Chapter 1
Three general kinds of commodities may be taken as a representative of all commodities being produced within the economy: agricultural goods, industrial goods and services. These goods may have different production technology and different prices. Macroeconomics also tries to analyse how the individual output levels, prices, and employment levels of these different goods gets determined.
To recapitulate briefly, in microeconomics, you came across individual ‘economic agents’ (see box) and the nature of the motivations that drive them. They were ‘micro’ (meaning ‘small’) agents – consumers choosing their respective optimum combinations of goods to buy, given their tastes and incomes; and producers trying to make maximum profit out of producing their goods keeping their costs as low as possible and selling at a price as high as they could get in the markets. In other words, microeconomics was a study of individual markets of demand and supply and the ‘players’, or the decision- makers, were also individuals (buyers or sellers, even companies) who were seen as trying to maximise their profits (as producers or sellers) and their personal satisfaction or welfare levels (as consumers). Even a large company was ‘micro’ in the sense that it had to act in the interest of its own shareholders which was not necessarily the interest of the country as a whole. For microeconomics the ‘macro’ (meaning ‘large’) phenomena affecting the economy as a whole, like inflation or unemployment, were either not mentioned or were taken as given. These were not variables that individual buyers or sellers could change. The nearest that microeconomics got to macroeconomics was when it looked at General Equilibrium, meaning the equilibrium of supply and demand in each market in the economy.
Economic Agents
By economic units or economic agents, we mean those individuals or institutions which take economic decisions. They can be consumers who decide what and how much to consume. They may be producers of goods and services who decide what and how much to produce. They may be entities like the government, corporation, banks which also take different economic decisions like how much to spend, what interest rate to charge on the credits, how much to tax, etc.
Macroeconomics tries to address situations facing the economy as a whole. Adam Smith, the founding father of modern economics, had suggested that if the buyers and sellers in each market take their decisions following only their own self-interest, economists will not need to think of the wealth and welfare of the country as a whole separately. But economists gradually discovered that they had to look further.
Economists found that first, in some cases, the markets did not or could not exist. Secondly, in some other cases, the markets existed but failed to produce equilibrium of demand and supply. Thirdly, and most importantly, in a large number of situations society (or the State, or the people as a whole) had decided to pursue certain important social goals unselfishly (in areas like employment, administration, defence, education and health) for which some of the aggregate effects of the microeconomic decisions made by the individual economic agents needed to be modified. For these purposes macroeconomists had to study the effects in the markets of taxation and other budgetary policies, and policies for bringing about changes in money supply, the rate of interest, wages, employment, and output.
Macroeconomics shows two simple characteristics that are evident in dealing with the situations we have just listed. These are briefly mentioned below.
First, who are the macroeconomic decision makers (or ‘players’)? Macroeconomic policies are pursued by the State itself or statutory bodies like the Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI) and similar institutions. Typically, each such body will have one or more public goals to pursue as defined by law or the Constitution of India itself. These goals are not those of individual economic agents maximising their private profit or welfare. Thus the macroeconomic agents are basically different from the individual decision-makers.
Secondly, what do the macroeconomic decision-makers try to do? Obviously they often have to go beyond economic objectives and try to direct the deployment of economic resources for such public needs as we have listed above. Such activities are not aimed at serving individual self-interests. They are pursued for the welfare of the country and its people as a whole.
EMERGENCE OF MACROECONOMICS
Macroeconomics, as a separate branch of economics, emerged after the British economist John Maynard Keynes published his celebrated book The General Theory of Employment, Interest and Money in 1936. The dominant thinking in economics before Keynes was that all the labourers who are ready to work will find employment and all the factories will be working at their full capacity. This school of thought is known as the classical tradition. However, the Great Depression of 1929 and the subsequent years saw the output and employment levels in the countries of Europe and North America fall by huge amounts. It affected other countries of the world as well. Demand for goods in the market was low, many factories were lying idle, workers were thrown out of jobs. In USA, from 1929 to 1933, unemployment rate rose from 3 per cent to 25 per cent (unemployment rate may be defined as the number of people who are not working and are looking for jobs divided by the total number of people who are working or looking for jobs). Over the same period aggregate output in USA fell by about 33 per cent. These events made economists think about the functioning of the economy in a new way. The fact that the economy may have long lasting unemployment had to be theorised about and explained. Keynes’ book was an attempt in this direction. Unlike his predecessors, his approach was to examine the working of the economy in its entirety and examine the interdependence of the different sectors. The subject of macroeconomics was born.
After producing output with the help of these three factors of production, namely capital, land and labour, the entrepreneur sells the product in the market. The money that is earned is called revenue. Part of the revenue is paid out as rent for the service rendered by land, part of it is paid to capital as interest and part of it goes to labour as wages. The rest of the revenue is the earning of the entrepreneurs and it is called profit. Profits are often used by the producers in the next period to buy new machinery or to build new factories, so that production can be expanded. These expenses which raise productive capacity are examples of investment expenditure.
In short, a capitalist economy can be defined as an economy in which most of the economic activities have the following characteristics (a) there is private ownership of means of production (b) production takes place for selling the output in the market (c) there is sale and purchase of labour services at a price which is called the wage rate (the labour which is sold and purchased against wages is referred to as wage labour).
In both the developed and developing countries, apart from the private capitalist sector, there is the institution of State. The role of the state includes framing laws, enforcing them and delivering justice. The state, in many instances, undertakes production – apart from imposing taxes and spending money on building public infrastructure, running schools, colleges, providing health services etc. These economic functions of the state have to be taken into account when we want to describe the economy of the country.
Apart from the firms and the government, there is another major sector in an economy which is called the household sector. By a household we mean a single individual who takes decisions relating to her own consumption, or a group of individuals for whom decisions relating to consumption are jointly determined.
Macroeconomics sees an economy as a combination of four sectors, namely households, firms, government and external sector
Chapter 2
National Income Accounting
Adam Smith, named his most influential work – An Enquiry into the Nature and Cause of the Wealth of Nations(1776).
The economic wealth, or well-being, of a country thus does not necessarily depend on the mere possession of resources; the point is how these resources are used in generating a flow of production and how, as a consequence, income and wealth are generated from that process.
An item that is meant for final use and will not pass through any more stages of production or transformations is called a final good.
Why do we call this a final good? Because once it has been sold it passes out of the active economic flow. It will not undergo any further transformation at the hands of any producer. It may, however, undergo transformation by the action of the ultimate purchaser. In fact many such final goods are transformed during their consumption. Thus the tea leaves purchased by the consumer are not consumed in that form – they are used to make drinkable tea, which is consumed. Similarly most of the items that enter our kitchen are transformed through the process of cooking. But cooking at home is not an economic activity, even though the product involved undergoes transformation. Home cooked food is not sold to the market. However, if the same cooking or tea brewing was done in a restaurant where the cooked product would be sold to customers, then the same items, such as tea leaves, would cease to be final goods and would be counted as inputs to which economic value addition can take place. Thus it is not in the nature of the good but in the economic nature of its use that a good becomes a final good.
if we consider all the final goods and services produced in an economy in a given period of time they are either in the form of consumption goods (both durable and non-durable) or capital goods. As final goods they do not undergo any further transformation in the economic process.
Of the total production taking place in the economy a large number of products don’t end up in final consumption and are not capital goods either. Such goods may be used by other producers as material inputs. Examples are steel sheets used for making automobiles and copper used for making utensils. These are intermediate goods, mostly used as raw material or inputs for production of other commodities. These are not final goods.
But why are we to measure final goods only? Surely intermediate goods are crucial inputs to any production process and a significant part of our manpower and capital stock are engaged in production of these goods. However, since we are dealing with value of output, we should realise that the value of the final goods already includes the value of the intermediate goods that have entered into their production as inputs. Counting them separately will lead to the error of double counting. Whereas considering intermediate goods may give a fuller description of total economic activity, counting them will highly exaggerate the final value of our economic activity.
At this stage it is important to introduce the concepts of stocks and flows.
Thus income, or output, or profits are concepts that make sense only when a time period is specified. These are called flows because they occur in a period of time.
Flows are defined over a period of time.
In contrast, capital goods or consumer durables once produced do not wear out or get consumed in a delineated time period. In fact capital goods continue to serve us through different cycles of production.
These are called stocks. Stocks are defined at a particular point of time. However we can measure a change in stock over a specific period of time like how many machines were added this year. Such changes in stocks are thus flows, which can be measured over specific time periods. A particular machine can be part of the capital stock for many years (unless it wears out); but that machine can be part of the flow of new machines added to the capital stock only for a single year when it was initially installed.
The consumer goods sustain the consumption of the entire population of the economy. Purchase of consumer goods depends on the capacity of the people to spend on these goods which, in turn, depends on their income.
Depreciation does not take into account unexpected or sudden destruction or disuse of capital as can happen with accidents, natural calamities or other such extraneous circumstances.
But aren’t we contradicting ourselves? Earlier we have seen how, of the total output of final goods of an economy, if a larger share goes for production of capital goods, a smaller share is available for production of consumer goods. And now we are saying more capital goods would mean more consumer goods. There is no contradiction here however. What is important here is the element of time. At a particular period, given a level of total output of the economy, it is true if more capital goods are produced less of consumer goods would be produced. But production of more capital goods would mean that in future the labourers would have more capital equipments to work with. We have seen that this leads to a higher capacity of the economy to produce with the same number of labourers.
John Maynard Keynes
He prophesied the break down of the peace agreement of the War in the book The Economic Consequences of the Peace (1919). His book General Theory of Employment, Interest and Money (1936) is regarded as one of the most influential economics books of the
twentieth century. He was also a shrewd foreign currency speculator.
Since we are dealing with all goods and services that are produced for the market, the crucial factor enabling such sale is demand for such products backed by purchasing power. One must have the necessary ability to purchase commodities. Otherwise one’s need for commodities does not get recognised by the market.
As we have mentioned before, there may fundamentally be four kinds of contributions that can be made during the production of goods and services (a) contribution made by human labour, remuneration for which is called wage (b) contribution made by capital, remuneration for which is called interest (c) contribution made by entrepreneurship, remuneration of which is profit (d) contribution made by fixed natural resources (called ‘land’), remuneration for which is called rent.
The Product or Value Added Method
The term that is used to denote the net contribution made by a firm is called its value added. We have seen that the raw materials that a firm buys from another firm which are completely used up in the process of production are called ‘intermediate goods’. Therefore the value added of a firm is, value of production of the firm – value of intermediate goods used by the firm. The value added of a firm is distributed among its four factors of production, namely, labour, capital, entrepreneurship and land. Therefore wages, interest, profits and rents paid out by the firm must add up to the value added of the firm. Value added is a flow variable.
If we include depreciation in value added then the measure of value added that we obtain is called Gross Value Added. If we deduct the value of depreciation from gross value added we obtain Net Value Added. Unlike gross value added, net value added does not include wear and tear that capital has undergone.
In economics, the stock of unsold finished goods, or semi-finished goods, or raw materials which a firm carries from one year to the next is called inventory. Inventory is a stock variable.
Change in inventories takes place over a period of time. Therefore it is a flow variable.
Inventories are treated as capital. Addition to the stock of capital of a firm is known as investment. Therefore change in the inventory of a firm is treated as investment.
If government expenditure exceeds the tax revenue earned by it. This is referred to as budget deficit.Trade deficit–it measures the excess of import expenditure over the export revenue earned by the economy .
GNP ≡ GDP + Factor income earned by the domestic factors of production employed in the rest of the world – Factor income earned by the factors of production of the rest of the world employed in the domestic economy
Hence, GNP ≡ GDP + Net factor income from abroad
If we deduct depreciation from GNP the measure of aggregate income that we obtain is called Net National Product (NNP). Thus
NNP ≡ GNP – Depreciation
It is to be noted that all these variables are evaluated at market prices. Through the expression given above, we get the value of NNP evaluated at market prices. But market price includes indirect taxes. When indirect taxes are imposed on goods and services, their prices go up. Indirect taxes accrue to the government. We have to deduct them from NNP evaluated at market prices in order to calculate that part of NNP which actually accrues to the factors of production. Similarly, there may be subsidies granted by the government on the prices of some commodities (in India petrol is heavily taxed by the government, whereas cooking gas is subsidised). So we need to add subsidies to the NNP evaluated at market prices. The measure that we obtain by doing so is called Net National Product at factor cost or National Income.
Thus, NNP at factor cost ≡ National Income (NI ) ≡ NNP at market prices – (Indirect taxes – Subsidies) ≡ NNP at market prices – Net indirect taxes (Net indirect taxes ≡ Indirect taxes – Subsidies)
Part of NI which is received by households. We shall call this Personal Income (PI).
Personal Income (PI) ≡ NI – Undistributed profits – Net interest payments made by households – Corporate tax + Transfer payments to the households from the government and firms.
However, even PI is not the income over which the households have complete say. They have to pay taxes from PI. If we deduct the Personal Tax Payments (income tax, for example) and Non-tax Payments (such as fines) from PI, we obtain what is known as the Personal Disposable Income. Thus
Personal Disposable Income (PDI ) ≡ PI – Personal tax payments – Non-tax payments.
Personal Disposable Income is the part of the aggregate income which belongs to the households. They may decide to consume a part of it, and save the rest.
GOODS AND PRICES
If we measure the GDP of a country in two consecutive years and see that the figure for GDP of the latter year is twice that of the previous year, we may conclude that the volume of production of the country has doubled. But it is possible that only prices of all goods and services have doubled between the two years whereas the production has remained constant.
For comparison we take the help of real GDP. Real GDP is calculated in a way such that the goods and services are evaluated at some constant set of prices (or constant prices). Since these prices remain fixed, if the Real GDP changes we can be sure that it is the volume of production which is undergoing changes. Nominal GDP, on the other hand, is simply the value of GDP at the current prevailing prices.
The ratio of nominal to real GDP is a well known index of prices. This is called GDP Deflator. Thus if GDP stands for nominal GDP and
gdp stands for real GDP then, GDP deflator = GDP/gdp
There is another way to measure change of prices in an economy which is known as the Consumer Price Index (CPI). This is the index of prices of a given basket of commodities which are bought by the representative consumer. CPI is generally expressed in percentage terms. We have two years under consideration – one is the base year, the other is the current year. We calculate the cost of purchase of a given basket of commodities in the base year. We also calculate the cost of purchase of the same basket in the current year. Then we express the latter as a percentage of the former. This gives us the Consumer Price Index of the current year vis- ́a-vis the base year.
It is worth noting that many commodities have two sets of prices. One is the retail price which the consumer actually pays. The other is the wholesale price, the price at which goods are traded in bulk. These two may differ in value because of the margin kept by traders.
Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI). In countries like USA it is referred to as Producer Price Index (PPI). Notice CPI (and analogously WPI) may differ from GDP deflator because
- The goods purchased by consumers do not represent all the goods which are produced in a country. GDP deflator takes into account all such goods and services.
- CPI includes prices of goods consumed by the representative consumer,hence it includes prices of imported goods. GDP deflator does not include prices of imported goods.
- The weights are constant in CPI – but they differ according to production level of each good in GDP deflator.
GDP and Welfare
Can the GDP of a country be taken as an index of the welfare of the people of that country?
GDP is the sum total of value of goods and services created within the geographical boundary of a country in a particular year.
But there are at least three reasons why this may not be correct
1. Distribution of GDP–how uniform is it: If the GDP of the country is rising, the welfare may not rise as a consequence. This is because the rise in GDP may be concentrated in the hands of very few individuals or firms. For the rest, the income may in fact have fallen. In such a case the welfare of the entire country cannot be said to have increased.
2. Non-monetary exchanges: Many activities in an economy are not evaluated in monetary terms. For example, the domestic services women perform at home are not paid for. The exchanges which take place in the informal sector without the help of money are called barter exchanges. In barter exchanges goods (or services) are directly exchanged against each other. But since money is not being used here, these exchanges are not registered as part of economic activity. In developing countries, where many remote regions are underdeveloped, these kinds of exchanges do take place, but they are generally not counted in the GDPs of these countries. This is a case of underestimation of GDP. Hence GDP calculated in the standard manner may not give us a clear indication of the productive activity and well-being of a country.
3. Externalities: Externalities refer to the benefits (or harms) a firm or an individual causes to another for which they are not paid (or penalised). Externalities do not have any market in which they can be bought and sold. For example, let us suppose there is an oil refinery which refines crude petroleum and sells it in the market. The output of the refinery is the amount of oil it refines. We can estimate the value added of the refinery by deducting the value of intermediate goods used by the refinery (crude oil in this case) from the value of its output. The value added of the refinery will be counted as part of the GDP of the economy. But in carrying out the production the refinery may also be polluting the nearby river. This may cause harm to the people who use the water of the river. Hence their well being will fall. Pollution may also kill fish or other organisms of the river on which fish survive. As a result the fishermen of the river may be losing their livelihood. Such harmful effects that the refinery is inflicting on others, for which it will not bear any cost, are called externalities. In this case, the GDP is not taking into account such negative externalities. Therefore, if we take GDP as a measure of welfare of the economy we shall be overestimating the actual welfare. This was an example of negative externality. There can be cases of positive externalities as well. In such cases GDP will underestimate the actual welfare of the economy.
Chapter 3
Money and Banking
FUNCTIONS OF MONEY
The first and foremost role of money is that it acts as a medium of exchange.
DEMAND FOR MONEY
Money is the most liquid of all assets in the sense that it is universally acceptable and hence can be exchanged for other commodities very easily. On the other hand, it has an opportunity cost. If, instead of holding on to a certain cash balance, you put the money in a fixed deposits in some bank you can earn interest on that money. While deciding on how much money to hold at a certain point of time one has to consider the trade off between the advantage of liquidity and the disadvantage of the foregone interest. Demand for money balance is thus often referred to as liquidity preference. People desire to hold money balance broadly from two motives.
The Transaction Motive
The Speculative Motive
An individual may hold her wealth in the form of landed property, bullion, bonds, money etc. For simplicity, let us club all forms of assets other than money together into a single category called ‘bonds’. Typically, bonds are papers bearing the promise of a future stream of monetary returns over a certain period of time. These papers are issued by governments or firms for borrowing money from the public and they are tradable in the market.
A firm wishes to raise a loan of Rs 100 from the public. It issues a bond that assures Rs 10 at the end of the first year and Rs 10 plus the principal of Rs 100 at the end of the second year. Such a bond is said to have a face value of Rs 100, a maturity period of two years and a coupon rate of 10 per cent
Clearly the bond is more attractive than the savings bank account and people will rush to get hold of the bond. Competitive bidding will raise the price of the bond above its face value, till price of the bond is equal to its PV(Present Value). If price rises above the PV the bond becomes less attractive compared to the savings bank account and people would like to get rid of it. The bond will be in excess supply and there will be downward pressure on the bond-price which will bring it back to the PV. It is clear that under competitive assets market condition the price of a bond must always be equal to its present value in equilibrium.
It follows that the price of a bond is inversely related to the market rate of interest.
Different people have different expectations regarding the future movements in the market rate of interest based on their private information regarding the economy. If you think that the market rate of interest should eventually settle down to 8 per cent per annum, then you may consider the current rate of 5 per cent too low to be sustainable over time. You expect interest rate to rise and consequently bond prices to fall. If you are a bond holder a decrease in bond price means a loss to you – similar to a loss you would suffer if the value of a property held by you suddenly depreciates in the market. Such a loss occurring from a falling bond price is called a capital loss to the bond holder. Under such circumstances, you will try to sell your bond and hold money instead. Thus speculations regarding future movements in interest rate and bond prices give rise to the speculative demand for money.
When the interest rate is very high everyone expects it to fall in future and hence anticipates capital gains from bond-holding. Hence people convert their money into bonds. Thus, speculative demand for money is low. When interest rate comes down, more and more people expect it to rise in the future and anticipate capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money. Hence speculative demand for money is inversely related to the rate of interest.
As mentioned earlier, interest rate can be thought of as an opportunity cost
or ‘price’ of holding money balance. If supply of money in the economy increases
and people purchase bonds with this extra money, demand for bonds will go
up, bond prices will rise and rate of interest will decline. In other words, with an
increased supply of money in the economy the price you have to pay for holding
money balance, viz. the rate of interest, should come down.
However, if the market rate of interest is already low enough so that everybody expects it to rise in
future, causing capital losses, nobody will wish to hold bonds. Everyone in the
economy will hold their wealth in money balance and if additional money is injected within the economy it will be used up to satiate people’s craving for money balances without increasing the demand for bonds and without further lowering the rate of interest below the floor Rmin. Such a situation is called a liquidity trap. The speculative money demand function is infinitely elastic here.
When r = rmax, speculative demand for money is zero. The rate of interest is so high that everyone expects it to fall in future and hence is sure about a future capital gain. Thus everyone has converted the speculative money balance into bonds.
When r = rmin, the economy is in the liquidity trap. Everyone is sure of a future rise in interest rate and a fall in bond prices. Everyone puts whatever wealth they acquire in the form of money and the speculative demand for money is infinite.
Total demand for money in an economy is, therefore, composed of transaction demand and speculative demand. The former is directly proportional to real GDP and price level, whereas the latter is inversely related to the market rate of interest.
THE SUPPLY OF MONEY
In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India. However, coins are issued by the Government of India. Apart from currency notes and coins, the balance in savings, or current account deposits, held by the public in commercial banks is also considered money since cheques drawn on these accounts are used to settle transactions. Such deposits are called demand deposits as they are payable by the bank on demand from the account- holder. Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits.
The value of the currency notes and coins is derived from the guarantee provided by the issuing authority of these items. Every currency note bears on its face a promise from the Governor of RBI that if someone produces the note to RBI, or any other commercial bank, RBI will be responsible for giving the person purchasing power equal to the value printed on the note. The same is also true of coins. Currency notes and coins are therefore called fiat money. They do not have intrinsic value like a gold or silver coin. They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction. Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of payment. Hence, demand deposits are not legal tenders.
Legal Definitions: Narrow and Broad Money
Money supply, like money demand, is a stock variable. The total stock of money in circulation among the public at a particular point of time is called money supply. RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows
M1 = CU + DD
M2 = M1 + Savings deposits with Post Office savings banks
M2 = M1 + Savings deposits with Post Office savings banks
M3 = M1 + Net time deposits of commercial banks
M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates)
M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates)
where, CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks. The word ‘net’ implies that only deposits of the public held by the banks are to be included in money supply. The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of money supply.
M1 and M2 are known as narrow money. M3 and M4 are known as broad money. These gradations are in decreasing order of liquidity. M1 is most liquid and easiest for transactions whereas M4 is least liquid of all. M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources1.
The Currency Deposit Ratio: The currency deposit ratio (cdr) is the ratio of money held by the public in currency to that they hold in bank deposits. cdr = CU/DD. If a person gets Re 1 she will put Rs 1/(1 + cdr) in her bank account and keep Rs cdr/(1 + cdr) in cash. It reflects people’s preference for liquidity. It is a purely behavioural parameter which depends, among other things, on the seasonal pattern of expenditure. For example, cdr increases during the festive season as people convert deposits to cash balance for meeting extra expenditure during such periods.
The Reserve Deposit Ratio: Banks hold a part of the money people keep in their bank deposits as reserve money and loan out the rest to various investment projects. Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI. Banks use this reserve to meet the demand for cash by account holders. Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves.
Keeping reserves is costly for banks, as, otherwise, they could lend this balance to interest earning investment projects. However, RBI requires commercial banks to keep reserves in order to ensure that banks have a safe cushion of assets to draw on when account holders want to be paid.
RBI uses various policy instruments to bring forth a healthy rdr in commercial banks. The first instrument is the Cash Reserve Ratio which specifies the fraction of their deposits that banks must keep with RBI. There is another tool called Statutory Liquidity Ratio which requires the banks to maintain a given fraction of their total demand and time deposits in the form of specified liquid assets. Apart from these ratios RBI uses a certain interest rate called the Bank Rate to control the value of rdr. Commercial banks can borrow money from RBI at the bank rate when they run short of reserves. A high bank rate makes such borrowing from RBI costly and, in effect, encourages the commercial banks to maintain a healthy rdr.
Commercial Banks accept deposits from the public and lend out this money to interest earning investment projects. The rate of interest offered by the bank to deposit holders is called the ‘borrowing rate’ and the rate at which banks lend out their reserves to investors is called the ‘lending rate’. The difference between the two rates, called ‘spread’, is the profit that is appropriated by the banks. Deposits are broadly of two types – demand deposits, payable by the banks on demand from the account holder, e.g. current and savings account deposits, and time deposits, which have a fixed period to maturity, e.g. fixed deposits. Lending by commercial banks consists mainly of cash credit, demand and short- term loans to private investors and banks’ investments in government securities and other approved bonds. The creditworthiness of a person is judged by her current assets or the collateral (a security pledged for the repayment of a loan) she can offer.
High Powered Money: The total liability of the monetary authority of the country, RBI, is called the monetary base or high powered money. It consists of currency (notes and coins in circulation with the public and vault cash of commercial banks) and deposits held by the Government of India and commercial banks with RBI. If a member of the public produces a currency note to RBI the latter must pay her value equal to the figure printed on the note. Similarly, the deposits are also refundable by RBI on demand from deposit-holders. These items are claims which the general public, government or banks have on RBI and hence are considered to be the liability of RBI.
RBI acquires assets against these liabilities. The process can be understood easily if we consider a simple stylised example. Suppose RBI purchases gold or dollars worth Rs 5. It pays for the gold or foreign exchange by issuing currency to the seller. The currency in circulation in the economy thus goes up by Rs 5, an item that shows up on the liability side of the balance sheet. The value of the acquired assets, also equal to Rs 5, is entered under the appropriate head on the Assets side. Similarly, RBI acquires debt bonds or securities issued by the government and pays the government by issuing currency in return. It issues loans to commercial banks in a similar fashion2.
Instruments of Monetary Policy and the Reserve Bank of India
The total amount of deposits held by all commercial banks in the country is much larger than the total size of their reserves. If all the account-holders of all commercial banks in the country want their deposits back at the same time, the banks will not have enough means to satisfy the need of every account- holder and there will be bank failures.
All this is common knowledge to every informed individual in the economy. Why do they still keep their money in bank deposits when they are aware of the possibility of default by their banks in case of a bank run (a situation where everybody wants to take money out of one’s bank account before the bank runs out of reserves)?
The Reserve Bank of India plays a crucial role here. In case of a crisis like the above it stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter. This system of guarantee assures individual account-holders that their banks will be able to pay their money back in case of a crisis and there is no need to panic thus avoiding bank runs. This role of the monetary authority is known as the lender of last resort.
Apart from acting as a banker to the commercial banks, RBI also acts as a banker to the Government of India, and also, to the state governments. It is commonly held that the government, sometimes, ‘prints money’ in case of a budget deficit, i.e., when it cannot meet its expenses (e.g. salaries to the government employees, purchase of defense equipment from a manufacturer of such goods etc.) from the tax revenue it has earned. The government, however, has no legal authority to issue currency in this fashion. So it borrows money by selling treasury bills or government securities to RBI, which issues currency to the government in return. The government then pays for its expenses with this
money. The money thus ultimately comes into the hands of the general public (in the form of salary or sales proceeds of defense items etc.) and becomes a part of the money supply. Financing of budget deficits by the governments in this fashion is called Deficit Financing through Central Bank Borrowing.
However, the most important role of RBI is as the controller of money supply and credit creation in the economy. RBI is the independent authority for conducting monetary policy in the best interests of the economy – it increases or decreases the supply of high powered money in the economy and creates incentives or disincentives for the commercial banks to give loans or credits to investors. The instruments which RBI uses for conducting monetary policy are as follows.
Open Market Operations:
RBI purchases (or sells) government securities to the general public in a bid to increase (or decrease) the stock of high powered money in the economy.
If RBI wishes to reduce the supply of high powered money it undertakes an open market sale of government securities of its own holding in just the reverse fashion, thereby reducing the monetary base.
Bank Rate Policy: RBI can affect the reserve deposit ratio of commercial banks by adjusting the value of the bank rate – which is the rate of interest commercial banks have to pay RBI – if they borrow money from it in case of shortage of reserves.
Varying Reserve Requirements: Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) also work through the rdr-route. A high (or low) value of CRR or SLR helps increase (or decrease) the value of reserve deposit ratio, thus diminishing (or increasing) the value of the money multiplier and money supply in the economy in a similar fashion.
Sterilisation by RBI: RBI often uses its instruments of money creation for stabilising the stock of money in the economy from external shocks. Suppose due to future growth prospects in India investors from across the world increase their investments in Indian bonds which under such circumstances, are likely to yield a high rate of return. They will buy these bonds with foreign currency. Since one cannot purchase goods in the domestic market with foreign currency, a person or a financial institution who sells these bonds to foreign investors will exchange its foreign currency holding into rupee at a commercial bank. The bank, in turn, will submit this foreign currency to RBI and its deposits with RBI will be credited with equivalent sum of money.
What kind of adjustments take place from this entire transaction? The commercial bank’s total reserves and deposits remain unchanged (it has purchased the foreign currency from the seller using its vault cash, which, therefore, goes down; but the bank’s deposit with RBI goes up by an equivalent amount – leaving its total reserves unchanged). There will, however, be increments in the assets and liabilities on the RBI balance sheet. RBI’s foreign exchange holding goes up. On the other hand, the deposits of commercial banks with RBI also increase by an equal amount. But that means an increase in the stock of high powered money – which, by definition, is equal to the total liability of RBI. With money multiplier in operation, this, in turn, will result in increased money supply in the economy.
This increased money supply may not altogether be good for the economy’s health. If the volume of goods and services produced in the economy remains unchanged, the extra money will lead to increase in prices of all commodities. People have more money in their hands with which they compete each other in the commodities market for buying the same old stock of goods. As too much money is now chasing the same old quantities of output, the process ends up in bidding up prices of every commodity – an increase in the general price level, which is also known as inflation.
RBI often intervenes with its instruments to prevent such an outcome. In the above example, RBI will undertake an open market sale of government securities of an amount equal to the amount of foreign exchange inflow in the economy, thereby keeping the stock of high powered money and total money supply unchanged. Thus it sterilises the economy against adverse external shocks. This operation of RBI is known as sterilisation.
Money supply is, therefore, an important macroeconomic variable. Its overall influence on the values of the equilibrium rate of interest, price level and output of an economy is of great significance.
Chapter 4
Income Determination
Ex Ante Investment: Investment is defined as addition to the stock of physical capital (such as machines, buildings, roads etc., i.e. anything that adds to the future productive capacity of the economy) and changes in the inventory (or the stock of finished goods) of a producer. Note that ‘investment goods’ (such as machines) are also part of the final goods – they are not intermediate goods like
raw materials. Machines produced in an economy in a given year are not ‘used up’ to produce other goods but yield their services over a number of years.
Chapter 5
Government Budget and the Economy
First, certain goods, referred to as public goods (such as national defence, roads, government administration), as distinct from private goods (like clothes, cars, food items), cannot be provided through the market mechanism, i.e. by transactions between individual consumers and producers and must be provided by the government. This is the allocation function.
Second, through its tax and expenditure policy, the government attempts to bring about a distribution of income that is considered ‘fair’ by society. The government affects the personal disposable income of households by making transfer payments and collecting taxes and, therefore, can alter the income distribution. This is the distribution function.
Third, the economy tends to be subject to substantial fluctuations and may suffer from prolonged periods of unemployment or inflation. The overall level of employment and prices in the economy depends upon the level of aggregate demand which is a function of the spending decisions of millions of private economic agents apart from the government. These decisions, in turn, depend on many factors such as income and credit availability. In any period, the level of expenditures may not be sufficient for full utilisation of labour and other resources of the economy. Since wages and prices are generally rigid downwards (they do not fall below a level), employment cannot be restored automatically. Hence, policy measures are needed to raise aggregate demand. On the other hand, there may be times when expenditures exceed the available output under conditions of high employment and thus may cause inflation. In such situations, restrictive conditions are needed to reduce demand. These constitute the stabilisation requirements of the domestic economy.
To understand the need for governmental provision of public goods, we must consider what distinguishes them from private goods. There are two major differences.
One, the benefits of public goods are not limited to one particular consumer, as in the case of private goods, but become available to all.
However, if we consider a public park or measures to reduce air pollution, the benefits will be available to all. The consumption of such products by several individuals is not ‘rivalrous’ in the sense that a person can enjoy the benefits without reducing their availablity to others.
Two, in case of private goods anyone who does not pay for the good can be excluded from enjoying its benefits. If you do not buy a ticket, you are excluded from watching a film at a local theatre. However, in case of public goods, there is no feasible way of excluding anyone from enjoying the benefits of the good (they are non-excludable). Since non-paying users usually cannot be excluded, it becomes difficult or impossible to collect fees for the public good. This leads to the ‘free-rider’ problem.
COMPONENTS OF THE GOVERNMENT BUDGET
There is a constitutional requirement in India (Article 112) to present before the Parliament a statement of estimated receipts and expenditures of the government in respect of every financial year which runs from 1 April to 31 March. This ‘Annual Financial Statement’ constitutes the main budget document. Further, the budget must distinguish expenditure on the revenue account from other expenditures. Therefore, the budget comprises of the (a) Revenue Budget and the (b) Capital Budget .
The Revenue(-Income) Account
The Revenue Budget shows the current receipts of the government and the expenditure that can be met from these receipts.
The Revenue Budget shows the current receipts of the government and the expenditure that can be met from these receipts.
Gov Budget= Revenue Budget( Receipts + Expenditure)+Capital Budget( Receipts + Expenditure)
Revenue Receipts = Tax Revenue + Non-Tax Revenue
Revenue Expenditure = Plan Revenue+ Non-plan Revenue
Capital Receipts
Capital Expenditure = Plan Capital Expenditure + Non-plan Capital Expenditure
Revenue Receipts: Revenue receipts are receipts of the government which are non-redeemable, that is, they cannot be reclaimed from the government. They are divided into tax and non-tax revenues.
Tax revenues consist of the proceeds of taxes and other duties levied by the central government. Tax revenues, an important component of revenue receipts, comprise of direct taxes – which fall directly on individuals (personal income tax) and firms (corporation tax), and indirect taxes like excise taxes (duties levied on goods produced within the country), customs duties (taxes imposed on goods imported into and exported out of India) and service tax. Other direct taxes like wealth tax, gift tax and estate duty (now abolished) have never been of much significance in terms of revenue yield and have thus been referred to as ‘paper taxes’. Corporation tax contributed the largest share in revenues in 2010-11 (37.7 per cent) while Personal Income tax contributed the second largest (17.4 per cent). The share of direct taxes in gross tax revenue has increased from 19.1 per cent in 1990-91 to 52.2 per cent in 2010-11.
The redistribution objective is sought to be achieved through progressive income taxation, in which higher the income, higher is the tax rate. Firms are taxed on a proportional basis, where the tax rate is a particular proportion of profits. With respect to excise taxes, necessities of life are exempted or taxed at low rates, comforts and semi-luxuries are moderately taxed, and luxuries, tobacco and petroleum products are taxed heavily.
Non-tax revenue of the central government mainly consists of interest receipts on account of loans by the central government, dividends and profits on investments made by the government, fees and other receipts for services rendered by the government. Cash grants-in-aid from foreign countries and international organisations are also included.
The estimates of revenue receipts take into account the effects of tax proposals made in the Finance Bill.
Revenue Expenditure: Revenue Expenditure is expenditure incurred for purposes other than the creation of physical or financial assets of the central government. It relates to those expenses incurred for the normal functioning of the government departments and various services, interest payments on debt incurred by the government, and grants given to state governments and other parties (even though some of the grants may be meant for creation of assets).
Budget documents classify total expenditure into plan and non-plan expenditure. Within revenue expenditure, a distinction is made between plan and non-plan. According to this classification, plan revenue expenditure relates to central Plans (the Five-Year Plans) and central assistance for State and Union Territory plans. Non-plan expenditure, the more important component of revenue expenditure, covers a vast range of general, economic and social services of the government. The main items of non-plan expenditure are interest payments, defence services, subsidies, salaries and pensions.
Interest payments on market loans, external loans and from various reserve funds constitute the single largest component of non-plan revenue expenditure. Defence expenditure, is committed expenditure in the sense that given the national security concerns, there exists little scope for drastic reduction. Subsidies are an important policy instrument which aim at increasing welfare. Apart from providing implicit subsidies through under-pricing of public goods and services like education and health, the government also extends subsidies explicitly on items such as exports, interest on loans, food and fertilisers. The amount of subsidies as a per cent of GDP 1.7 per cent in 1990-91 and 1.8 per cent in 2012-13 (Budget Estimates).
The Capital Account
The Capital Budget is an account of the assets as well as liabilities of the central government, which takes into consideration changes in capital. It consists of capital receipts and capital expenditure of the government. This shows the capital requirements of the government and the pattern of their financing.
Capital Receipts: All those receipts of the government which create liability or reduce financial assets are termed as capital receipts. The main items of capital receipts are loans raised by the government from the public which are called market borrowings, borrowing by the government from the Reserve Bank and commercial banks and other financial institutions through the sale of treasury bills, loans received from foreign governments and international organisations, and recoveries of loans granted by the central government. Other items include small savings (Post-Office Savings Accounts, National Savings Certificates, etc), provident funds and net receipts obtained from the sale of shares in Public Sector Undertakings (PSUs) (This is referred to as PSU disinvestment).
Capital Expenditure: There are expenditures of the government which result in creation of physical or financial assets or reduction in financial liabilities. This includes expenditure on the acquisition of land, building, machinery, equipment, investment in shares, and loans and advances by the central government to state and union territory governments, PSUs and other parties. Capital expenditure is also categorised as plan and non-plan in the budget documents. Plan capital expenditure, like its revenue counterpart, relates to central plan and central assistance for state and union territory plans. Non- plan capital expenditure covers various general, social and economic services provided by the government.
Along with the budget, three policy statements are mandated by the Fiscal Responsibility and Budget Management Act, 2003 (FRBMA).
The Medium-term Fiscal Policy Statement sets a three-year rolling target for specific fiscal indicators and examines whether revenue expenditure can be financed through revenue receipts on a sustainable basis and how productively capital receipts including market borrowings are being utilised.
The Fiscal Policy Strategy Statement sets the priorities of the government in the fiscal area, examining current policies and justifying any deviation in important fiscal measures.
The Macroeconomic Framework Statement assesses the prospects of the economy with respect to the GDP growth rate, fiscal balance of the central government and external balance.
Measures of Government Deficit
When a government spends more than it collects by way of revenue, it incurs a budget deficit. There are various measures that capture government deficit and they have their own implications for the economy.
Revenue Deficit: The revenue deficit refers to the excess of government’s revenue expenditure over revenue receipts
Revenue deficit = Revenue expenditure – Revenue receipts
This will lead to a build up of stock of debt and interest liabilities and force the government, eventually, to cut expenditure. Since a major part of revenue expenditure is committed expenditure, it cannot be reduced. Often the government reduces productive capital expenditure or welfare expenditure. This would mean lower growth and adverse welfare implications.
Fiscal Deficit: Fiscal deficit is the difference between the government’s total expenditure and its total receipts excluding borrowing
Gross fiscal deficit = Total expenditure – (Revenue receipts + Non-debt creating capital receipts)
The fiscal deficit will have to be financed through borrowing. Thus, it indicates the total borrowing requirements of the government from all sources. From the financing side
Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad
Net borrowing at home includes that directly borrowed from the public through debt instruments (for example, the various small savings schemes) and indirectly from commercial banks through Statutory Liquidity Ratio (SLR). The gross fiscal deficit is a key variable in judging the financial health of the public sector and the stability of the economy. From the way gross fiscal deficit is measured as given above, it can be seen that revenue deficit is a part of fiscal deficit (Fiscal Deficit = Revenue Deficit + Capital Expenditure - non-debt creating capital receipts). A large share of revenue deficit in fiscal deficit indicated that a large part of borrowing is being used to meet its consumption expenditure needs rather than investment.
Gross primary deficit = Gross fiscal deficit – Net interest liabilities
FISCAL POLICY
One of Keynes’s main ideas in The General Theory of Employment, Interest and Money was that government fiscal policy should be used to stabilise the level of output and employment. Through changes in its expenditure and taxes, the government attempts to increase output and income and seeks to stabilise the ups and downs in the economy. In the process, fiscal policy creates a surplus (when
total receipts exceed expenditure) or a deficit budget (when total expenditure exceed receipts) rather than a balanced budget (when expenditure equals receipts).
Changes in Government Expenditure
We consider the effects of increasing government purchases (G) keeping taxes constant. When G exceeds T, the government runs a deficit. Because G is a component of aggregate spending, planned aggregate expenditure will increase.
The proportional income tax, thus, acts as an automatic stabiliser – a shock absorber because it makes disposable income, and thus consumer spending, less sensitive to fluctuations in GDP.
When GDP rises, disposable income also rises but by less than the rise in GDP because a part of it is siphoned off as taxes. This helps limit the upward fluctuation in consumption spending.
During a recession when GDP falls, disposable income falls less sharply, and consumption does not drop as much as it otherwise would have fallen had the tax liability been fixed. This reduces the fall in aggregate demand and stabilises the economy.
Debt
Budgetary deficits must be financed by either taxation, borrowing or printing money. Governments have mostly relied on borrowing, giving rise to what is called government debt. The concepts of deficits and debt are closely related. Deficits can be thought of as a flow which add to the stock of debt. If the government continues to borrow year after year, it leads to the accumulation of debt and the government has to pay more and more by way of interest. These interest payments themselves contribute to the debt.
Perspectives on the Appropriate Amount of Government Debt:
There are two interlinked aspects of the issue.
One is whether government debt is a burden and two, the issue of financing the debt. The burden of debt must be discussed keeping in mind that what is true of one small trader’s debt may not be true for the government’s debt, and one must deal with the ‘whole’ differently from the ‘part’. Unlike any one trader, the government can raise resources through taxation and printing money.
By borrowing, the government transfers the burden of reduced consumption on future generations. This is because it borrows by issuing bonds to the people living at present but may decide to pay off the bonds some twenty years later by raising taxes. These may be levied on the young population that have just entered the work force, whose disposable income will go down and hence consumption. Thus, national savings, it was argued, would fall. Also, government borrowing from the people reduces the savings available to the private sector. To the extent that this reduces capital formation and growth, debt acts as a ‘burden’ on future generations.
Traditionally, it has been argued that when a government cuts taxes and runs a budget deficit, consumers respond to their after -tax income by spending more. It is possible that these people are short-sighted and do not understand the implications of budget deficits. They may not realise that at some point in the future, the government will have to raise taxes to pay off the debt and accumulated interest. Even if they comprehend this, they may expect the future taxes to fall not on them but on future generations.
A counter argument is that consumers are forward-looking and will base their spending not only on their current income but also on their expected future income. They will understand that borrowing today means higher taxes in the future. Further, the consumer will be concerned about future generations because they are the children and grandchildren of the present generation and the family which is the relevant decision making unit, continues living. They would increase savings now, which will fully offset the increased government dissaving so that national savings do not change. This view is called Ricardian equivalence after one of the greatest nineteenth century economists, David Ricardo, who first argued that in the face of high deficits, people save more. It is called ‘equivalence’ because it argues that taxation and borrowing are equivalent means of financing expenditure. When the government increases spending by borrowing today, which will be repaid by taxes in the future, it will have the same impact on the economy as an increase in government expenditure that is financed by a tax increase today.
It has often been argued that ‘debt does not matter because we owe it to ourselves’. This is because although there is a transfer of resources between generations, purchasing power remains within the nation. However, any debt that is owed to foreigners involves a burden since we have to send goods abroad corresponding to the interest payments.
Other Perspectives on Deficits and Debt: One of the main criticisms of deficits is that they are inflationary. This is because when government increases spending or cuts taxes, aggregate demand increases. Firms may not be able to produce higher quantities that are being demanded at the ongoing prices. Prices will, therefore, have to rise. However, if there are unutilised resources, output is held back by lack of demand. A high fiscal deficit is accompanied by higher demand and greater output and, therefore, need not be inflationary.
Also, if the government invests in infrastructure, future generations may be better off, provided the return on such investments is greater than the rate of interest. The actual debt could be paid off by the growth in output. The debt should not then be considered burdensome. The growth in debt will have to be judged by the growth of the economy as a whole.
Deficit Reduction: Government deficit can be reduced by an increase in taxes or reduction in expenditure. In India, the government has been trying to increase tax revenue with greater reliance on direct taxes (indirect taxes are regressive in nature – they impact all income groups equally). There has also been an attempt to raise receipts through the sale of shares in PSUs. However, the major thrust has been towards reduction in government expenditure. This could be achieved through making government activities more efficient through better planning of programmes and better administration.
We must note that larger deficits do not always signify a more expansionary fiscal policy. The same fiscal measures can give rise to a large or small deficit, depending on the state of the economy. For example, if an economy experiences a recession and GDP falls, tax revenues fall because firms and households pay lower taxes when they earn less. This means that the deficit increases in a recession and falls in a boom, even with no change in fiscal policy.
Chapter 6
Open Economy Macroeconomics
In reality, most modern economies are open. Interaction with other economies of the world widens choice in three broad ways
- (i) Consumers and firms have the opportunity to choose between domestic and foreign goods. This is the product market linkage which occurs through international trade.
- (ii) Investors have the opportunity to choose between domestic and foreign assets. This constitutes the financial market linkage.
- (iii) Firms can choose where to locate production and workers to choose where to work. This is the factor market linkage. Labour market linkages have been relatively less due to various restrictions on the movement of people through immigration laws. Movement of goods has traditionally been seen as a substitute for the movement of labour. We focus here on the first two linkages.
An open economy is one that trades with other nations in goods and services and, most often, also in financial assets. Indians, for instance, enjoy using products produced around the world and some of our production is exported to foreign countries. Foreign trade, therefore, influences Indian aggregate demand in two ways.
First, when Indians buy foreign goods, this spending escapes as a leakage from the circular flow of income decreasing aggregate demand.
Second, our exports to foreigners enter as an injection into the circular flow, increasing aggregate demand for domestically produced goods. Total foreign trade (exports + imports) as a proportion of GDP is a common measure of the degree of openness of an economy.
In 2011-12, this was 53.6 per cent for the Indian Economy (imports constituted 32.3 per cent and exports 21.3 per cent of GDP). There are several countries whose foreign trade proportions are above 50 per cent of GDP.
India’s Services Import at 81.1 billion US$ grew by 3.3% in 2014-15 . The Government has taken policy initiatives to promote services exports which include the Service Export from India Scheme (SEIS) and organising Global Exhibition on Services (GES).
Case Study
Are our imports also damaging the growth of traditionally labour-intensive segments? Thus, by following a free-trade regime, are we importing unemployment?
Let us attempt to answer some of these questions. As far as partners go, the imbalance in trade with China stares us in the face. In 2011-12 we sold $18 billion of goods to China and bought $57.5 bn, leaving behind a whopping trade deficit of $40 bn. The deficit is incidentally up from $16.2 bn in 2007-08. There is much to be admired in the Chinese manufacturing and export model. However, given the fact that China has draconian controls over its labour markets, that Chinese banks are known to give subsidised credit to manufacturing enterprises and the government is believed to, at least in some instances, subsidise exports, it is perhaps legitimate to wonder whether trade with China is entirely fair and beneficial for our own economy.
There are a number of ways in which our trading relationship with China could be hurting our economy. At one end of the spectrum, imports of cheap capital goods, particularly power equipment (currently allowed at 0 per cent duty) threatens the survival of our domestic capital goods companies that have over the decades been acknowledged to be of high quality and efficient. A similar issue has arisen with iron, steel and organic chemicals in which Indian manufacturers have historically been known to have a comparative advantage.
Thus, there appears to be a logical case to consider some safeguards against the flood of imports from China. One option is to raise import tariffs that in most cases are way below the "bindings" we have committed to at the WTO. (The Arun Maira committee has incidentally recommended an increase in the import duty on power equipment to 14 per cent). Second, we must be more vigilant about unfair trade practices such as "dumping" and use the extant forums of redress to fight the flow of "subsidised" exports.
We also need to identify sectors in the economy that are guzzling more imports than we had bargained for. The case of the automobile sector is a case in point. When foreign car manufacturers were allowed in, they made an implicit commitment that they would be foreign exchange neutral — that is, their import needs of components, etc would be balanced by the exports they make from their Indian manufacturing units. While for some companies (particularly the early entrants), this balance is visible in their financials, it would be interesting to assess whether others are following this neutrality principle. If some are violating this, it is for the government to step in and ensure that they play by the rules.
Finally, we need to revisit the old strategy of import substitution, especially when it comes to industrial raw materials. A number of studies have shown that for diverse products Indian firms are competitive and yet we are net importers because of ruthless undercutting of prices. Some examples are organic chemicals, vegetables and animal fats, fibres and yarns. These industries need to be supported and revived. A moderate depreciation in the currency should help as would, again, a selective increase in tariffs.
The optimal degree of openness involves a balance between the benefits it brings and the costs it entails.
Foreign economic agents will accept a national currency only if they are convinced that the currency will maintain a stable purchasing power. Without this confidence, a currency will not be used as an international medium of exchange and unit of account since there is no international authority with the power to force the use of a particular currency in international transactions. Governments have tried to gain confidence of potential users by announcing that the national currency will be freely convertible at a fixed price into another asset, over whose value the issuing authority has no control. This other asset most often has been gold, or other national currencies. There are two aspects of this commitment that has affected its credibility – the ability to convert freely in unlimited amounts and the price at which conversion takes place. The international monetary system has been set up to handle these issues and ensure stability in international transactions. A nation’s commitment regarding the above two issues will affect its trade and financial interactions with the rest of the world.
THE BALANCE OF PAYMENTS
The balance of payments (BoP) record the transactions in goods, services and assets between residents of a country with the rest of the world for a specified time period typically a year. There are two main accounts in the BoP – the current account and the capital account.
The current account records exports and imports in goods and services and transfer payments.When exports exceed imports, there is a trade surplus and when imports exceed exports there is a trade deficit. In
Trade in services denoted as invisible trade (because they are not seen to cross national borders) includes both factor income (net income from compensation of employees and net investment income, the latter equals, the interest, profits and dividends on our assets abroad minus the income foreigners earn on assets they own in India) and net non-factor income (shipping, banking, insurance, tourism, software services, etc.).
Transfer payments are receipts which the residents of a country receive ‘for free’, without having to make any present or future payments in return. They consist of remittances, gifts and grants. They could be official or private.
The balance of exports and imports of goods is referred to as the trade balance.
Adding trade in services and net transfers to the trade balance, we get the current account balance. Transactions from the current account component caused more dollars to flow out as payment than the receipts that flowed in. This is referred to as a current account deficit. If this figure had been a positive number, there would have been a current account surplus.
The capital account records all international purchases and sales of assets such as money, stocks, bonds, etc.
We note that any transaction resulting in a payment to foreigners is entered as a debit and is given a negative sign. Any transaction resulting in a receipt from foreigners is entered as a credit and is given a positive sign.
Can a country have a trade deficit and a current account surplus simultaneously?
In India, although trade deficit is a recurrent feature every year, for three consecutive years from 2001-02, 2002-03 to 2003-04, there was a surplus on the current account, to the tune of 0.7, 1.3 and 2.3 per cents of GDP respectively. This is because that earnings from services and private transfers outweighed the trade deficit.
Any current account deficit is of necessity financed by a net capital inflow.
Alternatively, the country could engage in official reserve transactions, running down its reserves of foreign exchange, in the case of a deficit by selling foreign currency in the foreign exchange market. The decrease (increase) in official reserves is called the overall balance of payments deficit (surplus).
Autonomous and Accommodating Transactions: International economic transactions are called autonomous when transactions are made independently of the state of the BoP (for instance due to profit motive). These items are called ‘above the line’ items in the BoP.
THE FOREIGN EXCHANGE MARKET
The price of one currency in terms of the other is known as the exchange rate.
However, returning to our example, if one wants to plan a trip to London, she needs to know how expensive British goods are relative to goods at home. The measure that captures this is the real exchange rate – the ratio of foreign to domestic prices, measured in the same currency. It is defined as Real exchange rate = ePf / P
where P and Pf are the price levels here and abroad, respectively, and e is the rupee price of foreign exchange (the nominal exchange rate). The numerator expresses prices abroad measured in rupees, the denominator gives the domestic price level measured in rupees, so the real exchange rate measures prices abroad relative to those at home. If the real exchange rate is equal to one, currencies are at purchasing power parity. This means that goods cost the same in two countries when measured in the same currency. For instance, if a pen costs $4 in the US and the nominal exchange rate is Rs 50 per US dollar, then with a real exchange rate of 1, it should cost Rs 200 (ePf = 50 4) in India. If the real exchange rises above one, this means that goods abroad have become more expensive than goods at home. The real exchange rate is often taken as a measure of a country’s international competitiveness.
Flexible Exchange Rates
In a system of flexible exchange rates (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply. In a completely flexible system, the central banks follow a simple set of rules – they do nothing to directly affect the level of the exchange rate, in other words they do not intervene in the foreign exchange market (and therefore, there are no official reserve transactions).
For instance, if the equilibrium rupee-dollar exchange rate was Rs 45 and now it has become Rs 50 per dollar, the rupee has depreciated against the dollar. By contrast, the currency appreciates when it becomes more expensive in terms of foreign currency.
The rise in exchange rate (depreciation) will cause the quantity of import demand to fall since the rupee price of imported goods rises with the exchange rate. Also, the quantity of exports demanded will increase since the rise in the exchange rate makes exports less expensive to foreigners.
Speculation: Exchange rates in the market depend not only on the demand and supply of exports and imports, and investment in assets, but also on foreign exchange speculation where foreign exchange is demanded for the possible gains from appreciation of the currency. Money in any country is an asset. If Indians believe that the British pound is going to increase in value relative to the rupee, they will want to hold pounds. For instance, if the current exchange rate is Rs 80 to a pound and investors believe that the pound is going to appreciate by the end of the month and will be worth Rs 85, investors think if they took Rs 80,000 and bought 1,000 pounds, at the end of the month, they would be able to exchange the pounds for Rs 85,000, thus making a profit of Rs 5,000. This expectation would increase the demand for pounds and cause the rupee-pound exchange rate to increase in the present, making the beliefs self-fulfilling.
The above analysis assumes that interest rates, incomes and prices remain constant. However, these may change and that will shift the demand and supply curves for foreign exchange.
Interest Rates and the Exchange Rate: In the short run, another factor that is important in determining exchange rate movements is the interest rate differential i.e. the difference between interest rates between countries. There are huge funds owned by banks, multinational corporations and wealthy individuals which move around the world in search of the highest interest rates. If we assume that government bonds in country A pay 8 per cent rate of interest whereas equally safe bonds in country B yield 10 per cent, the interest rate differential is 2 per cent. Investors from country A will be attracted by the high interest rates in country B and will buy the currency of country B selling their own currency. At the same time investors in country B will also find investing in their own country more attractive and will therefore demand less of country A’s currency. This means that the demand curve for country A’s currency will shift to the left and the supply curve will shift to the right causing a depreciation of country A’s currency and an appreciation of country B’s currency. Thus, a rise in the interest rates at home often leads to an appreciation of the domestic currency. Here, the implicit assumption is that no restrictions exist in buying bonds issued by foreign governments.
Income and the Exchange Rate: When income increases, consumer spending increases. Spending on imported goods is also likely to increase. When imports increase, the demand curve for foreign exchange shifts to the right. There is a depreciation of the domestic currency. If there is an increase in income abroad as well, domestic exports will rise and the supply curve of foreign exchange shifts outward. On balance, the domestic currency may or may not depreciate. What happens will depend on whether exports are growing faster than imports. In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world’s normally finds its currency depreciating because its imports grow faster than its exports. Its demand curve for foreign currency shifts faster than its supply curve.
Exchange Rates in the Long Run: The Purchasing Power Parity (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system. According to the theory, as long as there are no barriers to trade like tariffs (taxes on trade) and quotas (quantitative limits on imports), exchange rates should eventually adjust so that the same product costs the same whether measured in rupees in India, or dollars in the US, yen in Japan and so on, except for differences in transportation. Over the long run, therefore, exchange rates between any two national currencies adjust to reflect differences in the price levels in the two countries.
According to the PPP theory, differences in the domestic inflation and foreign inflation are a major cause of adjustment in exchange rates. If one country has higher inflation than another, its exchange rate should be depreciating.
Fixed Exchange Rates
Countries have had flexible exchange rate system ever since the breakdown of the Bretton Woods system in the early 1970s. Prior to that, most countries had fixed or what is called pegged exchange rate system, in which the exchange rate is pegged at a particular level. Sometimes, a distinction is made between the fixed and pegged exchange rates. It is argued that while the former is fixed, the latter is maintained by the monetary authorities, in that the value at which the exchange rate is pegged (the par value) is a policy variable – it may be changed.
Managed Floating
Without any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system. It is a mixture of a flexible exchange rate system (the float part) and a fixed rate system (the managed part). Under this system, also called dirty floating, central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate. Official reserve transactions are, therefore, not equal to zero.
Exchange Rate Management: The International Experience
The Gold Standard: From around 1870 to the outbreak of the First World War in 1914, the prevailing system was the gold standard which was the epitome of the fixed exchange rate system. All currencies were defined in terms of gold; indeed some were actually made of gold.
The question arose – would not a country lose all its stock of gold if it imported too much (and had a BoP deficit)?
In the post-World War II scenario, countries devastated by the war needed enormous resources for reconstruction. Imports went up and their deficits were financed by drawing down their reserves. At that time, the US dollar was the main component in the currency reserves of the rest of the world, and those reserves had been expanding as a consequence of the US running a continued balance of payments deficit (other countries were willing to hold those dollars as a reserve asset because they were committed to maintain convertibility between their currency and the dollar).
The problem was that if the short-run dollar liabilities of the US continued to increase in relation to its holdings of gold, then the belief in the credibility of the US commitment to convert dollars into gold at the fixed price would be eroded. The central banks would thus have an overwhelming incentive to convert the existing dollar holdings into gold, and that would, in turn, force the US to give up its commitment. This was the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system. Triffin suggested that the IMF should be turned into a ‘deposit bank’ for central banks and a new ‘reserve asset’ be created under the control of the IMF.
when the economy has both trade deficit and budget deficit, it is said to be facing twin deficits
- Trade deficits need not be alarming if the country invests the borrowed funds yielding a rate of growth higher than the interest rate.
- The epitome of the fixed exchange rate system was the gold standard in which each participant country committed itself to convert freely its currency into gold at a fixed price. The pegged exchange rate is a policy variable and may be changed by official action (devaluation).
- Under clean floating, the exchange rate is market-determined without any central bank intervention. In case of managed floating, central banks intervene to reduce fluctuations in the exchange rate.
- The nominal exchange rate is the price of one unit of foreign currency in terms
of domestic currency.
- Openness in product and financial markets allows a choice between domestic and foreign goods and between domestic and foreign assets.
- The BoP records a country’s transactions with the rest of the world.
- The current account balance is the sum of the balance of merchandise trade, services and net transfers received from the rest of the world. The capital account balance is equal to capital flows from the rest of the world, minus
capital flows to the rest of the world.
- A current account deficit is financed by net capital flows from the rest of the
world, thus by a capital account surplus.
Exchange Rate Management: The Indian Experience
The beginning of 1990s saw significant rise in oil prices and suspension of remittances from the Gulf region in the wake of the Gulf crisis. This, and other domestic and international developments, led to severe balance of payments problems in India. The drying up of access to commercial banks and short-term credit made financing the current account deficit difficult. India’s foreign currency reserves fell rapidly from US $ 3.1 billion in August to US $ 975 million on July 12, 1991 (we may contrast this with the present; as of January 27, 2006, India’s foreign exchange reserves stand at US $ 139.2 billion). Apart from measures like sending gold abroad, curtailing non-essential imports, approaching the IMF and multilateral and bilateral sources, introducing stabilisation and structural reforms, there was a two-step devaluation of 18–19 per cent of the rupee on July 1 and 3, 1991. In march 1992, the Liberalised Exchange Rate Management System (LERMS) involving dual exchange rates was introduced. Under this system, 40 per cent of exchange earnings had to be surrendered at an official rate determined by the Reserve Bank and 60 per cent was to be converted at the market- determined rates.The dual rates were converged into one from March 1, 1993; this was an important step towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the IMF. The exchange rate of the rupee thus became market determined, with the Reserve Bank ensuring orderly conditions in the foreign exchange market through its sales and purchases.
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