (1) K* , and
2) Kt
Increase in desired capital stock would lead to increase in investment. Thus, the rate of
investment will increase when:
(i) expected output will increase
Or
(ii) real interest rate decreases
Or
(iii) Investment tax credit increases.

The Relationship Between Income & Expenditure

The relationship between income and expenditure is often called a consumption schedule. It is
used to describe economic trends in the household sector. When there is more money or
anticipation of income, more goods are purchased by consumers. Meaning money is spent on
expenditures, at times, even if there isn't enough income to cover them. This is a common
economic principal used to describe spending trends for national and world economies. A
business should consider the relationship between consumption and savings to extract data on
buyer trends within its own industry. Consumption Schedule: Expenditure and Income
The difference between income and consumption is used to define the consumption schedule.
When income grows, disposable income rises and thus consumers buy more goods. The result
is an increase in the consumption of major purchases and non-essential goods. The increase in
consumer expenditures is not a direct relationship to income. For every extra dollar earned,
there may be a fraction spent on disposable income. Low-income areas may actually see more
in expenditures than in actual income at different times.
The difference between income and consumption is how much is spent and left over as savings
at the end of the month. There are many factors that determine why consumers choose to spend
more on goods not required for day-to-day living expenses. These include stock market trends,
tax laws, and even consumer optimism. Economic experts look at historical data to predict
future trends based on new market conditions.
The Effect of Consumer Confidence
Consumers won't spend money unless they are confident in their personal economic situation
and strength. This means consumers feel good about having and keeping a job with the
potential of promotion. Pay increases, stock portfolio rises and tax cuts can put more money in
each person's pocket. As these conditions merge, consumer confidence increases.
Consumer confidence is the trust a buyer has that he can afford a purchase either today or in
the near future. For example, consumer confidence is shown by homebuyer trends. This is a
major purchase that takes decades to pay off. A buyer must feel good about the economy, as
well as feeling secure about his personal financial situation to take on such a major purchase.
Establishing Business Inventory Practices
Another factor that affects consumer confidence in inventory. Supply and demand have a
strong effect on whether buyers feel there is a need to purchase now. Going back to the house
purchasing example, if there are not a lot of homes for sale but interest rates are low, supply is
down but demand may increase. This could lead to higher buying desires among consumers
trying to get in while they can for the best deal possible.
A business should consider its own inventory levels when seeing consumption schedules and
consumer confidence ratings. When inventory increases for any item, it's less urgent to buy it.
When inventory builds up in a sector, such as in the automotive industry, it suggests reduced
consumer confidence where conditions drive savings more than spending. A business in this
sector would want to take heed and keep inventory levels manageable to prevent sitting on
inventory stock for extended periods of time.
While no business can control consumer confidence, it can take proactive measures to protect
itself as buyer trends change. A business may need to increase or reduce manufacturing,
wholesale orders or it may even offer promotional pricing to retain profitability and movement
in its inventory. Poor consumer confidence with a negative relationship between income and
expenditures means less people are going to the movies, buying new cars, homes or spending
less on the little extras they do when they feel that their pockets are a little deeper.

Example of an Induced Expenditure

In macroeconomics, there are two types of expenditures that factor into the equation to
determine equilibrium gross national product. The first is autonomous expenditures that fall
outside our economic system, such as foreign economic events, weather patterns, political
changes and wars. The second is induced expenditures. This is a type of expenditure that varies
with income – the more money someone has, the more they will spend. In economics, induced
expenditure is generally broken down into four sectors: consumer, business, government and
external. Induced Consumption Expenditures
Induced consumption expenditures are consumer purchases in the marketplace. According to
the economics reference site Penpoin, as national income rises, consumers feel more confident
and are more willing to spend their money on goods and services, creating an increase in
consumption expenditures. Examples here include new car purchases, new home purchases,
recreational vehicles, vacation travel, dinners out and other entertainment.
Conversely, if national income falls or remain stagnant, consumers become more cautious in
their spending and consumption expenditures fall.
Induced Investment Expenditures
In an expanding economy with rising income, businesses feel more confident about their
financial position and are more willing to purchase capital goods. These capital goods – such
as new equipment, new construction, plant improvements and new business vehicles – help
increase productivity and boost the economy even further. Increased productivity also leads to
an increase in jobs and additional national income that continues the cycle of rising national
income.
When national income falls, business owners become more cautious and often hold off on
purchasing new capital goods, reducing investment expenditures.
Government Induced Spending
Generally, government spending is regarded as autonomous expenditures since the spending
must be incurred regardless of income levels, reports the Corporate Finance Institute. For
instance, schools must be provided and roads maintained no matter how well the country is
going economically.
However, rising national income generates more tax revenue for local, state and federal
governments. The result of increased tax revenue is additional government purchases.
Government purchases also increase the national income. Governments spend tax money on a
wide variety of goods, including vehicles, construction projects, infrastructure improvements
such as roads, bridges and interstate highways, and other projects designed to benefit the public.
If national income decreases or remains stagnant, tax revenues also decrease. Government
agencies may continue to spend during bad economic times, but this produces deficits that can
further depress the economy and reduce other induced expenditures.
Net Exports
The difference between a country's total exports and total imports is its net exports. Increased
exports benefit domestic businesses because foreign countries by their products. Imports
benefit consumers because they have the opportunity to buy a wider variety of goods,
sometimes at lower prices. Both imports, such as electronics, automobiles and clothing, and
exports, such as wheat, construction equipment and prescription drugs, are induced
expenditures. Generally, economists like to see a trade balance that includes more exports than
imports because this means the nation is selling to foreign nations more than it is buying.

How Does an Expenditure Plan Work?

ByDiana Wicks
An expenditure plan, also known as a spending plan, is a strategic tool that a small business
can use to manage money. The expenditure plan helps in tracking the amount of income or
revenue available, and in making decisions on how to use this income and also to save some.
Therefore, a spending plan is an inevitable and essential tool in the formulation of long-term
and short-term financial planning of a small business.
Evaluate Income
Evaluation of income entails listing down all sources of income and adding these together.
Sources of income include a person's salary, bonuses and interests, taxation in case of a
government, or the sales of different products in business. It is advisable not to account for
income that has not materialized or income that is not at hand. This amount might not be
generated at all and accounting for it may distort the true amount of available income.
Fixed Expenses
An essential aspect of the expenditure plan is the fixed expenses. These are the expenses that
do not change too regularly, such as rent and utilities, payment of loans, or payment of salaries
to workers. Importantly, account for a fixed amount of savings as part of the fixed expenses in
an expenditure plan. This ensures the availability of emergency funds to cater to unforeseen
expenses within the business or household.
Variable Expenses
Identifying flexible or variable expenses involves listing those expenses that vary in usage and
in costs from time to time. These include the cost of food, entertainment, repair and
maintenance, cost of inventory, and indirect labor in business. It is essential to provide a dollar
amount even for variable expenses. Do this by referring to the past cost of these expenses. You
should pay for fixed expenses before spending on variable expenses.
Change
You then subtract the total expenditure from the total income to see if you are attaining your
financial goals, such as paying off debts or making a profit. However, the total of fixed and
variable expenses should not exceed the total income. You can ensure this by lowering the
amount spent on variable expenses. You may also change your financial goals so that they are
more realistic and flexible to your needs.

Data, Methodology and Empirical Results for income,consumption and gdp:

In order to analyze the relation between consumption, income and GDP per capita during 1980
– 2010 we considered a number of 79 countries (extracted from the World Bank statistics)
divided in 3 categories of income. The criterion used was the World Bank classification, but
for reasons of size adequacy, our panel for low income countries is formed by conjunction of
low and lower middle income countries (see Appendix E); the other two categories remained
unchanged. The targeted variables were: private consumption per capita (expressed in the form
of household final consumption expenditure per capita), adjusted net national income per capita
and GDP per capita. 1538 Paula-Elena Diacon and Liviu-George Maha / Procedia Economics
and Finance 23 ( 2015 ) 1535 – 1543 World Bank provides private consumption data in constant
2005 US$, and the other variables in current US$. We transformed constant 2005 US$ in
current US$ using the inflation conversion factors (Sahr, 2014), to have the same unit measures.
All the tests were performed in EViews (version 7.1). First, we investigated the stationary
character of the variables with tests which assume common (Levin Lin & Chu and Breitung)
and individual (Im, Pesaran & Shin, ADF-Fisher Chi-square and PP-Fisher Chi-square) unit
root process (see Appendix A̢ with the probability values p in brackets; here we must make a
comment: the value of probability is displayed in all the cases with an approximation of 4
digits, so in our analysis the value of p = 1.0000 or 0.0000 is many times an approximation).
In the analyzed panels (low, middle, high income and total countries), we found that all the
three variables – consumption, income and GDP per capita – are non-stationary and have unit
roots, both when intercept and when intercept plus trend is considered. However, when the
outcomes were mixed (for example, in the case of income and GDP per capita for intercept and
trend) we have considered the majority of the results. Further, all the data series are integrated
of first order and became stationary at 1st difference. Second, we performed cointegration tests,
since we found out that in all the cases the variables are integrated to the same order I(1). We
started to investigate the long-run relation with Pedroni Test (see Appendix B). Pedroni (1999,
p. 666) proved that the null hypothesis of no cointegration between variables is rejected when
the calculated panel statistics have large negative values, except for panel v-statistics which
take large positive values in this case. In our study, there is strong evidence that consumption
and income are cointegrated only in middle income countries when an intercept is considered
and only in low income countries when a trend is considered in the time series. For the
relationship between consumption, income and GDP, the association was significant only for
middle income countries when intercept is considered and in the case of low and middle income
countries for intercept and trend. However, the calculated tests values reported a combined
interpretation in every considered case (for every panel and both associations between
variables). We considered the criterion reported by most of the results for each particular
situation. For example, even if a small difference was found when we analyzed the relation
between consumption, income and GDP for intercept and trend in all countries, only 5 out of
11 statistics rejected the null hypothesis, the decision was that there is no association between
variables. We continued the analysis by performing additional tests of cointegration, because
the results varied, using the methodology proposed by Kao and Fisher (see Appendix C). Kao
Test reported the existence of cointegration between consumption, income and GDP in all
panels. Also, we found that excepting middle income countries, the statistics reported an
association between consumption and income – for low income, high income and all countries.
Appling Fisher Test, only for intercept, the results confirmed the long-run relation between
consumption and income in the case of low and high income countries and the long-run relation
between consumption, income and GDP in the case of low and high income countries. When
intercept and trend are considered, both associations are significant in all data panels (low
income, middle income, high income and all countries). To conclude with the cointegration
results, a summary is presented in Appendix D. Most evidences (for constant and for constant
plus trend together) show a strong relationship between consumption and income mainly in
low and high income panels, but weaker for middle income countries. Also, a significant
association, reported by the majority of results, was found between consumption, income and
GDP in all the country panels (low, middle and high income countries). For the analyzed
period, in the considered sample of all countries the conclusions are mixed for both associations
of variables.

Consumption function
The Keynesian consumption function expresses the level of consumer spending depending on
three factors.
Yd = disposable income (income after government intervention – e.g. benefits, and taxes)
a = autonomous consumption (consumption when income is zero. e.g. even with no income,
you may borrow to be able to buy food)
b = marginal propensity to consume (the % of extra income that is spent). Also known as
induced consumption.
Consumption function formula
C = a + b Yd
This suggests consumption is primarily determined by the level of disposable income (Yd).
Higher Yd leads to higher consumer spending.
This model suggests that as income rises, consumer spending will rise. However, spending will
increase at a lower rate than income.
At low incomes, people will spend a high proportion of their income. The average propensity
to consume could be one or greater than one. This means people spend everything they have.
When you have low income, you don’t have the luxury of being able to save. You need to
spend everything you have on essentials.
However, as incomes rise, people can afford the luxury of saving a higher proportion of their
income. Therefore, as incomes rise, spending increases at a lower rate than disposable income.
People with high incomes have a lower average propensity to spend.

Implications of consumption function

If you cut income tax for those on low income, they tend to have a higher marginal propensity
to consume this extra income. Therefore, there is a large increase in spending. People with high
incomes will tend to have a lower marginal propensity to consume. If they benefit from a tax
cut, they will save a greater proportion.
Shift in the consumption function

In this diagram, the consumption function has shifted to the upwards (to the left. (C1 to C2).
This means consumers are spending a higher % of their income. This could be due to a rise in
property prices which increases consumer confidence and lead to higher consumer spending.

Increased marginal propensity to consume

In this diagram, the consumption function has become steeper. This means the value of b
(MPC) has increased. Therefore, people are spending a higher % of their additional income.
This could be due to rising confidence, lower saving and easier availability of credit.

Limitations of consumption function

In the real world, people are influenced by other factors
Life cycle factors – e.g. students more likely to borrow and spend during university days.
Behavioural factors – e.g. people may be influenced by general optimism.
Other theories of consumption
Consumption is primarily determined by levels of income but also other factors such as:
Dependants such as children
expectations of future income,
total wealth

Stage in the life cycle

Marginal propensity to consume
Permanent income hypothesis (Milton Friedman) This is a theory that a person’s consumption
is determined, not just by current income, but also future expected income. It suggests that
consumers will attempt to ‘smooth consumption’ over their lifetime, e.g. borrowing as a
student, running down savings in retirement.
Life-cycle hypothesis (Richard Brumberg & Franco Modigliani). Another theory that people
attempt to smooth consumption over their lifecycle. This suggests that spending will be
dependent on current income, future expected income and also a function of wealth. See: Life-
cycle hypothesis
 UNIT 3
NATURE AND FUNCTIONS OF MONEY
There has been lot of controversy and confusion over the meaning and nature of money. As
pointed out by Scitovsky, “Money is a difficult concept to define, partly because it fulfills not
one but three functions, each of them providing a criterion of moneyness … those of a unit of
account, a medium of exchange, and a store of value.”
Though Scitovsky points toward the difficulty of defining money due to moneyness, yet he
gives a wide definition of money. Professor Coulborn defines money as “the means of valuation
and of payment; as both the unit of account and the generally acceptable medium of exchange.”
Coulborn’s definition is very wide. He includes in it the ‘concrete’ money such as gold,
cheques, coins, currency notes, bank draft, etc. and also abstract money which “is the vehicle
of our thoughts of value, price and worth.”
Such wide definitions have led Sir John Hicks to say that “money is defined by its functions:
anything is money which is used as money: ‘money is what money does.” These are the
functional definitions of money because they define money in terms of the functions it
performs.
Some economists define money in legal terms saying that “anything which the state declares
as money is money.” Such money possesses general acceptability and has the legal power to
discharge debts. But people may not accept legal money by refusing to sell goods and services
against the payment of legal tender money. On the other hand, they may accept some other
things as money winch are not legally defined as money in discharge of debts which may
circulate freely. Such things are cheques and notes issued by commercial banks. Thus besides
legality, there are other determinants which go to make a thing to serve as money.

FUNCTIONS OF MONEY
Money performs a number of primary, secondary, contingent and other functions which not
only remove the difficulties of barter but also oils the wheels of trade and industry in the present
day world. We discuss these functions one by one.

1. Primary Functions:
The two primary functions of money are to act as a medium of exchange and as a unit of value.
i) Money as a Medium of Exchange:
This is the primary function of money because it is out of this function that its other functions
developed. By serving as a medium of exchange, money removes the need for double
coincidence of wants and the inconveniences and difficulties associated with barter. The
introduction of money as a medium of exchange decomposes the single transaction of barter
into separate transactions of sale and purchase thereby eliminating the double coincidence of
wants.
This function of money also separates the transactions in time and place because the sellers and
buyers of a commodity are not required to perform the transactions at the same time and place.
This is because the seller of a commodity buys some money and money, in turn, buys the
commodity over time and place.
When money acts as a medium of exchange, it means that it is generally acceptable. It,
therefore, affords the freedom of choice. With money, we can buy an assorted bundle of goods
and services. At the same time, we can purchase the best and also bargain in the market. Thus
money gives us a good deal of economic independence and also perfects the market mechanism
by increasing competition and widening the market.
(ii) Money as Unit of Value:
The second primary function of money is to act as a unit of value. Under barter one would have
to resort to some standard of measurement, such as a length of string or a piece of wood. Since
one would have to use a standard to measure the length or height of any object, it is only
sensible that one particular standard should be accepted as the standard. Money is the standard
for measuring value just as the yard or metre is the standard for measuring length.
The monetary unit measures and expresses the values of all goods and services. In fact, the
monetary unit expresses the value of each good or service in terms of price. Money is the
common denominator which determines the rate of exchange between goods and services
which are priced in terms of the monetary unit. There can be no pricing process without a
measure of value.
The use of money as a standard of value eliminates the necessity of quoting the price of apples
in terms of oranges, the price of oranges in terms of nuts and so on. Unlike barter, the prices of
such commodities are expressed in terms of so many units of dollars, rupees, francs, pounds,
etc., depending on the nature of the monetary unit in a country.

2. Secondary Functions:
Money performs three secondary functions: as a standard of deferred payments, as a store of
value, and as a transfer of value. They are discussed below.
(i) Money as a Standard of Deferred Payments:
The third function of money is that it acts as a standard of deferred or postponed payments. All
debts are taken in money. It was easy under barter to take loans in goats or grains but difficult
to make repayments in such perishable articles in the future. Money has simplified both the
taking and repayment of loans because the unit of account is durable.
Money links the present values with those of the future. It simplifies credit transactions. It
makes possible contracts for the supply of goods in the future for an agreed payment of money.
It simplifies borrowing by consumers on hire-purchase and from house-building and
cooperative societies.
(ii) Money as a Store of Value:
Another important function of money is that it acts as a store of value. “The good chosen as
money is always something which can be kept for long periods without deterioration or
wastage. It is a form in which wealth can be kept intact from one year to the next. Money is a
bridge from the present to the future. It is therefore essential that the money commodity should
always be one which can be easily and safely stored.”
Money as a store of value is meant to meet unforeseen emergencies and to pay debts. Newlyn
calls this the asset function of money. “Money is not, of course, the only store of value. This
function can be served by any valuable asset. One can store value for the future by holding
short-term promissory notes, bonds, mortgages, preferred stocks, household furniture, houses,
land, or any other kind of valuable goods. The principal advantages of these other assets as a
store of value are that they, unlike money, ordinarily yield an income in the form of interest,
profits, rent or usefulness…,and they sometimes rise in value in terms of money.
On the other hand, they have certain disadvantages as a store of value, among which are the
following: (1) They sometimes involve storage costs; (2) they may depreciate in terms of
money; and (3) they are “illiquid” in varying degrees, for they are not generally acceptable as
money and it may be possible to convert them into money quickly only by suffering a loss of
value.”
Keynes placed much emphasis on this function of money. According to him, to hold money is
to keep it as a reserve of liquid assets which can be converted into real goods. It is a matter of
comparative indifference whether wealth is in money, money claims, or goods. In fact, money
and money claims have certain advantages of security, convenience and adaptability over real
goods. But the store of value function of money also suffers from changes in the value of
money. This introduces considerable hazard in using money or assets as a store of value.
(iii) Money as a Transfer of Value:
Since money is a generally acceptable means of payment and acts as a store of value, it keeps
on transferring values from person to person and place to place. A person who holds money in
cash or assets can transfer that to any other person. Moreover, he can sell his assets at Delhi
and purchase fresh assets at Bangalore. Thus money facilitates transfer of value between
persons and places.

3. Contingent Functions:
Money also performs certain contingent or incidental functions, according to Prof. David
Kinley. They are:
(i) Money as the Most Liquid of all Liquid Assets:
Money is the most liquid of all liquid assets in which wealth is held. Individuals and firms may
hold wealth in infinitely varied forms. “They may, for example, choose between holding wealth
in currency, demand deposits, time deposits, savings, bonds, Treasury Bills, short-term
government securities, long-term government securities, debentures, preference shares,
ordinary shares, stocks of consumer goods, and productive equipment.” All these are liquid
forms of wealth which can be converted into money, and vice-versa.
(ii) Basis of the Credit System:
Money is the basis of the credit system. Business transactions are either in cash or on credit.
Credit economises the use of money. But money is at the back of all credit. A commercial bank
cannot create credit without having sufficient money in reserve. The credit instruments drawn
by businessmen have always cash guarantee supported by their bankers.
(iii) Equaliser of Marginal Utilities and Productivities:
Money acts as an equaliser of marginal utilities for the consumer. The main aim of a consumer
is to maximise his satisfaction by spending a given sum of money on various goods which he
wants to purchase. Since prices of goods indicate their marginal utilities and are expressed in
money, money helps in equalising the marginal utilities of various goods. This happens when
the ratios of the marginal utilities and prices of the various goods are equal. Similarly, money
helps in equalising the marginal productivities of the various factors. The main aim of the
producer is to maximise his profits. For this, he equalises the marginal productivity of each
factor with its price. The price of each factor is nothing but the money he receives for his work.
(iv) Measurement of National Income:
It was not possible to measure the national income under the barter system. Money helps in
measuring national income. This is done when the various goods and services produced in a
country are assessed in money terms.
(v) Distribution of National Income:
Money also helps in the distribution of national income. Rewards of factors of production in
the form of wages, rent, interest and profit are determined and paid in terms of money.

4. Other Functions:
Money also performs such functions which affect the decisions of consumers and governments.
(i) Helpful in making decisions:
Money is a means of store of value and the consumer meets his daily requirements on the basis
of money held by him. If the consumer has a scooter and in the near future he needs a car, he
can buy a car by selling his scooter and money accumulated by him. In this way, money helps
in taking decisions.
(ii) Money as a Basis of Adjustment:
To carry on trade in a proper manner, the adjustment between money market and capital market
is done through money. Similarly, adjustments in foreign exchange are also made through
money. Further, international payments of various types are also adjusted and made through
money.
It is on the basis of these functions that money guarantees the solvency of the payer and
provides options to the holder of money to use it any way, he likes.

INFLATION
1 Year 2020 was unprecedented with the global pandemic of COVID-19 induced social
distancing disrupting economic activity globally. At the domestic level, two opposing forces
were at play. On the one hand, there was a dampening of demand owing to lower economic
activity. On the other hand, supply chain disruptions have caused spikes in food inflation that
have continued to persist during the unlocking of the economy, though the effect has softened
in the recent months. Overall, headline CPI inflation remained high during the lockdown period
and subsequently as well, due to the persistence of supply side disruptions (Table 1). At the
global level, inflation remained benign on the back of subdued economic activity as a result of
COVID-19 outbreak and sharp fall in international crude oil prices in advanced economies. In
Emerging Markets and Developing Economies (EMDEs), there was slight fall in inflation on
account of weaker economic activity, though there has been uptick in inflation in some
economies ending at similar levels as in the previous year (IMF, 2020)
Current Trends In Inflation
5.2 Headline inflation based on CPI-Combined (CPI-C) was on a downward path from 2014 to
2018. Though a rising trend was observed since 2019, a moderation in inflation is clearly
visible now (Figure 2). The average CPI-C inflation, which was 5.9 per cent in 2014-15, fell
continuously to 3.4 per cent in 2018-19 and recorded 4.8 per cent in 2019-20. It however
increased to 6.6 per cent in 2020-21 (Apr-Dec) before easing to a 15-month low of 4.6 per cent
in December 2020. Within various groups of CPI-C, the increase in inflation in the current year
was mainly driven by rise in food inflation, which increased from 0.1 per cent in 2018-19 to
6.7 per cent in 2019-20 and further to 9.1 per cent in 2020-21 (Apr-Dec), owing to build up in
vegetable prices. However, the swift steps taken by the Government eased food inflation
significantly to 3.4 per cent in December 2020 from a high of 11 per cent in October 2020. CPI
Core (non-food non-fuel) inflation declined from 5.8 per cent in 2018-19 to 4.0 per cent in
2019- 20 and averaged 5.4 per cent in 2020-21 (Apr-Dec) (Table 2). Rise in core inflation in
the current year is mainly on account of miscellaneous group which primarily consists of
services. Inflation in transport & communication, which have maximum weightage in the
miscellaneous group, increased to 9.4 per cent in the current year as compared to 2.4 per cent
in 2019-20. Further, volatility in gold and silver prices also pushed core inflation up. However,
at major group level of CPI-C, significant fall has been observed in housing inflation from 6.7
per cent in 2018-19 to 4.5 per cent in 2019-20 and further to 3.3 per cent in 2020-21 (Apr-Dec).
WPI inflation declined from 4.3 per cent in 2018-19 to 1.7 per cent in 2019-20 and further to
(-) 0.1 per cent in 2020-21 (Apr-Dec). It remained negative from April to July 2020 and stood
at 1.2 per cent in December 2020 (Figure 3). The decline in WPI inflation in the current year
is mainly on account of fuel & power. Persistent volatility in the global crude oil prices during
the year led to fall in inflation of major fuel products. WPI fuel & power inflation dropped
sharply from 11.6 per cent in 2018-19 to (-) 1.8 per cent in 2019-20 and further to (-) 12.2 per
cent in 2020-21 (Apr-Dec). WPI food inflation declined from 6.9 per cent in 2019-20 to 4.2
per cent in 2020-21 (Apr-Dec) and WPI core inflation increased to 0.8 per cent in 2020-21
(Apr-Dec) as compared to (-) 0.4 per cent in 2019-20
The rural-urban difference in CPI inflation, which was high in 2019, saw a decline in 2020.
From July 2018 to December 2019, CPI-Urban inflation was consistently above CPI-Rural
inflation, mainly on account of the differential rates of food inflation between rural and urban
areas witnessed during this period. However, in the current year, CPI-Urban inflation has
moved closely with CPI-Rural inflation (Figure 4). Although food inflation in rural and urban
areas has almost converged now (Figure 5), divergence in rural-urban inflation is observed in
other components of CPI (Figure 6). Inflation in non-food components of CPI is higher in urban
areas as compared to rural areas in the current year. While fuel & light inflation is (-) 0.1 per
cent in rural areas, it is 6.7 per cent in urban areas. The rural-urban differential in other
components is in the range of 1.6 to 2.3 percentage points, except housing, which is not
compiled for rural areas
CPI-IW is a price index released by the Labour Bureau to measure the impact of price rise on
the cost of living for working class families spread across certain select industries. The base
year of CPI-IW has been revised from its earlier 2001 to a more recent base year of 2016
WHICH MEASURE OF INFLATION Reflected Economic Activity Better IN 2020-21?
5.26 The previous two sections indicate the role of supply-side constraints, especially in the
case of perishable vegetables contributing to inflation. Since February 2017, CPI-C inflation
and WPI inflation have been moving more or less in tandem till beginning of 2019-20. After
this period, gap has emerged, which has widened in the recent months (Figure 19). Between
April-July 2020, WPI inflation has been in the negative region while CPI-C inflation has been
above 6 per cent. The major feature in this widening gap is that this has happened in a period
witnessing high food inflation. The shaded region in Figure 19 shows the period during which
CFPI inflation has remained higher than non-food inflation. The movement in CPI-C inflation
is quite contrary to the weak demand conditions prevalent in the economy in the recent months
owing to the COVID-19 crisis. Food items have a large weight of around 39 per cent in the
CPI-C index. This means that shocks to food prices can have large impacts on CPI-C inflation.
5.27 For the period April 2020 to November 2020, CPI-C is weakly related to IIP growth while
WPI inflation and CPI-C Core inflation are positively and strongly related to IIP growth.
Therefore, core CPI-C inflation and WPI Inflation, have been more in sync with the demand
conditions in the economy. During the period April 2020 to November 2020, the correlation
coefficient between WPI inflation and YoY growth in IIP is around 0.8 while the correlation
coefficient between CPI-C core inflation and IIP growth has been 0.9. The correlation between
Figure 19: CPI-C and WPI Inflation Source: NSO and OEA, DPIIT Note: The shaded region
in the graph represents the period where Consumer Food Price Inflation has been higher than
Non-Food inflation 182 Economic Survey 2020-21 Volume 2 IIP growth and CPI inflation
during the same period is 0.2. Similarly, we can see high correlation of CPI Core inflation and
WPI inflation with other metrics of production and demand in the Indian economy
A tight monetary policy may have a role in managing inflation in case of excess demand driving
high inflation. However, the current scenario presents a different picture. The current spike in
CPI inflation driven by spike in food prices is mainly a supply-side phenomenon. This can be
easily assessed from the fact that arrivals in the market, for agricultural commodities like onion,
tomato and potato that have witnessed spikes in recent times, have been much lower compared
to the previous years (Figure 20). Further, the weights of all items in CPI-C are based on NSO
Household Consumption Expenditure Survey 2011-12. Weight of food items in the index might
have significantly decreased over the decade since 2011-12. There is a need to capture the
revised weight of food items in the index to correctly depict the true Prices and Inflation 183
picture of inflation in the country. Further, in the context of increasing retail e-commerce
transactions, it is important to include such new sources of price data for the construction price
indices
Measures To Control Inflation
5.35 The Government reviews the price situation regularly and has taken number of measures
from time to time to stabilize prices of food items. In the wake of rising prices of pulses, onion
and potato, the Government has taken several steps to improve the availability of these
commodities and make them available to consumers at affordable prices. These include: i.
Banning the export of onion w.e.f. 14.09.2020, revoked w.e.f. 1.01.2021. ii. Imposition of stock
limit on onion under the EC Act w.e.f. 23.10.2020 to prevent hoarding, lapsed 31.12.2020. iii.
Easing of restrictions on imports, facilitating imports at integrated check-posts, issuance of
licenses for imports and reduction in import duties. These measures have resulted in increased
imports of onion, tur dal and masur dal in the country and resultant cooling of prices.
How Inflation Cause Unemployment
There are a few different scenarios where inflation can cause unemployment. However, there
is not a direct link. Often we will notice a trade-off between inflation and unemployment – e.g.
in a period of strong economic growth and falling unemployment; we see a rise in inflation

The Phillips Curve suggests there is a trade off between unemployment and inflation. Higher
demand reduces unemployment but causes inflation
Also, it is important to bear in mind, (especially in the current climate) If the economy has
deflation or very low inflation and the monetary authorities target a modest rate of inflation,
then this may help boost growth and reduce unemployment.
In this Phillips curve, the increase in AD has caused the economy to shift from point A to point
B. Unemployment has fallen, but a trade-off of higher inflation.
If an economy experienced inflation, then the Central Bank could raise interest rates. Higher
interest rates will reduce consumer spending and investment leading to lower aggregate
demand. This fall in aggregate demand will lead to lower inflation. However, if there is a
decline in Real GDP, firms will employ fewer workers leading to a rise in unemployment.

Inflation Can Cause Unemployment When:

The uncertainty of inflation leads to lower investment and lower economic growth in the long
term.
Inflationary growth is unsustainable leading to a boom and bust economic cycle.
Inflation leads to a decline in competitiveness and lower export demand, causing
unemployment in the export sector (especially in a fixed exchange rate).
Why is there a trade-off between Unemployment and Inflation?
If the economy experiences a rise in AD, it will cause increased output.
As the economy comes closer to full employment, we also experience a rise in inflation.
However, with the increase in real GDP, firms take on more workers leading to a decline in
unemployment ( a fall in demand deficient unemployment)
Thus with faster economic growth in the short-term, we experience higher inflation and lower
unemployment.
Inflation And Unemployment In India
ndia recorded a 11-year high wholesale price index (WPI) in April 2021 due to the rise in prices
of oil, manufactured goods, minerals, and food products such as eggs and meat. As the country
continues to reel under the second wave of the COVID-19 pandemic, the unemployment rate
shot up by 8% in April (up by 1.5 ppts from March) causing 3.4 million salaried employees to
lose their jobs. In general, 84%* of the consumers in India are still extremely/quite concerned
about the impact of COVID-19 pandemic in general, according to a survey by GlobalData, a
leading data and analytics company. The Indian Rupee also depreciated to 75.35 against the
US dollar in April 2021 from 72.35 in March 2021 due to a surge in infection rate, restrictions
on businesses and mobility.
Meanwhile, effective vaccine rollouts and trade diversification led to the revival of economy
and infused a sense of optimism in commodity markets such as the US and China, thereby
resulting in soaring commodity prices. This along with the weakened Indian currency has
significantly increased landed cost and import prices, thus placing downward pressure on
India’s economy.

THE EVOLUTION OF BANKING

What Is the History of Banking?
Banking has been around since the first currencies were minted—perhaps even before that, in
some form or another. Currency, in particular coins, grew out of taxation. As empires
expanded, functional systems were needed to collect taxes and distribute wealth.

Understanding Banking History

The history of banking began when empires needed a way to pay for foreign goods and services
with something that could be exchanged easily. Coins of varying sizes and metals eventually
replaced fragile, impermanent paper bills.
Coins, however, needed to be kept in a safe place, and ancient homes did not have steel safes.
According to World History Encyclopedia, wealthy people in ancient Rome kept their coins
and jewels in the basements of temples. The presence of priests or temple workers, who were
assumed devout and honest, and armed guards added a sense of security.3
Historical records from Greece, Rome, Egypt, and Ancient Babylon have suggested that
temples loaned money out in addition to keeping it safe. The fact that most temples also
functioned as the financial centers of their cities is a major reason why they were ransacked
during wars.3
Coins could be hoarded more easily than other commodities, such as 300-pound pigs for
example, so a class of wealthy merchants took to lending coins, with interest, to people in need.
Temples typically handled large loans and loans to various sovereigns, and wealthy merchant
money lenders handled the rest.

The First Bank

The Romans, who were expert builders and administrators, extricated banking from the temples
and formalized it within distinct buildings. During this time, moneylenders still profited,
as loan sharks do today, but most legitimate commerce—and almost all government
spending—involved the use of an institutional bank.
According to World History Encyclopedia, Julius Caesar, in one of the edicts changing Roman
law after his takeover, gives the first example of allowing bankers to confiscate land in lieu of
loan payments. This was a monumental shift of power in the relationship of creditor and debtor,
as landed noblemen were untouchable through most of history, passing debts off to descendants
until either the creditor or debtor's lineage died out.4
The Roman Empire eventually crumbled, but some of its banking institutions lived on in the
form of the papal bankers that emerged in the Holy Roman Empire and the Knights Templar
during the Crusades. Small-time moneylenders that competed with the church were often
denounced for usury.

Visa Royal
Eventually, the various monarchs that reigned over Europe noted the strengths of banking
institutions. As banks existed by the grace, and occasionally explicit charters and contracts, of
the ruling sovereignty, the royal powers began to take loans to make up for hard times at the
royal treasury, often on the king's terms. This easy financing led kings into unnecessary
extravagances, costly wars, and arms races with neighboring kingdoms that would often lead
to crushing debt.
In 1557, Philip II of Spain managed to burden his kingdom with so much debt (as the result of
several pointless wars) that he caused the world's first national bankruptcy—as well as the
world's second, third, and fourth, in rapid succession. This occurred because 40% of the
country's gross national product (GNP) was going toward servicing the debt.5 The trend of
turning a blind eye to the creditworthiness of big customers continues to haunt banks today.

J.P. Morgan and Monopoly

J.P. Morgan & Co. emerged at the head of the merchant banks during the late 1800s. It was
connected directly to London, then the world's financial center, and had considerable political
clout in the United States. Morgan and Co. created U.S. Steel, AT&T, and International
Harvester, as well as duopolies and near-monopolies in the railroad and shipping industries,
through the revolutionary use of trusts and a disdain for the Sherman Antitrust Act.
Although the dawn of the 1900s saw well-established merchant banks, it was difficult for the
average American to obtain loans. These banks didn't advertise, and they rarely extended credit
to the "common" people. Racism was also widespread, and although bankers had to work
together on large issues, their customers were split along clear class and race lines. These banks
left consumer loans to the lesser banks that were still failing at an alarming rate.
EVOLUTION OF BANK IN INDIA
The Indian banking system consists of commercial banks, which may be public scheduled or
non-scheduled, private, regional, rural and cooperative banks. The banking system in India
defines banking through the Banking Companies Act of 1949.
In this post, we take a look at the evolution of banks in India, the different categories and the
impact of nationalised banks.
Phase 1: The Pre-Independence Phase
There were almost 600 banks present in India before independence. The first bank to be
established as the Bank of Hindustan was founded in 1770 in Calcutta. It closed down in 1832.
The Oudh Commercial Bank was India's first commercial bank in the history of the evolution
of banking in India.
A few other banks that were established in the 19th century, such as Allahabad Bank (Est.
1865) and Punjab National Bank (Est. 1894), have survived the test of time and exist even
today.
Some other banks like the Bank of Bengal, Bank of Madras, and Bank of Bombay - established
in the early to mid-1800s - were merged as one to become the Imperial Bank, which later
became the State Bank of India.
Phase 2: The Post-Independence Phase
After independence, the evolution of the banking system in India continued pretty much the
same as before. In 1969, the Government of India decided to nationalise the banks under the
Banking Regulation Act, 1949. A total of 14 banks were nationalised, including the Reserve
Bank of India (RBI).
In 1975, the Government of India recognised that several groups were financially excluded.
Between 1982 and 1990, it created banking institutions with specialised functions in line with
the evolution of financial services in India.

 NABARD (1982) – to support agricultural activities

 EXIM (1982) – to promote export and import
 National Housing Board – to finance housing projects
 SIDBI – to fund small-scale industries
Phase 3: The LPG Era (1991 Till Date)
From 1991 onwards, there was a sea change in the Indian economy. The government invited
private investors to invest in India. Ten private banks were approved by the RBI. A few
prominent names which exist even today from this liberalisation are HDFC, Axis Bank, ICICI,
DCB and IndusInd Bank.
In the early to mid-2000s, two other banks, Kotak Mahindra Bank (2001) and Yes Bank (2004),
received their licenses. IDFC and Bandhan banks were also given licenses in 2013-14.
Other notable changes and developments during this era were:
Foreign banks like Citibank, HSBC and Bank of America set up branches in India.
The nationalisation of banks came to a standstill.
RBI and the government treated public and private sector banks equally.
Payments banks came into existence.
Small finance banks were permitted to set up their branches throughout India.
Banks began to digitalise transactions and various other related banking operations
Reasons Why Banks Were Nationalised in India
To get a clearer picture of the impact of nationalisation on the banking industry and the general
population, let's understand why the government decided to nationalise banks:

 To Energise Priority Sectors: Banks were collapsing at a fast rate – 361 banks
failed between 1947 and 1955, which converts to about 40 banks a year! Customers lost
their deposit with no chance of recovering them.
 A Neglected Agricultural Sector: Banks favoured large industries and
businesses and neglected the rural sector. Nationalisation came with a pledge to support
the agricultural sector.
 Expansion of Branches: Nationalisation facilitated the opening of new
branches to ensure maximum coverage of banks throughout the country.
 Mobilisation of Savings: Nationalising the banks would allow people more
access to banks and encourage them to save, injecting additional revenue into a cash-
strapped economy.
 Economic and Political Factors: The two wars in 1962 and 1965 had put a
tremendous burden on the economy. The nationalisation of Indian banks would give
the economy a boost through increased deposits.

CREDIT CREATION AND CREDIT CONTROL

Credit Creation by a Commercial Bank
A commercial bank is a dealer of credit. It creates money based on cash deposits. Further, it
issues new money through its loan operations and creates credit or expands the monetary base
of a country.
Therefore, this process of credit creation leads depositors to believe that they have money with
the bank. Also, borrowers believe that they owe a certain amount of money to the bank. Let’s
understand credit creation through an example.
Example:
Let’s say that a bank receives a sum of Rs.1,000 as a demand deposit. Also, let’s assume that
the Cash Reserve Ratio (CRR) is 20%.
Therefore, the bank retains Rs.200 and lends the remaining Rs.800 to a borrower. While the
depositor claims that he has Rs.1000 with the bank, the borrower has Rs.800 too.
Therefore, a single bank manages to create a credit of Rs.800.
If we extend this example to the entire banking system, then it offers an interesting insight.
Let’s say that the borrower takes a loan of Rs.800 from Bank A and deposits it with another
bank (Bank B). Bank B retains 20% of the deposited amount (Rs.160 = 800×20%) and lends
the remaining Rs.640 to another borrower.
Further, let’s say that the second borrower deposits the loan amount of Rs.640 with Bank C.
This bank also retains the CRR of 20% (Rs.128 = 640×20%) and lends the remaining Rs.512
to the third borrower. This process continues until the time that the deposited sum is nearly
equal to the CRR.
Just to give you a perspective, a single deposit of Rs.1000 with a CRR of 20% (1/5th) leads to
the credit creation of Rs.5000. Therefore, the size of the multiplier is 5 (1000×5 = 5000).
Limitations of Credit Creation
The multiple credit creation process, as explained in the example above, depends on various
factors:
A lot depends on the Cash Reserve Ratio (CRR). In fact, there is an inverse relationship
between the CRR and the size of the multiplier. Therefore, if the CRR is 100%, then the bank
cannot create credit.
What happens when a society is in an economic depression? People stop taking loans. If a bank
cannot lend, then it cannot create credit. In other words, the credit creation depends on the
amount of loan that a bank grants.
The size of the cash deposit is an important factor too. If a bank has a smaller cash base, then
it has a lesser scope for creating credit.
A commercial bank lends money against accepted securities. The bank specifies the securities
against which it offers loans. Also, the value of the securities must be equal to the amount of
the loan. Even if the bank has a large cash base for creating credit, it will not lend money if it
does not get acceptable security.
The Central Bank (Reserve Bank of India) substantially control the credit-creating power of all
commercial banks. It has certain instruments which enable it to increase or decrease the volume
of credit creation. Further, it also controls the direction and purpose of credit that the banks
offer. All banks accept the regulations of the Central Bank as it is their lender of last resort.
Credit Control
Definition: Credit Control is a function performed by the Central Bank (Reserve Bank of
India), to control the credit, i.e. the demand and supply of money or say liquidity in the
economy. With this function, the central bank regulates the credit granted by the commercial
banks to its customers. It aims to achieve economic development with stability as well as to
manage the inflationary and deflationary pressure.
Objectives of Credit Control
The basic objectives of credit control are:
 To attain stability in the internal price level.
 To obtain stability in the foreign exchange rates, which maintains the external value of
the currency.
  To maintain stability in the money market through liquidity control measures.
 To promote overall economic growth and development, by maximizing income,
employment and output.
 To promote national interest.

Methods of Credit Control

Different methods are used by the Central Bank to control credit, which is broadly classified
into two main categories:
Quantitative Methods or General Methods
Quantitative Methods of Credit Control are related to Quantity or Volume of Money and are
aimed at regulating the total volume of bank credit. These tools are indirect in nature and they
tend to influence the loanable funds of the commercial banks.
The total quantity of deposits created by the commercial banks is expected to be controlled and
adjusted using these methods. It maintains a balance between savings and investment.
1. Bank Rate Policy: Otherwise called a discount rate policy. It is described as the standard
rate at which the central bank is ready to purchase and rediscount eligible instruments like
government-approved bills and commercial papers. It has a great influence on the availability
and cost of credit.
When the central bank increases the bank rate, it may result in a reduction in the volume of
borrowings by the commercial bank from RBI, whereas when the RBI reduces the bank rate,
the borrowings become economical for the commercial bank and thus encourages credit
expansion of the economy.
2. Open Market Operations (OMO): It implies trading of eligible securities by the country’s
apex bank, i.e. RBI in both capital market and money market. When the central bank purchases
or sells short term or long term securities, it leads to an increase or decrease in the financial
resources of the commercial bank.
This will ultimately influence the credit creation of the banks.
3. Variations in the Reserve Ratio: We all know that commercial banks have to maintain a
specified percentage of their net demand and time liabilities as Cash Reserves, with RBI. As
well as a certain proportion of their net demand and time liabilities has to be maintained by the
banks in the form of liquid assets. These reserve ratios are called Cash Reserve Ratio
(CRR) and Statutory Liquidity Ratio (SLR) respectively.
Even the slightest change in these ratios can affect the reserve position of the commercial
banks, which in turn regulates the supply of money in the economy.
4. Repo, i.e. Repurchase Option: Repo or otherwise called Repurchase transactions are
carried out by the central bank, to regulate the money market situation. As per this transaction,
the Central bank grants loan to commercial banks against government-approved securities for
a fixed period, at a specified rate, called as Repo Rate, on a condition that the borrower bank
will repurchase the securities at the predetermined rate, once the period is over. These
transactions are undertaken by the central bank in order to absorb or drain liquidity from the
system.
Qualitative Methods or Selective Methods
Qualitative Methods are used in addition to general credit control methods. there are a number
of situations wherein quantitative methods may not work effectively and may cause harm to
particular sectors. As the quantitative methods of credit control, control the volume of credit,
as a whole. So, there are chances that it may affect genuine productive purposes.
In this way, the qualitative methods of credit control come into the picture, wherein the credit
is made available to productive and priority sectors, while the others are restricted.
1. Fixation of margin requirements: In this technique, the central bank determines the margin
which commercial banks and financial institutions need to maintain for the amount extended
by them in the form of loans, against commodities, stocks and shares. The central bank also
prescribes margin requirements for the underlying securities, so as to restrict speculative
dealing in stock exchanges.
2. Credit Rationing: As per this method, the central bank attempts to restrict the upper ceiling
of loans and advances to a particular sector. Moreover, in specific cases, the central bank may
also fix the ceiling for different categories of loans and advances. Also, commercial banks are
expected to stick to this limit. This facilitates the lessingt of bank credit exposure to unwanted
sectors.
3. Regulation of Consumer Credit: With an aim of regulating consumer credit, the apex bank
determines the down payments and the length of the period over which installments are to be
spread. At the time of inflation, higher restrictions are levied to control the prices by controlling
demands whereas, at the time of depression, relaxations are provided so as to increase demand
for goods.
4. Control through directives: In this technique, the central bank issues directives from time
to time so as to regulate the credit created by the commercial banks. These can be written
orders, warnings, notices, or appeals.
It can help in regulating lending policies of the commercial banks or to fix a maximum limit of
credit for specific purposes and also to restrain the flow of bank credit into non-essential lines.
It may result in diverting the credit to productive use.

CENTRAL BANK
What is a Central Bank
A central bank controls the supply of money as well as how it reaches the consumer. It can not
only print and inject money into the economy, but also regulate commercial banks distribution
of it.
The central bank controls monetary policy, which includes power over inflation, exchange
rates, and the money supply. It has a number of tools by which it uses to control such. For
example, it can set interest rates to control inflation, buy foreign currencies to weaken the
domestic currency, and engage in open market operations by purchasing assets from financial
institutions.
In turn, the central bank uses monetary tools to meet its objectives. These range from country
to country, but generally include targets for inflation, unemployment, economic growth, and
financial stability.
Objectives of Central Bank
The objectives of central banks have largely changed over the years, due to disastrous economic
events. For example, back in the 1970s, the main goal of central banks was to ensure full
employment. However, the focus on employment blinded central banks attention on inflation.
Rather than maintain price stability, central banks would pump money into the economy to
ensure people were being employed. Yet this came at the cost of inflation.
For example, in 1973, there was a massive oil crisis that was to be named the ‘OPEC crisis’. It
led to a sharp increase in the unemployment rates across the developed world. In retaliation,
central banks opened the taps and supplied the economy with money in the hope of boosting
investment and jobs.
Whilst the plan worked, it boosted employment in the short-term, but created long-term effects.
Double digit inflation occurred into the 1980s and employment equally suffered. As a result,
central banks learnt that a more balanced approach is needed – one that focuses on several
objectives rather than one.
Examples of the central banks objectives include:

 Price Stability
 Full Employment
 Financial Stability
 Economic Growth
 Exchange Rate Stability
1. Price Stability
Price stability is probably one of the leading objectives of central banks. After the high levels
of inflation in the 1970s and 1980s, and the disaster that was the Great Depression of 1929,
control over prices is a key element of central banking policy.
2. Full Employment
Going back through history, full employment was one of the leading objectives of the central
bank. However, as the welfare state has expanded and the understanding of monetary policy
increased, it has taken a backwards step.
Nevertheless, full employment is still a relatively important objective. Most central banks
would take action if employment starts keeping up. Usually, this is done by lowering the
interest rates to fuel cheaper credit to businesses. In turn, businesses would use the cheap credit
to invest and expand its operations, thereby stimulating jobs in the process.
3. Financial Stability
The central bank often acts as lender of last resort in order to maintain financial stability. For
instance, most commercial banks need short-term loans in order for them to be able to align
their assets and liabilities.
On occasion, a commercial bank may have to pay a loan to another financial institution, but
their assets are tied up in long-term loans and other illiquid assets. As a result, they need some
short-term liquidity to meet their obligations, which is where the central bank comes into play.
4. Economic Growth
Economic growth is important to central banks as it generally means more jobs and better living
conditions. When there is economic growth, it is often associated with increased business
investment, improving employment, and increasing demand.
Now economic growth is an objective for central banks but is not necessarily its main one.
They often have to weigh up the pros and cons, as controlling inflation and prices may be more
beneficial than stimulating the economy. Nevertheless, central banks will often look to prop up
the economy if they can do so whilst also maintaining price stability.
5. Exchange Rate Stability
For one reason or another, a nation may face a currency shock by which the demand for its
currency declines rapidly. This may be due to a domestic political output or a financial crisis.
In turn, this creates instability within the markets, which central banks look to avoid.

FUNCTIONS OF CENTRAL BANK

There are four main functions of a central bank. They are – setting the base rate, control the
money supply through open market operations, ensure banks maintain reserves, and control
the nations reserves of foreign currencies.
 Base Rate
 Open Market Operations
 Reserve Requirements
 Foreign Exchange Reserves
Base Rate
One of the central banks leading functions is the setting of the interest rate. Also known as the
base rate, it sets a rate which commercial banks can borrow from the central bank. In turn,
commercial banks react with higher interest rates to the public as they are paying a higher rate
to the central bank.
The base rate is a useful function as it acts somewhat like a tap. By increasing the rate,
borrowing from the central bank becomes more expensive for commercial organisations. In
turn, loans to businesses and consumers becomes more expensive, thereby reducing the
circulation of money.
By contrast, a decline in the base rate is used to stimulate demand. As debt becomes cheaper
to finance, businesses and consumers demand more of it, thereby increasing the circulation of
money.
Open Market Operations
Open market operations simply involves central banks creating money and purchasing financial
assets with it. In recent times, it has come under the naming ‘Quantitative Easing’. The aim of
which is to take away either ‘toxic’ assets as we saw under quantitative easing, or to buy up
assets and free up money to invest elsewhere.
When a central bank engages in open market operations, it firstly creates cash. Then, it
purchases financial assets such as government bonds and gilts, and other instruments. The cash
then passes over to the financial institution that it purchased them from. This then acts as new
money into the economy.
At the same time, some central banks such as the US’ Federal Reserve transfer any profits
made back to the treasury. So central banks purchase government debt and when government
payments include interest, these profits go back to the government anyway.
Reserve Requirements
Central banks often use reserve requirements to increase and decrease the supply of money. It
does this by requiring each bank to keep back a certain percent of each deposit they take in.
For instance, most commercial banks will only keep 5 cents for each dollar put in, and loan out
the other 95 cents.
So if the central bank was to raise the reserve requirement to 10 percent, then commercial banks
would have to keep 10 cents for each dollar, and only loan out 90 cents. In turn that means few
loans going out, thereby restricting the circulation of money.
Foreign Exchange Reserves
Central banks will usually hold a significant amount of international currencies at any one
point. For instance, the Federal Reserve held $41 billion in foreign currencies at the start of
2020.
The aim of which is to be able to help stabilise fluctuations in the foreign exchange market. If
the US dollar was to significantly lose its value, the Federal Reserve may look to purchase US
dollars with foreign currencies in order to increase its value.
As the Federal Reserve purchases more and more US dollars, it sends a signal to the market
that it is in high demand, thereby strengthening its value and stabilising the market.

COMMERCIAL BANK
The term commercial bank refers to a financial institution that accepts deposits,
offers checking account services, makes various loans, and offers basic financial products
like certificates of deposit (CDs) and savings accounts to individuals and small businesses. A
commercial bank is where most people do their banking.
Commercial banks make money by providing and earning interest from loans such as
mortgages, auto loans, business loans, and personal loans. Customer deposits provide banks
with the capital to make these loans
Significance of Commercial Banks
Commercial banks are an important part of the economy. Not only do they provide consumers
with an essential service, but they also help create capital and liquidity in the market.
They ensure liquidity by taking the funds that their customers deposit in their accounts and
lending them out to others. Commercial banks play a role in the creation of credit, which leads
to an increase in production, employment, and consumer spending, thereby boosting the
economy.
As such, commercial banks are heavily regulated by a central bank in their country or region.
For instance, central banks impose reserve requirements on commercial banks. This means
banks are required to hold a certain percentage of their consumer deposits at the central bank
as a cushion if there's a rush to withdraw funds by the general public.
Special Considerations
Customers find commercial bank investments, such as savings accounts and CDs, attractive
because they are insured by the Federal Deposit Insurance Corporation (FDIC), and money can
be easily withdrawn. Customers have the option to withdraw money upon demand and the
balances are fully insured up to $250,000. Therefore, banks do not have to pay much for this
money.1
Many banks pay no interest at all on checking account balances (or at least pay very little) and
offer interest rates for savings accounts that are well below U.S. Treasury bond (T-bond) rates.
Consumer lending makes up the bulk of North American bank lending, and of this,
residential mortgages make up by far the largest share. Mortgages are used to buy properties
and the homes themselves are often the security that collateralizes the loan. Mortgages are
typically written for 30 year repayment periods and interest rates may be fixed, adjustable, or
variable. Although a variety of more exotic mortgage products were offered during the U.S.
housing bubble of the 2000s, many of the riskier products, including pick-a-payment mortgages
and negative amortization loans, are much less common now.
Automobile lending is another significant category of secured lending for many banks.
Compared to mortgage lending, auto loans are typically for shorter terms and higher rates.
Banks face extensive competition in auto lending from other financial institutions, like captive
auto financing operations run by automobile manufacturers and dealers.
Bank Credit Cards
Credit cards are another significant type of financing. Credit cards are, in essence, personal
lines of credit that can be drawn down at any time. Private card issuers offer them through
commercial banks.
Visa and MasterCard run the proprietary networks through which money is moved around
between the shopper's bank and the merchant's bank after a transaction. Not all banks engage
in credit card lending, as the rates of default are traditionally much higher than in mortgage
lending or other types of secured lending.
That said, credit card lending delivers lucrative fees for banks—interchange fees charged to
merchants for accepting the card and entering into the transaction, late-payment fees, currency
exchange, over-the-limit, and other fees for the card user, as well as elevated rates on the
balances that credit card users carry from one month to the next.
What Role Do Commercial Banks Play in the Economy?
Commercial banks are crucial to the fractional reserve banking system, currently found in most
developed countries. This allows banks to extend new loans of up to (typically) 90% of the
deposits they have on hand, theoretically growing the economy by freeing capital for lending.

Function of Commercial Bank:

The functions of commercial banks are classified into two main divisions.
(a) Primary functions
Accepts deposit : The bank takes deposits in the form of saving, current, and fixed deposits.
The surplus balances collected from the firm and individuals are lent to the temporary
requirements of the commercial transactions.
Provides loan and advances : Another critical function of this bank is to offer loans and
advances to the entrepreneurs and business people, and collect interest. For every bank, it is
the primary source of making profits. In this process, a bank retains a small number of
deposits as a reserve and offers (lends) the remaining amount to the borrowers in demand
loans, overdraft, cash credit, short-run loans, and more such banks.
Credit cash: When a customer is provided with credit or loan, they are not provided with
liquid cash. First, a bank account is opened for the customer and then the money is
transferred to the account. This process allows the bank to create money.

(b) Secondary functions

Discounting bills of exchange: It is a written agreement acknowledging the amount of money
to be paid against the goods purchased at a given point of time in the future. The amount can
also be cleared before the quoted time through a discounting method of a commercial bank.
Overdraft facility: It is an advance given to a customer by keeping the current account to
overdraw up to the given limit.
Purchasing and selling of the securities: The bank offers you with the facility of selling
and buying the securities.
Locker facilities: A bank provides locker facilities to the customers to keep their valuables
or documents safely. The banks charge a minimum of an annual fee for this service.
Paying and gathering the credit : It uses different instruments like a promissory note,
cheques, and bill of exchange.

Types of Commercial Banks:

There are three different types of commercial banks.
Private bank –: It is a type of commercial banks where private individuals and businesses
own a majority of the share capital. All private banks are recorded as companies with limited
liability. Such as Housing Development Finance Corporation (HDFC) Bank, Industrial Credit
and Investment Corporation of India (ICICI) Bank, Yes Bank, and more such banks.
 Public bank –: It is a type of bank that is nationalised, and the government holds a significant
stake. For example, Bank of Baroda, State Bank of India (SBI), Dena Bank, Corporation Bank,
and Punjab National Bank.
Foreign bank –: These banks are established in foreign countries and have branches in other
countries. For instance, American Express Bank, Hong Kong and Shanghai Banking
Corporation (HSBC), Standard & Chartered Bank, Citibank, and more such banks.
You might also want to know: What are the 4Ps of Marketing?

Examples of Commercial Banks

Few examples of commercial banks in India are as follows:
1. State Bank of India (SBI)
2. Housing Development Finance Corporation (HDFC) Bank
3. Industrial Credit and Investment Corporation of India (ICICI) Bank
4. Dena Bank
5. Corporation Bank

RBI MONTARY POLICY

RBI Monetary Policy 2022
The monetary policy is a policy formulated by the central bank, i.e., RBI (Reserve Bank of
India) and relates to the monetary matters of the country. The policy involves measures taken
to regulate the supply of money, availability, and cost of credit in the economy.
The policy also oversees distribution of credit among users as well as the borrowing and
lending rates of interest. In a developing country like India, the monetary policy is significant
in the promotion of economic growth.
Objectives of Monetary Policy
While the main objective of the monetary policy is economic growth as well as price and
exchange rate stability, there are other aspects that it can help with as well.
 Promotion of saving and investment: Since the monetary policy controls the
rate of interest and inflation within the country, it can impact the savings and investment
of the people. A higher rate of interest translates to a greater chance of investment and
savings, thereby, maintaining a healthy cash flow within the economy.
 Controlling the imports and exports: By helping industries secure a loan at a
reduced rate of interest, monetary policy helps export-oriented units to substitute
imports and increase exports. This, in turn, helps improve the condition of the balance
of payments.
 Managing business cycles: The two main stages of a business cycle are boom
and depression. The monetary policy is the greatest tool using which the boom and
depression of business cycles can be controlled by managing the credit to control the
supply of money. The inflation in the market can be controlled by reducing the supply
 of money. On the other hand, when the money supply increases, the demand in the
economy will also witness a rise.
 Regulation of aggregate demand: Since the monetary policy can control the
demand in an economy, it can be used by monetary authorities to maintain a balance
between demand and supply of goods and services. When credit is expanded and the
rate of interest is reduced, it allows more people to secure loans for the purchase of
goods and services. This leads to the rise in demand. On the other hand, when the
authorities wish to reduce demand, they can reduce credit and raise the interest rates.
 Generation of employment: As the monetary policy can reduce the interest
rate, small and medium enterprises (SMEs) can easily secure a loan for business
expansion. This can lead to greater employment opportunities.
 Helping with the development of infrastructure: The monetary policy allows
concessional funding for the development of infrastructure within the country.
 Allocating more credit for the priority segments: Under the monetary policy,
additional funds are allocated at lower rates of interest for the development of the
priority sectors such as small-scale industries, agriculture, underdeveloped sections of
the society, etc.
 Managing and developing the banking sector: The entire banking industry is
managed by the Reserve Bank of India (RBI). While RBI aims to make banking
facilities available far and wide across the nation, it also instructs other banks using the
monetary policy to establish rural branches wherever necessary for agricultural
development. Additionally, the government has also set up regional rural banks and
cooperative banks to help farmers receive the financial aid they require in no time.
FLEXIBLE INFLATION TARGETING FRAMEWORK (FITF)
The Flexible Inflation Targeting Framework (FITF) was introduced in India post the
amendment of the Reserve Bank of India (RBI) Act, 1934 in 2016. In accordance with the RBI
Act, the Government of India sets the inflation target every 5 years after consultation with the
RBI. While the inflation target for the period between 5 August 2016 and 31 March 2021 has
been determined to be 4% of the Consumer Price Index (CPI), the Central Government has
announced that the upper tolerance limit for the same will be 6% and the lower tolerance limit
can be 2% for the same.
 In this framework, there are chances of not achieving the inflation target fixed
for a particular amount of time. This can happen when:
 The average inflation is greater than the upper tolerance level of the inflation
target as predetermined by the Central Government for 3 quarters in a row.
 The average inflation is less than the lower tolerance level of the target inflation
fixed by the Central Government beforehand for 3 consecutive quarters.
MONETARY POLICY TOOLS
To control inflation, the Reserve Bank of India needs to decrease the supply of money or
increase cost of fund in order to keep the demand of goods and services in control.

Quantitative tools
The tools applied by the policy that impact money supply in the entire economy, including
sectors such as manufacturing, agriculture, automobile, housing, etc.
Reserve Ratio
Banks are required to keep aside a set percentage of cash reserves or RBI approved assets.
Reserve ratio is of two types:
 Cash Reserve Ratio (CRR) – Banks are required to set aside this portion in
cash with the RBI. The bank can neither lend it to anyone nor can it earn any interest
rate or profit on CRR.
 Statutory Liquidity Ratio (SLR) – Banks are required to set aside this portion
in liquid assets such as gold or RBI approved securities such as government securities.
Banks are allowed to earn interest on these securities, however it is very low.
 Open Market Operations (OMO):
In order to control money supply, the RBI buys and sells government securities in the
open market. These operations conducted by the Central Bank in the open market are
referred to as Open Market Operations.
When the RBI sells government securities, the liquidity is sucked from the market, and
the exact opposite happens when RBI buys securities. The latter is done to control
inflation. The objective of OMOs are to keep a check on temporary liquidity
mismatches in the market, owing to foreign capital flow.

Qualitative tools
Unlike quantitative tools which have a direct effect on the entire economy’s money supply,
qualitative tools are selective tools that have an effect in the money supply of a specific sector
of the economy.
1. Margin requirements – The RBI prescribes a certain margin against collateral, which in
turn impacts the borrowing habit of customers. When the margin requirements are
raised by the RBI, customers will be able to borrow less.
2. Moral suasion – By way of persuasion, the RBI convinces banks to keep money in
government securities, rather than certain sectors.
3. Selective credit control – Controlling credit by not lending to selective industries or
speculative businesses.

MARKET STABILISATION SCHEME (MSS) -

POLICY RATES:
1. Bank rate – The interest rate at which RBI lends long term funds to banks is
referred to as the bank rate. However, presently RBI does not entirely control money
supply via the bank rate. It uses Liquidity Adjustment Facility (LAF) – repo rate as one
of the significant tools to establish control over money supply.
Bank rate is used to prescribe penalty to the bank if it does not maintain the prescribed
SLR or CRR.
2. Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to
adjust liquidity and money supply. The following types of LAF are:
  Repo rate: Repo rate is the rate at which banks borrow from RBI on a short-
term basis against a repurchase agreement. Under this policy, banks are required to
provide government securities as collateral and later buy them back after a pre-defined
time.
 Reverse Repo rate: It is the reverse of repo rate, i.e., this is the rate RBI pays
to banks in order to keep additional funds in RBI. It is linked to repo rate in the
following way:
Reverse Repo Rate = Repo Rate – 1
3. Marginal Standing Facility (MSF) Rate: MSF Rate is the penal rate at which
the Central Bank lends money to banks, over the rate available under the rep policy.
Banks availing MSF Rate can use a maximum of 1% of SLR securities.
MSF Rate = Repo Rate + 1

MONETARY POLICY TRANSMISSION

Borrowers fail to fully benefit from RBI’s repo rate cut due to the following reasons:
 Banks are not affected by RBI rate cuts as the Central Bank is not their primary money
supplier.
 Deposits already made are fixed at the rates when taken and cannot be reduced; the rate
cuts will only reflect in the new deposit rates.
 PPF, Post Office accounts and other small saving instruments are available at high
administered interest rates and in case of reduction of bank deposit rates, customers
have the choice to move to those funds.
 Banks do not prefer to lower their rates as high lending rates keep their profit margins
up.
 India does not have a well-developed corporate bond market, therefore corporate
customers have little choice but to reach out to banks for borrowing.
Steps to improve monetary transmission:
Both the government and RBI has taken and plans to take some steps in order to accelerate the
transmission of monetary policy.
 Government intends to bring down the interest rates on small saving accounts. If the
small saving rates are linked to the bank rate, this could serve as a permanent solution.
 In order to improve monetary transmission, RBI wants banks to change the calculation
methodology of base rate to marginal cost of funds from average cost of funds.
Despite banks raising the lending rates immediately after RBI’s rate cuts, the Central Bank is
unable to control inflation due to the following reasons:
 Financial deficit in the higher government.
 Issues at the supply side, such as crude oil prices, issues in agri marketing, etc.
 Lack of financial inclusion as borrowers still depend on moneylenders, who are not
under RBI’s control.
 Non-monetised economy in certain rural areas.
 Fiscal Policy:
 A policy set by the finance ministry that deals with matters related to government
expenditure and revenues, is referred to as the fiscal policy. Revenue matter include
matters such as raising of loans, tax policies, service charge, non-tax matters such as
 divestment, etc. While expenditure matters include salaries, pensions, subsidies, funds
used for creating capital assets like bridges, roads, etc.
Demand Pull Inflation:
 This is a state when people have excess money to buy goods in the market. RBI
practises easier control on this as it can lead to a fall in money supply in the economy,
which in turn would mean a drop in the prices.
Supply Side Inflation:
 Inflation in the economy owing to constraints in the supply side of goods in the market.
This cannot be controlled by RBI as it does not control prices of commodities. The
government plays an important role in this case through fiscal policy.
Conclusion:
 The Reserve Bank of India had reduced the repo rate and reverse repo rate to 4.40%
and 4.00% on 27 March. However, with coronavirus pandemic hurting the economy,
the central bank has reduced the reverse repo rate by another 25 basis points on 17
April. Following the reduction, the reverse repo rate stands at 3.75%.
 On 27 March, the central bank had reduced the Marginal Standing Facility (MSF) rate
and the bank rate to 4.65% respectively.