Economic Awareness

8/6/2019 Economic Awareness

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SOCIO- ECONOMIC BANKING (AWARENESS) AND FINANCE RELATED

TERMS

Economics is the study of how individuals and societies choose to use the scarceresources that nature and previous generations have provided. Economics is a behavioralscience. In large measure it is the study of how people make choices. The choices thatpeople make, when added up, translate into societal choices.*The word economics has been derived from two Greek Words Oikos (meaning ahouse) and Nemein(meaning to manage).*Economics meant managing a household with the limited funds available in the house inan economical manner.*Alternatively, economics is the study of how a society chooses to use its limitedresources to produce, exchange and consume goods and services."An economist is an expert who will know tomorrow why the things he predicted

yesterday didn't happen today". Laurence J. PeterEconomic systems refer to mode of production, exchange and distribution and the rolewhich govt. plays in an economic activity. It may be of following types:-a) Capitalism Economy (free market economy) is one in which the factors ofproduction are privately owned and managed and in which production takes place on theinitiative for private profits.* This system is based on Laissez-faire system i.e., no govt. interference is found.Sovereignty of consumer prevails in this system. In a free market economy, the

allocation of resources is determined by the consumer preference. Consumer behaves likea king under capitalism.*Income in a capitalist system takes at least two forms, profit and wages. Profit is what is

received by virtue of control of the tools of production, by the capitalists (those whoprovide the capital). Wages are received by those who sell their labour with those tools,i.e. the workers.*In a capitalist economy, competition exists among sellers and producers of similargoods in the form of advertisement, price cutting, discount etc.*In capitalism, all of the capital investments and decisions about production, distribution,and the prices of goods, services, and labor, are determined in the free market andaffected by the forces of supply and demand.b)Socialist Economy(controlled economy) is one in which the means of production(machines, materials and output) should be owned by society and specifically either bythe state, as in the case of nationalized industries or by the workers directly, as in the case

of producer co-operatives.* In socialist economy, production is carried out to directly to produce use-value, usually,but not always, coordinated through economic planning and a system of accounting basedon calculation-in-kind or labour-time.* Central planning authority allocates all resources according to prespecified goals andobjectives to attain maximum social welfare. The central planning authority decideswhat, how and for whom to produce. In India, planning commission is central planningauthority.


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*Since state works for the welfare of the society, no individual or private profit accrues.Price policy is guided by the aims of social welfare rather than profit motive.*Since state has the monopoly of production and investment, it avoids all sorts ofcompetition and rivalry as between different production units.c) Mixed Economy (India) refers to that economic system in which both private and

public sector co-exists. So in mixed economy all economic decisions are partly taken bythe state and partly taken by the private entrepreneurs.*In private sector price is decided by the help of price mechanism while govt. sectorprices are fixed by the govt. Government may also fix prices of certain essentialcommodities, which are used by the common man. For e.g., in India, diesel, LPG arefixed by govt. Over all planning is done by the state Authority called PlanningCommission.*Public sector enterprises may be located in the backward regions so as to ensure itsdevelopment. Subsidies may be offered to private sector to establish and developindustries in backward regions. In this system, freedom in economic activities are

influenced by the govt.s regulation and licensing policies.

d) Developed Economy typically refers to a country with a relatively high level ofeconomic growth and security.*Per capita income or gross domestic product (GDP), level of industrialization, generalstandard of living and the amount of widespread infrastructure evaluates a countrysdegree of development.*Human Development Index (HDI) is also included in evaluating an economy orcountrys degree of development. HDI reflects relative degrees of education, literacy andhealth.e) An economy is said to be undeveloped or underdeveloped, if it has followingfeatures:* Agriculture is main occupation of people. Nearly 60 to 80 per cent of population is

engaged in agriculture and its related activities.*Poverty is widespread. The ability to save of people is very low, so capital formationand investment is very low.*Population grows at a high rate (about 2% per annum) and burden of dependentpopulation is also high.*The standard of living of people is low and productivity of labour is considerably low.*The production techniques are backward. Investment in research and development isquite low.*The incidence of unemployment and underdevelopment is quite high.*The level of human well-being measured in terms of real income, health and educationis generally low.

* Income inequalities are widespread.* Low participation in export, import and foreign trade.

Fiscal year: The term used for a business's accounting year for which a budget isprepared. The period is usually twelve months which can begin during any month of thecalendar year (e.g. 1st April 2001 to 31st March 2002).


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Fiscal Policy refers to public revenue expenditure policy (or budgetary policy) of theGovt. and allied matters thereof. Fiscal policy is that part of government economic policywhich deals with taxation, expenditure, borrowing, deficit financing and the managementof public debt in the economy. Fiscal policy primarily concerns itself with the flow offunds (or purchasing power) in the economy to correct the situations of deflationary gap

or inflationary gap.Monetary policy is the process by which the government and RBI controlsi)the supply of money, (ii) availability of money (or credit), and (iii) cost of money orrate of interest in the economy, with a view to achieving economic stability.Monetary Policy deals with both the lending and borrowing rates of interest forcommercial banks. Monetary policy corrects the situations of deflationary gap orinflationary gap through increase or decrease in the flow of credit/money in the economy.Objectives of Monetary policy

To regulate monetary growth so as to maintain a reasonable degree of price stability andfull employment;

To ensure adequate expansion in credit to assist economic growth;

To encourage the flow of credit into certain desired channels including priority and thehitherto neglected sectors; and

To introduce measures for strengthening the banking system and creating institutions forfilling credit gaps.

To affect the total stock of such assets (i.e. money) as well as to influence the demand ofthe community for such assets.Difference between Fiscal policy and monetary policy

Fiscal policy is concerned with the public revenue, public expenditure and govt. budget.Monetary Policy is concerned with the supply, availability and cost of money.

The main components of fiscal policy are taxes, public borrowing, deficit financing,public expenditure on public works, welfare, defense and subsidies.

The main components of monetary policy are bank rate, open market operation, changein cash reserve ratio, requirement of the margin etc.

Fiscal policy has a direct bearing on all the sectors of the economy. Monetary policy hasa direct bearing largely on selective producing sectors of the economy.Inflationary Gap occurs because AD exceeds at AS at full employment level.Accordingly, inflationary gap can be controlled by lowering AD. This can be achievedthrough fiscal policy by lowering govt. expenditure and lowering private expenditurethrough high rates of taxation.This also can be achieved through monetary policy by restricting the supply ofmoney/credit in the economy.Deflationary Gap occurs because AD remains deficient compared to AS at full

employment level. Accordingly, deflationary gap can be corrected by raising AD. Thiscan be achieved through fiscal policy by increasing public expenditure (on public workprogrammes, public health and education, defense and law and order) and increasingprivate expenditure through low rates of taxation.This can also be achieved through monetary policy by encouraging the supply ofmoney/credit in the economy.Flow of credit in the economy can be increased by

Lowering bank rate, lowering cash reserve ratio


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Encouraging purchase of govt. securities so that the holders of securities get more cash

Lowering the margin requirement for loans.Or, simply stating, flow of credit can be increased by pursuing the Cheap-Money policy.Flow of credit can be decreased by pursuing the Dear-Money policy.Cheap Money Policy refers to the situation when credit is easily available at a reasonable

low rate of interest. So that people are encouraged to borrow and spend. This willgenerate demand for goods and services. This is required to combat deflation.Central bank adopts cheap money policy when supply of credit needs to be expandedduring periods of deflation.Dear Money is that money which can only be borrowed at a high rate of interest.Central bank adopts dear money policy when supply of credit needs to be reduced duringperiods of inflation.Dear Money Policy refers to the situation when credit is not easily available.In dear money policy, bank rate and other rates of interest are high. As a result creditbecomes scarce and expensive. So that people are discouraged to borrow and spend.This lowers the level of aggregate demand. This is required to combat inflation.

Monetary policy is implemented by RBI through instruments of credit control like(A)Quantitative or general measures and (B) Qualitative or selective measures.Quantitative or general measures are used for changing the total volume of credit in theeconomy. They are as follows:Bank Rate or Discount Rate(6%) is the rate at which central bank of the country (inIndia it is RBI) allows finance to commercial banks and other financial intermediariesagainst approved securities or rediscounts the eligible bills of exchange and othercommercial papers.

The change in the bank rate leads to changes in the market rates of interest i.e., short-term as well as long-term interest rates. Any upward revision in Bank Rate by central

bank is an indication that banks should also increase deposit rates as well as PrimeLending Rate. So the cost of credit rises. The demand for bank loans generally falls andso the demand for goods will also fall, leading to discourage investment in economy.Thus inflation can be checked or controlled by raising bank rate. Similarly, deflation (i.e.,state of falling prices) can be checked by lowering the bank rate.

This any revision in the Bank rate indicates could mean more or less interest on yourdeposits and also an increase or decrease in your EMI. Thus, it can said that in case bankrate is hiked, in all likelihood banks will hikes their own lending rates to ensure and theycontinue to make a profit.Open Market Operations (OMO) consists of buying and selling of Governmentsecurities in order to expand or contract the amount of money in the banking system by

RBI. When the central bank purchases securities from the banks, it increases their cashreserve position and hence, their credit creation capacity. On the other hand, when thecentral bank sells securities to the banks, it reduces their cash reserves and the creditcreation capacity.In India, the open market operations of the Reserve Bank have not beenso effectivebecause of the following reasons:(a) Open market operations are restricted to government securities.(b) Gift-edged market is narrow.(c) Most of the open market operations are in the nature of switch operations


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(i.e., purchasing one loan against the other).CRR Rate (Cash reserve Ratio is 6%)

Cash reserve Ratio (CRR) refers to that portion of total deposits which a commercialbank has to keep with central bank in form of cash reserves. It is a tool used by RBIeither to drain out excess liquidity (i.e. money) from banks or to release funds needed for

the economy from time to time.If RBI decides to increase the percent of this, the available amount with the banks comesdown and money is sucked out of circulation.

E.g. when a banks deposits increase by Rs100, and if the cash reserve ratio is 9%, thebanks will have to hold additional Rs. 9 with RBI and Bank will be able to use only Rs 91for investments and lending / credit purpose. Therefore, higher the ratio (i.e. CRR), thelower is the amount that banks will be able to use for lending and investment.SLR (Statutory Liquidity Ratio is 24%)

Under the Banking Regulation Act, 1949,a commercial bank needs to maintain in theform of cash or gold or govt. approved securities (i.e. Bonds) (equal to not less than 25%of their total demand and time deposits) before providing credit to its customers.

SLR rate is determined and maintained by the RBI (Reserve Bank of India) in order tocontrol the expansion of bank credit. SLR is determined as the percentage of totaldemand and percentage of time liabilities. Time Liabilities are the liabilities acommercial bank liable to pay to the customers on their anytime demand.

SLR is used to control inflation and propel growth. Through SLR rate tuning the moneysupply in the system can be controlled efficiently.

With SLR, the RBI can ensure the solvency of a commercial bank. It ia also helpful tocontrol the expansion of bank credits. By changing the SLR rates, RBI can increase ordecrease bank credit expansion. Also through SLR, RBI compels the commercial banksto invest in govt. securities like govt. bonds.Difference between SLR & CRR

1. SLR: An increase in SLR means restrict the banks leverage position to pump moremoney into the economy.CRR: Increase in CRR means that banks have less funds available and money is suckedout of circulation.2. SLR is maintained in liquid form with banks themselves.CRR is maintained in cash form with RBI.3. SLR, banks can use cash, gold or approved securities.CRR it has to be only cash.4. SLR: RBI is empowered to increase this ratio up to 40%.CRR: for scheduled banks between 3 per cent and 20 per cent.5. SLR regulates the credit growth in India.

CRR influences the country's economy and inflation.6. SLR: It restricts the banks leverage position to pump more money into the economy.CRR: we can say that this serves duel purposes i.e. it not only ensures that a portion ofbank deposits is totally risk-free, but also enables RBI to control liquidity in the system,and thereby, inflation by tying the hands of the banks in lending money.Demand Liabilities and Time Liabilities

Demand Liabilities: The liabilities which bank have to pay on demand. Current deposits,demand liabilities portion of savings bank deposits, margins held against letters of


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credit/guarantees, balances in overdue fixed deposits, cash certificates andcumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer(MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Creditaccount and deposits held as security for advances which are payable on demand comeunder Demand Liabilities.

Time Liabilities: The liabilities which bank have to pay after specific time period.Fixed deposits, cash certificates, cumulative and recurring deposits, time liabilitiesportion of savings bank deposits, staff security deposits, margin held against letters ofcredit if not payable on demand, deposits held as securities for advances which are notpayable on demand and Gold Deposits come under Time Liabilities.Repo or Repurchase Options

Repos were introduced in 1992 in India. They are instruments ofrepurchase agreementbetween the RBI and the commercial banks and this is used by banks for short termliquidity management. Repo is an agreement to sell a security for a specified price and tobuy it back later at another specified price. A repo is essentially a secured loan. By sellingrepos RBI mobs up temporary excess liquidity in the financial market. Their rates are

market- determined.Repo (Repurchase) Rate ( 6.25%)Whenever the banks have any shortage of funds they can borrow it from RBI.Repo rate is the rate at which our banks borrow shot-term money from RBI.A reduction in the repo rate will help banks to get money at a cheaper rate.When the repo rate increases, borrowing from RBI becomes more expensive.Therefore, we can say that in case, RBI wants to make it more expensive for the banks toborrow money, it increases the repo rate; similarly, if it wants to make it cheaper forbanks to borrow money, it reduces the repo rateReverse Repo Rate(5.25%)

This is exact opposite of Repo rate. Reverse Repo rate is the rate at which Reserve Bankof India (RBI) borrows money from banks. RBI uses this tool when it feels there is toomuch money floating in the banking system. Banks are always happy to lend money toRBI since their money is in safe hands with a good interest. An increase in the reverserepo rate means that the RBI will borrow money from the banks at a higher rate ofinterest. As a result, banks would transfer more funds to RBI.Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected

in the banking system by RBI, whereas Reverse repo rate signifies the rate at which

the central bank absorbs liquidity from the banks.

PLR (Prime Interest Rate is 11%-12%)

The Prime Interest Rate is the interest rate charged by banks to their most creditworthycustomers (usually the most prominent and stable business customers). The rate is almostalways the same amongst major banks. Adjustments to the prime rate are made by banksat the same time; although, the prime rate does not adjust on any regular basis. The PrimeRate is usually adjusted at the same time and in correlation to the adjustments of the FedFunds Rate. The rates reported below are based upon the prime rates on the first day ofeach respective month. Some banks use the name "Reference Rate" or "BaseLending Rate" to refer to their Prime Lending Rate.

Deposit Rate(6%-7.50%)

Interest Rates paid by a depository institution on the cash on deposit.


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Lending/Deposit Rates:Savings Bank rate: 3.5%.Base Rate: 7.60% - 8.50%

(B) Qualitative or selective methods direct or restrict the flow of credit to specified

areas of economic activity. In a developing economy like India, qualitative credit controlshas following purposes:(a) To prevent anti-social use of credit like speculative hoarding of stock.(b) To divert credit from unproductive activities to productive activities.(c) To divert credit from non-essential to essential industries.(d) To encourage credit for certain sectors like priority sector.Some of qualitative instruments are as follows:Securing loan regulation by fixation of margin requirements

Margin requirements of loan refers to the difference between the current value of thesecurity offered for loans and the value of loans granted. Suppose, a person mortgages anarticle worth Rs.100 with the bank and the bank gives him loan of Rs.80. The margin

requirement in this case would be 20%.The central bank is empowered to fix the margin and thereby fix the maximum amountwhich the purchaser of securities may borrow against those securities. Raising of margincurbs the borrowing capacity of the security holder. The margin-requirement is loweredin case the expansion of credit is desired.Consumer credit regulation

The regulation of consumer credit consists of laying down the rules regarding downpayments and maximum maturities of installment credit for the purchase of specifieddurable consumer goods. Raising the required down payment limits and shortening ofmaximum period tend to reduce demand for such loans and thereby check consumercredit.Issue of directives to commercial banks

These directives are usually in the form of oral or written statements, appeals, orwarnings, particularly to curb individual credit structure and to restrain the aggregatevolume of loans.Rationing of Credit refers to fixation of credit quotas for different business activities,particularly for speculative activities in the economy. It is adopted by central bank forcontrolling and regulating the purpose for which credit is granted or allocated bycommercial banks. Commercial banks cannot exceed quota limits while granting loans.Moral Suasion is combination of both persuasion and pressure made by the centralbank to the commercial banks to co-operate with the general monetary policy with a viewto controlling the flow of credit. The central bank may also persuade or requestcommercial banks not to apply for further accommodation from it or not to financespeculative or non-essential activities.Direct Action

The central bank may take direct action against the erring commercial banks. It mayrefuse to rediscount their papers, and give excess credit, or it may charge a penal rate ofinterest over and above the bank rate, for the credit demanded beyond a prescribed limit.Direct action also includes derecognition of a commercial bank as a member of thecountrys banking system.


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Money can be defined as anything that is generally accepted as a means of exchange andat the same time acts as a measure and as a store of value. It has unlimited legal tenderthroughout the country.Classification of Money

Fiat Money refers to money backed with order (authority) of the govt. It includes notesand coins.Fiduciary Money refers to money backed with mutual trust between the payer andpayee. E.g. cheques are fiduciary money as these are accepted as a means of payment onthe basis of trust, not on the basis of any order of the Govt.Holding Money means holding claims against goods and services. Money has facilitatedthe transfer of these claims from one set of individuals to the other for achieving equalityand social justice.Hot Money refers to large amounts of short term funds held internationally by banks,financial institutions and wealthy individuals, which quickly move out of or into acountry, in anticipation of interest rate charges or exchange rate fluctuations. This is,

therefore, a very volatile source of funds and its flight from a country in terms of crisismay trigger a collapse of the economy.Hard Currency

A currency that is in strong demand, but in short supply on the foreign exchange market.Hard currency status is usually associated with an economically strong country which isrunning a large surplus on its balance of repayments. Demand for the currency is high tofinance purchases of its exports, but the supply of the currency is relatively limitedbecause amount of it being made available through purchase of imports is much lower.Soft Currency is opposite of hard currency and it indicates a type of currency whosevaluemay depreciate rapidly or that is difficult to convert into other currencies. Softcurrencycan be in the form of paper, electronic or debt-based "IOUs" which have in thepast beenused in place of hard currency. This currency has limited convertibility intogold andother currencies.Full bodied Money refers to money in terms of coins whose commodity value is equal tothe money value as and when these are issued.E.g. A rupee coin during the British period in India was made of silver. Commodity valueof the coin was equal to its money value at the time of its issuing. Or, the market value ofthe silver contained in the coin was equal to Re.1.Representative Full-bodied Money refers to paper notes as representative of full bodiedmoney. Such paper notes are in fact like a receipt issued by the Govt. for full bodiedcoins. Of course, paper as such has no market value.Credit Money refers to that money of which money value is more than commodityvalue. It happens because the material used for money is only a small component of thetotal supply of material in the market.Forms of Credit Money

Token coins, like a rupee coin or a 50 paisa coin is a credit money because the metalcontent of the coin is of lesser market value than the value printed on the coin.(i.e.CV


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Representative Token Money or paper notes which represent token coins or metalcontent of coins. If the metal content of the coins is melted and sold in the market, themarket value will be less than the value printed on the paper note.Circulating Promissory Notes of the Central Bank

These are the paper notes issued by the central bank. Commodity value of a promissory

note is less than the money value of a promissory note. Hence, it is credit money.Demand Deposits at Bankare chequable deposits and can be withdrawn from the bankor transferred to some other person by issuing a cheque. Commodity value of a cheque isless than money value of a cheque. Hence chequable deposits are credit money.

Money stock in India

Earlier classification

In 1979 the RBI classified money stock in India as follows:M1= Currency with the public (i.e. coins and currency notes) + Demand deposits of thepublic known as narrow money.M2= M1 + Post office saving deposits

M3=M1+ Time deposits of public with banks called broad money.M4 = M3+ Total post office deposits.Note: Distinction between narrow money and broad money is in treatment of timedeposits with banks. In banking and economic terms money supply is referred to as M3 -which indicates the level (stock) of legal currency in the economy.

Present classification

M1= Currency + Demand deposits + other deposits with RBI.M2= M1 + Time Liabilities portion of savings deposits with banks + certificates ofdeposits issued by banks+ Term deposits maturing within a year excluding FCNR(B)deposits.M3=M2+ Term deposits with banks with maturity over one year + call/ term borrowingsof the banking system.Note: M4 has been excluded from the scheme of monetary aggregates.

The Reserve Bank of India is the central bank of India, was established on April 1, 1935in accordance with the provisions of the Reserve Bank of India Act, 1934. The ReserveBank of India was set up on the recommendations of the Hilton Young Commission. Thecommission submitted its report in the year 1926, though the bank was not set up for nineyears. To regulate the issue of Bank Notes and keeping of reserves with a view tosecuring monetary stability in India and generally to operate the currency and creditsystem of the country to its advantage.Types of bank

Regional Rural Banks were established with an objective to ensure sufficientinstitutional credit for agriculture and other rural sectors. The RRBs mobilize financialresources from rural / semi-urban areas and grant loans and advances mostly to small andmarginal farmers, agricultural labourers and rural artisans. The area of operation of RRBsis limited to area as notified by Govt. of India covering one or more districts in the State.Banking services for individual customers is known as retail banking.


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A bank that deals mostly in but international finance, long-term loans for companies andunderwriting. Merchant banks do not provide regular banking services to the generalpublicOnline banking (or Internet banking) allows customers to conduct financial transactionson a secure website operated by their retail or virtual bank.

Mobile Banking is a service that allows you to do banking transactions on your mobilephone without making a call, using the SMS facility. Is a term used for performingbalance checks, account transactions, payments etc. via a mobile device such as a mobilephone.Traditional banking is the normal bank accounts we have. Like, put your money in thebank and they act as a security and you will get only the normal interests (decided by RBIin our case, FED bank in US).Investment banking is entirely different. Here, people who are having so much money(money in excess which will yield only less interest if in Banks) will invest their moneyand get higher returns. For example, if I have more money instead of taking the pain ofinvesting in share market, buying properties etc. I will give to investment banks and they

will do the money management and give me higher returns when compared to traditionalbanks.

Credit Card

A small plastic card, called credit card, is issued by a bank to a prospective customer,after verifying his credibility, which is generally measured by his income sources. Thiscard would contain an embossed 16-digit card number and name of the cardholder.

Credit card gives access to a line of credit.Line of credit refers to an authorized amountof credit given to an individual, business, or institution. Presently available most popularcredit cards visa card, master card, American express card and others.

A credit card holder buys now and pays later. In effect, the credit card issuer hands him

a loan. A commission of 1% to 4% is charged by the bank issuing the credit card. Thiscommission is extracted from the sellers bank account by direct debit.

Users are limited in how much they can charge, but they are not required to repay thefull amount each month. Instead the balance (or "revolve") accrues interest with only aminimum payment due.

A monthly statement of account is sent by the credit card company to their cardholderswho may pay in full or in part. However, if they do not pay in full, they suffer an interestcharge until the full amount is paid up.

Credit cards are a booster to consumer spending, raising the level of aggregate demandin the economy. This encourages investment, growth and development.Debit Card

Debit card is issued by a bank to a customer who has an account with the bank,maintaining a minimum balance. The card replaces cash or checks. This card is enhancedwith ATM (automated teller machine) and POS (point-of-sale) features that can be usedto purchase goods and services electronically.

When a customer buys something, the value of his purchase is instantly debited from hisaccount. The merchant establishment from which the debit card holder makes hispurchase is linked electronically to the banks main computer which contains the accountdetails of the card holder.


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The account can be accessed with a personal identification number (PIN) known only tothe account holder. But through it, the merchant can check the card holders account anddebit the value of his purchase. Transactions are deducted from the cardholder's checkingaccount either immediately or within one to three days.The advantages of a debit card are:

It may be used to make larger payments than might be acceptable by cheque (provided

there are sufficient funds in the bank account of the cardholder).

It can be used to operate automated teller machines (ATM) with a special PIN code.Personal Identification Number (PIN) is a code that provides security for consumers at

an ATM.Similarity/Difference between debit and credit card

The main difference is that in the case of a debit card such payments are then debited tothe holders bank account in exactly the same way as a cheque.

A debit card is similar in appearance to a credit card and which is offered in a similarway in payment for goods and services.

Business Cycle or Trade Cycle refers to fluctuations in economic activity occurringregularly in the capitalists societies. It is found in aggregate economic activity and not inany single firm or industry.

In other words, alternating period of expansion and contraction in economic activitywith period of economic prosperity or expansion, have been called business cycle.

It is composed of period of good trade characterized by rising prices and lowunemployment, alternating with period of bad trade characterized by falling prices andhigh unemployment.

In a business cycle, there are wave-like fluctuations in four inter-linked economicvariables: aggregate employment, income, output and price level.

Every trade cycle have five different subphasesdepression, recovery, full employment,

prosperity (boom) and recession.Recovery

This is the phase of revival of demand for goods and services. Economic activity startspicking up and so does employment and output. Prices start rising.

Revival of demand for goods and services is mainly due to change in business psychology in favour of optimism and

fresh public investments in development projects (which are mainly motivated by non profit considerations) which create additional demand for goods and services.

Industrialist and the businessmen repay the loans taken by them from the banks earlierand the frozen stocks held by the banks are released.

Capital stock is allowed to depreciate without replacement. The progress in technologymakes the existing capital stock obsolete.

More and more employment is generated in construction sector. Wage incomes increaseat a rate higher than employment rate. Individuals who had postponed their plans toconstruct houses undertake this task now, lest cost of construction should mount.Prosperity (or Boom)

This is the phase of business cycle where there is rapid upward movement in income andemployment and a greater incentive for fresh investment. Sales show a tendency to


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increase. Both consumers and capital goods industries experience a sharp upturn.Generally, prosperity takes twice as much time to develop as the depression.

The gap between potential GNP and actual GNP is zero, that is, the level of productionis at the maximum production level.

Debtors find it more convient to pay off debts. Bank advances grow rapidly even though

bank rate increases. Idle funds find their way to productive investment since stock pricesincrease due to increase in profitability and dividend.

Retailers buy more than their present demand and wholesalers buy more than what isdemanded by retailers at present. Consequently, the producers tend to produce more thanthe amount they can sell at present. Producers gain due to faster rise in prices of finishedproducts than increase in wage-rate, raw material prices and interest rate.Recession

When business cycle takes a downward turn from the state of prosperity, the state ofrecession is said to have set in. A true economic recession can only be confirmed if GDP(Gross Domestic Product) growth is negative for a period of two or more consecutivequarters. Not as serious as depression.

Output, profits and employment start falling gradually. Business psychology ispessimistic and business prospects are poor. Investment remains very low. Thus theeffects on capital goods industries may thus be very severe.

Recession passes from one industry to another and chain reaction continues till thewhole economy is in grip of recession.Depression is characterized by a severe contraction in economic activity, which ismanifested in numerous business shut down, low prices, mass unemployment and slacktrade.

General demand for goods and services falls faster than the production of goods. This ismore in case of capital goods than consumer goods.

There are accumulated reserves with banks. Demand for credit is at its lowest, resulting

in idle funds with banks. In general, the bottom of depression is reached when liquidationof accumulated stocks is completed.

Interest rate falls. With lower rate of interest peoples demand for money holdingsincreases.

Producers suffer losses because selling prices is falling faster than their costs. Producersare unable to recover their full cost. Profits may even become negative and manybusinesses go bankrupt.

Due to over-production, workers lose their jobs because they are thrown out of work.Investment in plant and equipment declines on account of falling sales. Investment instock becomes less profitable and least attractive.

Poverty is a wide spread social evil in underdeveloped countries in the world.Absolute poverty

When poverty is taken in absolute terms and is not related to the distribution of income orconsumption expenditure, it is absolute poverty. It is relevant for less developedcountries. In India we use the concept of absolute poverty for measuring poverty. Thosewho fail to reach minimum level of consumption standard (known as poverty line) areregarded as poor.Relative poverty


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When poverty is taken in relative terms and is related to the distribution of income orconsumption expenditure, it is relative poverty. It is relevant for the developed countries.Gini co efficient are often used for measuring poverty in relative sense.Poverty Line

Poverty line is a virtual line demarcating persons living below and above it. In India all

those persons are treated living below poverty line(BPL) with an income of less thanRs.368(rural) and Rs. 559(urban) per month or consuming less than 2,400(rural) and2,100(urban) calories per person per day. As per UNDP, one US dollar (1993 PPP US $)per person per day is treated as poverty line.

Liberalization refers to relaxing of previous government restrictions usually in areas ofsocial and economic policies. Thus, when government liberalizes trade it means it hasremoved the tariff, subsidies and other restrictions on the flow of goods and servicesbetween countries.Privatisation refers to the transfer of assets or services functions from public to privateownership or control and the opening of hitherto closed areas to private sector entry.

Privatization can be achieved in many ways franchising, leasing, contracting anddivesture. Privatization in India generally is in the form of disinvestment of equity.Preconditions for privatization to prove successful are:-

Liberalization and de-regulation of the economy is an essential pre-requisite ifprivatization is to take off and help realise higher productivity and profits.

Capital markets should be sufficiently developed to be able to absorb the disinvestedpublic sector shares.Disinvestment is a method of privatization. It means disposal of public sector unitsequity in the market or in other words selling of a public sector investment to a privateentrepreneur. Disinvestment refers to withdrawal of existing investment. Money receivedthrough disinvestment is treated as capital receipt because it causes reduction in assets of

govt.Methods of Disinvestment

Differential Pricing Method

Equity Offer: Equity was offered to retail investors through domestic public issues to tapthe domestic markets.

Issue of Global Depository Receipts(GDRs) to tap overseas markets.

Cross-Holding: Govt. simply selling part of its shares in one PSU to other PSUs.

Strategic Sale Method: Govt. sells a major share to a strategic buyer. Disinvestmentprice would be market based and not prefixed.

Warehousing: Govt.s own financial institutions buying govt.stake in select PSUs andholding them until any third buyer emerged.

Retaining Golden Share: Retaining Govt.s stake up to 26 per cent in PSU to protect itsinterest.Globalization means integrating the domestic economy with the world economy.Globalization broadly implies free movement of goods and services and people across thecountries. It involves increasing interaction among national economic systems, moreintegrated financial markets, economies of trade, higher factor mobility, free flow oftechnology and spread of knowledge throughout the world.Main Organization For Facilitating Globalisation


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International Monetary Fund(IMF) was organised in 1946 and commenced itsoperation in March,1947. IMF is affiliated to UNO(United Nation Organization).Starting from its initial membership of 31 countries at the time of inception, IMF has nowa membership of 186 coutries.Objectives of IMF

The elimination or reduction of existing exchange controls;The establishment and maintenance of currency convertibility with stable exchange rate;

The widest extension of multilateral trade and payments.

The solving of short-term balance of payments problems faced by its member nations.

To promote exchange stability, to maintain orderly exchange arrangement amongmembers and to avoid competitive exchange depreciation.Functions of IMF

It functions as a short-term credit institution.

It provides machinery for the orderly adjustment of exchange rates.

It is a reservoir of the currencies of all the member nations who can borrow the currencyof other nations.

It is a sort of lending institution in foreign exchange. However, it grants loans forfinancing current transactions only and not capital transactions.

It also provides machinery for altering sometimes the par value of currency of a membercountry.

It also provides machinery for international consultations.

It monitors economic and financial developments of its members and provides policyadvice aimed at crisis preventions.Special Drawing Rights (SDRs)

It is a reserve asset (known as Paper Gold) created within the framework of the IMF in1969 in an attempt to increase international liquidity, and now forming a part ofcountries official reserves along with gold, reserve positions in the IMF and convertibleforeign currencies. SDRs are allocated to member countries and can be fully convertedinto international currencies so they serve as a supplement to the official foreign reservesof member countries. Its value is based on a basket of key international currencies (U.S.dollar, euro, yen and pound sterling).The value of SDR is based on a portfolio of widelyused currencies and they are maintained as accounting entries and not as hard currencyor physical assets like Gold.World Bank or International Bank for Reconstruction and Development (IBRD)

The world bank works in 186 countries with the primary focus of helping the poorestpeople and the poorest countries.World Bank is also called International Bank forReconstruction and Development (IBRD) as a part of deliberations at Bretton Woods in1945. The world bank group consists of, apart from the world bank itself,

International Development Association(IDA) is also called soft lending arm of worldbank. It helps the worlds poorest countries by giving interest free loans to them.

International Bank for Reconstruction and Development (IBRD) serves middle-income countries with capital investment and advisory services.

International Finance Corporation(IFC) provides investments and advisory servicesto build the private sector in developing countries.


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Multi-lateral Investment Guarantee Agency(MIGA) helps encourage foreigninvestment in developing countries by providing guarantees to foreign investors againstloss caused by non commercial risks. MIGA is created in 1988.

International Centre for Settlement of Investment Disputes(ICSID) is anautonomous body which facilitates the settlement of disputes between foreign investors

and their host countries. ICSID was founded in 1966.Objectives of World Bank

Investing in the people, particularly through basic health and education.

Focusing on social development

Protecting the environment.

Supporting and encouraging private business development.

Promoting reforms to create a stable macro-economic environment, conducive toinvestment and long-term planning.Functions of World Bank

To help its member countries in the reconstruction and development of their territoriesby facilitating the investment of capital for productive purposes.

To encourage private foreign investment and credit by providing guarantee of repaymentof private investors. If private capital is not forthcoming at reasonable terms, to makeloans for productive purposes out of its own resources or funds borowed by it.

To promote the long-term balanced growth of international trade and the maintenance ofequilibrium in balance of payments of its member countries.World Trade Organisation(WTO)

WTO came into existence on 1st jan,1955. Its present membership is 153 countries. It isonly global international organisation which deals with rules of trade between nations.WTO is the third economic pillar of world-wide dimensions along with IMF and theworld Bank.Features of WTO

WTO is a multilateral trade negotiations body. It implement Multilateral TradeAgreements(MTAs) and Plurilateral Trade Agreements(PTAs).

It has a far wider scope than its predecessor GATT Genaral Agreement Trade andTariff, because itincludes not only trade in goods but also trade in services, intellectualproperty protection and investment, TRIPs and TRIMs.

It is a full-fledged international organisation in its own right.

The decision making under WTO is carried out by consensus. Where a consensus is notarrived at. The issue shall be decided by voting. Each member has one vote.

The representative of the members and all officials of the WTO enjoy Internationalprivileges and immunities.

Functions of world trade organisationWTO shall facilitate the implementation, administration and operation of world tradeagreements.

WTO shall provide the forum for trade negotiations among its member countries.

WTO shall handle trade disputes.

WTO shall monitor national trade policies.

It shall provide technical assistance and training to developing countries.


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With a view to achieving greater coherence in global economic policy making, the WTOshall co-operate, as appropriate, with the IMF and IBRD and its affiliated agencies.

Population refers to total number of people residing in a place. Thus, population of Indiameans the total number of people living in India. The size of population is determined in

terms of number of persons. Density of population refers to the number of persons persquare kilometer. It is not same for all the states. Population is very essential for thegrowth of country. Actually, whether a big and growing population is an asset or aliability for the economy depends upon economy to economy.Advantages of population

It provides work force to produce.

It provides market for the products produced.

It may promote innovative ideas.

It may promote division of labour and specialisation.Disadvantages of population

There may not be adequate jobs to absorb all additional people.

They put pressure on means of subsistence. They put pressure on social overheads(hospitals, schools, roads etc.)

They may result in increased consumption and reduced savings and hence slow downcapital formation.

They may increase dependency.Birth rate (or Crude Birth Rate) refers to number of live births per 1000 of populationin a place, state or country, in a year. Only live births are included in the calculation ofbirth rate. The birth rate tends to decline as the country attains higher levels of economicdevelopment.Death rate (or Crude Death Rate) refers to number of deaths per 1000 of population ina year. Life expectancy is important determinant of death rate. A country having high lifeexpectancy will have a high crude death rate.Life expectancy at birth refers to the mean expectation of life at birth. In other words,it refers to the number of years a newborn infant would live if prevailing pattern of agespecific mortality rates at the time of birth were to stay the same throughout the childslife. If death rate is high and/ or death occurs at an early age, life expectancy will be lowand, it will be high if death rate is low and/ or death occurs at an advanced age.Rate of growth of population is the difference between birth rate and death rate of thecountry over a certain period of time. Rate of growth of population in India is per decadeand per annum.Infant Mortality Rate (IMR) is the number of deaths of infants, upto one year of age,per thousand lives birth. IMR is high in less developed countries due to lack of healthcare

facilities and proper nutrition to the infants and as development takes place, IMR isreduced in the country.Fertility Rate

The term fertility refers to the actual bearing of children or occurrence of births.Fertility rate measures the average number of the live births per 1000 women. This rate isone of the most important and useful aids to population projection. It helps in assessingpopulation trends in the economy.Leteracy ratio refers to the number of literates as a percentage of total population.


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Sex ratio refers tonumber of females per 1000 males. It is favourable to males in allstates except kerala.Theory of Demographic Transition explains the effect of economic development on thesize and growth rate of population of a country. This theory says that every countrypasses through 3 stages:

In Ist stage, both birth rate and death rate are high(i.e. slow uneven growth). Hence,population remains stable.In IInd stage, birth rate is high and death rate falls. This stage is also called the stage ofpopulation explosion as population increases at a very high rate during this stage.Population explosion is a transitory phase according to the theory of DemographicTransition. India is passing through phase of population explosion.In IIIrd stage, both birth rate and death rate are low(i.e. low rate of population growth).The net result is population grows at a very modest rate.

Meaning of Unemployment

Generally a person who is not gainfully employed in any productive activity is called

unemployed. Unemployment refers to the situation where the persons who are able towork and willing to work, fail to secure work or activity which gives them income ormeans of livelihood. Those who are fit to work but do not want to work and hence do notactively seek work are not included among the unemployed persons.Unemployment Rate is defined as the number of persons unemployed per 1000 personsin the labour force.Labour Force (or Economically active population) refers to the population whichsupplies or seeks to supply labour for production and, therefore, includes both employedand unemployed persons..Labour Force Participation Rate(LFPR) is defined as the number of persons in thelabour force per 1000 persons.Work Force is part of labour force and refers to the population which is employed.Work Force Participation Rate (WFPR) is defined as the number of persons/ person-days employed per 1000 person/person days.Types of Unemployment

Voluntary Unemployment results when a person is unemployed because he is notwilling to work at the existing wage rate and there are some people who get a continuousflow of income from their property or other sources and need not work.Such unemployment is a national waste of human energy, but it is not a serious economicproblem.Frictional Unemployment results when some workers are temporarily out of work whilechanging jobs or when the work is suspended due to strikes or lock outs. To some extent,such unemployment is also caused by imperfect mobility of labour.Casual Unemployment

In industries, such as construction, catering or agriculture, where workers are employedon a day-to-day basis or on short term contracts which are terminable any time, there arechances of casual unemployment.Cyclical Unemployment

Mostly found in capitalist based advanced countries like USA and Western EuropeanNations, etc.


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Downward phase of trade the cycles especially recessionary and depressionary phasescause such unemployment in these developed countries. Such an employment is reducedor eliminated when the business cycle turns up again.

Since cyclical phase is temporary, cyclical unemployment remains only a short-termphenomenon.

The solution for cyclical unemployment lies in measures for increasing total expenditurein economy, thereby pushing up the level of effective demand. Easy money policy andfiscal measures such as deficit financing may help.Chronic Unemployment

When unemployment tends to be a long term feature of a country it is called chronicunemployment.

Underdeveloped countries suffer from this on account of vicious circle of poverty, lackof developed resources and their utilisation, high population growth, backward, evenprimitive state of technology, low capital formation, etc.Seasonal Unemployment is caused by seasonal variation in demand for labour byvarious industries and occupations in which production activities are seasonal in nature.

Such as Ice Factory, Catering trade in holiday resorts, Construction, Tourism,Agriculture, Agro-based activities like sugar mills and rice mills, etc

People engaged in such type of work may remain unemployed during off-season.Such unemploymentnormally declines in spring as more outdoor work can beundertaken.Structural Unemployment is due to structural changes in economy. It is caused by adecline in demand for production in a particular industry, and consequently disinvestmentand reduction in its manpower requirement.Technoligical Unemployment

Some workers tend to be replaced by machines due to introduction of new machinery,improvements in methods of production, labour-saving devices, etc. Their unemployment

is termed as techological unemployment.Disguised unemployment refers to a situation of employment with surplus manpower inwhich some workers have zero marginal productivity so that their removal will not affectthe volume of total output. In other words, a person is apparently employed but hiscontribution to production is almost nil.

Such unempolyment in strict sense, implies underemployment of labour. Overcrowdingin an occupation leads to disguised unemployment.

This kind of unemployment is a common feature of under developed economiesespecially of their rural sector. It is a common phenomenon in an over populated country.Measures of employment and unemployment

Usual Principle Status Basis(UPS) gives us the lowest measure of unemployment for a

poor economy. It estimates the number of persons who may be said to be chronicallyunemployed.Current Weekly Status (CWS) A person is said to be employed for the week even if heis employed only for a day during that week.Current Daily Status(CDS) counts every half days activity status of the respodent overthe week. It is the aggregate of all unemployment days of all persons.CDS = Aggregate of all unemployment days of all persons during week./Aggregateestimate of total number of labour force days.


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Foreign Exchange Rate or Exchange Rate refers to the price of one currency in relationto other currencies in the international money market (or international exchange market.)In other words, it is the price paid in domestic currency in order to get one unit of foreigncurrency. Thus, exchange rate expresses the ratio of exchange between the curriencies of

two countries. E.g. If Rs. 50 are to be paid to buy one US dollar, exchange rate betweenthe two curriencies is 50:1. There are two system of exchange rate determination: FixedExchange Rate system and Flexible Exchange Rate System

Fixed Exchange Rate System refers to that rate of exchange fixed by the govt. on thebasis of gold as the common unit of parity between the curriencies of different nations. Ithas two important variants:Gold Standard System of Exchange rate and Bretton WoodsSystem of Exchange Rate or Adjustable Peg System of Exchange Rate:Following are features of fixed exchange rate system

It ensures stability in the international money market.

It ensourages international trade

It facilitates coordination of macro policies of trading partners.

It is to be supported with huge international reservesIt restricts the movement of capital in the international market.

It discourages venture capital.

It causes rigidity in resource allocation.Gold Standard System of Exchange rate

Each country is to define value of its currency in terms of gold. Accordingly, value of onecurrency in terms of the other currency is fixed considering gold value of each currency.If two curriencies are both on the gold standard, then the exchange rate between them isapproximately determined by their two prices in terms of gold. This system of exchangeis also known as mint par value of exchange. Mint value of a currency implied goldvalue of that currency.

Bretton Woods System of Exchange Rate or Adjustable Peg System of ExchangeRate: According to this system,

Different currencies were pegged (or related to) to currency, that is US dollar.

US dollar was assigned gold value at a fixed price.

Value of one currency in terms of US dollar ultimately implied value of that currency interms of gold.

Gold continued to be the ultimate unit of parity between any two currencies.

Adjustment in the parity value of a currency was possible but only if allowed byInternational Monetary Fund.Flexible rate of exchange is that rate which is determined by the demand for and supplyof the currencies concerned in the foreign exchange market. The exchange rate at whichdemand for foreign currency is equal to its supply is called Par Rate of Exchange and itconstitutes the Normal Rate or Equilibrium Rate. Equilibrium Exchange rate occurswhen supply of foreign exchange is equal to demand for foreign exchange.Flexible exchange rate promotes venture capital in the foreign exchange market.

Venture capital is money provided by an outside investor to finance a new, growing, ortroubled business. The venture capitalist provides the funding knowing that theres asignificant risk associated with the companys future profits and cash flow. Capital is


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invested in exchange for an equity stake in the business rather than given as a loan, andthe investor hopes the investment will yield a better-than-average return.Hybrid Systems of Exchange Rate are neither fully fixed systems nor fully flexiblesystems. These are often referred to as alternative systems of exchange rates whichcombine the merits of both fixed and flexible systems of exchange rate. Some of these

systems are:- wider bands, crawling peg, managed floating.Wider Bands is a system that allows wider adjustment in the fixed exchange rate system.It allows adjustment upto 10% around the parity between any two currencies in theinternational money market.E.g. if one US dollar is fixed as equal to fifty Indian rupees, 10% revision(upward ordownward) is to be allowed in this exchange rate of 1:50. Exchange rate may be revisedas 1:50+10% = 1:55 or as 1:50-10% =1:45.Crawling Peg allows small but regular adjustments in the exchange rate for differentcurrencies. Crawling Peg is a system of narrow bands. This scheme specifies parityvalue of the countrys currency permitting a variation of 1%.(i.e. not more than 1%adjustment is allowed at a time).

Managed Floating is a system that allows adjustments in exchange rate according to setof rules and regulations which are officially declared in the foreign exchange market.There is no pre-defined range and time of adjustment. When managed floating isexercised without caring for the rules and regulations is termed as dirty floating.Dirty floating occurs when one country manipulates exchange rate against the interest ofother country.Foreign Exchange Market

The market where foreign currencies are demanded and supplied is called foreignexchange market. In other words, it is a market for national currencies of differentcountries in the world. Foreign exchange market operates either as Spot Market (orCurent Market) or as Forward Market

Spot Market is that market which handles only spot transactions or current transactions.It deals with current sale and purchase of foreign exchange. Spot market is of daily natureand does not trade in future deliveries. It defines(or determines) spot rate of exchange orcurrent rate of exchange the exchange rate which happens to prevail at the time whentransactions are incurred.Forward Market is that market which handles only such transactions of foreignexchange as are meant for future delivery. It deals with sale and purchase of foreignexchange which are signed today but are to materialise (or are to be honoured) on somefuture date. Forward market defines(or determines) forward rate of exchange theexchange rate at which forward transactions are to be honoured.Forward market only caters to forward transactions for two reasons-:To avoid the risk of any adverse change in the exchange rate, and to make speculativegains.Concept of hedging in the context of forward market for foreign exchange

Hedging refers to risk management. The word is used in share markets, commoditymarkets and currency markets where the prices are likely to fluctuate. A perfect hedge isbasically a no risk no gain precaution. In formard market, while making contracts, thebuyers are managing the risk of rise in price of foreign exchange, while sellers are


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managing the risk of fall in price of foreign exchange in the near future. That is whathedging means: It is guarding against risk of change in exchange rate in near future.Hedge fund is an investment fund open to a limited range of investors and requires avery large initial minimum investment.It is important to note that hedging is actuallythe practice of attempting to reduce risk, but the goal of most hedge funds is to maximize

return on investment.Corporate Hedging: In corporate hedging, the corporate treasury officials try to save afirm from the exposure to the foreign exchange risk, maximize forex income andminimize costs.The minimizing of "transactional risks" is the main centerpiece of aCorporate Hedging Policy. The Reserve Bank of India had issued the first guidelines onCorporate Hedging in 2005. The market determined exchange rates in the country havemade the rupee more volatile against the major currencies. The strategy is useful forExim traders, who have to face the unpredictability in the currency movement.Measures of Exchange Rate in Spot Market: EER and PPP

Effective Exchange Rate (EER) is a measure of strength of one currency in relation toother currencies of our trading partners in the international money market. It can be of

two types: NEER and REERNominal Effective Exchange Rate(NEER) is that type of EER which does not accountfor changes in the price level while measuring average strength of one currency inrelation to the others.Real Effective Exchange Rate(REER) is that type of EER which accounts for changesin the price level across different countries of the world. It is based on constant prices orreal exchange rate.NEER differs from REERonly in one sense that in NEER we use nominal values ofexchange rate between countries, in REER we use real values of exchange rate betweencountries.Purchasing Power Parity(PPP) means rate of exchange in different countries isdetermined by the ratio of the purchasing power of their respecitve currencies.PPPs are the rates of currency conversionwhich equalise the purchasing power ofdifferent currencies and eliminate the differences in price levels between countries.It is of two types:Absolute Purchasing Power Parity means that exchange rate between two currencies isequal to the ratio of the price levels in the two countries.Relative Purchasing Power Parity means that change in exchange rate betweendifferent countries is related to the rates of inflation between the two countries.

Balance of payments (BOP) is a systematic record of all economic transactionsbetween the residents of one country and the residents of the rest of the world in a year.It records the nations purchases from and sales to all other nations and it accounts forany differences between sales and purchases by showing how these have been financed.Economic Transactions are those which cause transfer of value. Between the countries,value is transferred in terms of foreign exchange (i.e. payments are received and made interms of foreign exchange). Economic transactions in BOP consists of:

Visible items include all types of physical goods exported/imported. Balance (i.e.balance of trade) on account of visible items is known as visible trade.


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Invisible items include all types of services like shipping, banking, insurance, tourism,royalty, payments of interest on foreign debts. Balance (i.e. balance of payment of currentaccount) on account of invisible items is known as invisible trade.

Capital transfers are concerned with capital receipts and capital payments.Equilibrium in BOP

Payments into the country (or receipts) are entered as positive numbers, called credits.Payments out of the country (or payments) are entered as negative numbers, called debits.Equilibrium in BOP is achieved when net balance of all receipts and payments is zero.BOP adjustment mechanism

BOP adjustment mechanism refers to any process, especially any atomic one, by which acountry with a payments imbalance moves towards balance of payments equilibrium.Disequilibrium in BOP can be of two types:When imports are more or less than exports, the payments and receipts would not match,and therefore a balance of payments disequilibrium will emerge. It can be of twotypes:-

BOP surplus implies that nations exports are more than sufficient to finance the sum

of its imports, public and private grants, public and private capital outflows. When the netbalance of all receipts and all payments is positive, it is surplus BOP disequilibrium.

BOP deficit indicates insufficiency of exports to finance imports and other capitaloutflows. (i.e. it reduces down the external reserves of the country.) When the net balanceof all receipts and all payments is negative, it is deficit BOP disequilibrium.Worth Noting

Balance of payments must always balance in book-keeping. This is because for anysurplus (or deficit) in the overall balance of payments there must be a corresponding debit(or credit) entry in the net changes in external reserves. In other words, if there is asurplus it adds to external reserves of the country and if there is trade deficit, it reducesexternal reserves of the country.

Difference between balance of payment and balance of tradeBalance of trade takes into account, the difference in value of imports and exports of onlyphysical goods or visible items while balance of payment takes into account all threeitems-visible, invisible and capital transfers. Thus, Balance of trade is only a part ofbalance of payments.Balance of trade in goods or balance of visible trade or merchandise balance

The record of imports and exports of physical goods is known as visible. Balance inbalance of trade implies gap between exports and imports of commodities only, (i.e.visible items only). Movement of goods between countries is known as visible tradebecause the movement is open and can be verified by the custom officials. When abalance of trade is equal to zero(i.e. exports imports=0), it is called balanced trade.

Debit and Credit items of Balance of TradeImports result in an outflow of money and are therefore a debit item. Debit item includesimports, foreign aid, domestic spending abroad and domestic investments abroad.Exports result in an inflow of money and are therefore a credit item.Credit item includesexports, foreign spending in the domestic economy and foreign investments in thedomestic economy.Balance of trade equilibrium, deficit and surplus


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If value of exports of goods is equal to the value of imports of goods, we say that there isbalance of trade equilibrium.

If value of imports of goods is more than value of exports of goods, we say that there isbalance of trade deficit.

If value of exports of goods is more than value of imports of goods, we say that there is

surplus balance of trade.Another definition

Overall balance of payments is the sum of balance of current account and balance ofcapital account and includes all monetary transactions of the reporting country vis--visthe rest of the world.Balance of current account is a broader concept than the balance of trade . It consists ofbalance of visible trade(i.e. balance of trade), balance of invisible trade and balance ofunilateral transfers (i.e., unrequited transfers).Unilateral Transfers (i.e., unrequited transfers) refers to one sided transfers from onecountry to the other. These are not trading transactions. There is not payment in responseto the receipt of unilateral transfers. It includes all gifts, donations, grants, and reparation,

receipts and payments to foreign countries.Worth Noting

Balance of payments on current account covers all receipts on account of earnings(asopposed to borrowings) and all payments arising out of spending(as opposed to lending).This is in sharp contrast to balance of payments on capital account.

Any subsequent profit from the investment that flows abroad will be recorded as aninvestment income on current account.Balance of payment on capital account is concerned with purchase and sale of assetsthrough transactions in external assets and liabilities. BOP on capital account basicallydeals with debts (or borrowings) and claims (or lending) of the country. It records cross-border changes in the holding of shares, property, bank deposits and loans, government

securities, etc. BOP on capital account consists of:Private Direct Investment refers to purchase of assets abroad alongwith the power tocontrol them. E.g. Acquisition of assets of a company in country A by another companyin country B.Portfolio Investment refers to purchase of assets abroad, but without any control overthem. E.g. Purchase of shares/bonds of a company in country A by resident of Country B.

Inflation is an increase in the overall price level of an economy, usually as measured bythe CPI/WPI or by the implicit price deflator. Inflation is as an increase in the price ofbunch of Goods and services that projects the Indian economy. Inflation refers to apersistent upward movement in the general price level of goods and services after full

employment is reached. It results in a decline of the purchasing power. According to most economist inflation does not occur until price increase averages lessthan 5% per year for a sustained period. Inflation happens when there are less Goods andmore buyers; this will result in increase in the price of Goods, since there is more demandand less supply of the goods.Types of inflation


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Demand-pull inflation refers to increase in prices due to excess of demand, relative tosupply. In other words, when demand for goods and services are more than their supply,their prices rise. Such price rise is called demand-pull inflation.Cost pull inflation refers to a situation where prices persistently rise because ofgrowing factor costs. A rise in factor prices leads to a rise in total cost of production and

consequently a rise in price level. This may result in an inflationary spiral.Such type of inflation is caused by three factors: (i) an increase in wages, (ii) an increasein the profit margin and (iii) imposition of heavy taxation.Stagflation is the combined phenomenon of demand pull and cost pull inflationfound in both developed and the developing countries. Stagnation in India has beeninterpreted to mean that the economy is growing slowly or stagnating (i.e. GNP is eitherincreasing slowly or remaining constant or even declining) and at the same timeexperiencing a high rate of inflation.Deflation is the continuous decrease in prices of goods and services and thus thepurchasing power of money is increasing. Itis just the opposite of inflation. Deflationoccurs when the inflation rate becomes negative (below zero) and stays there for a longer

period. Deflation occurs at that time when the output of goods and services increasesmore rapidly than the volume of money in the economy. In the deflation the general pricelevel falls and the value of money rises.

Final goods

These goods are purchased for final use and not for resale or further processing. Thesegoods are outside boundary line of production because final goods itself include value ofall intermediate goods used in their production. These goods are ready to reach finalusers, for consumption or for investment.Gross Domestic Product (GDP) is the sum total of market money value of the finalgoods and services produced within the geographical boundaries of the country during agiven period of time (usually a year). GDP can be calculated both at current prices and atconstant prices. GDP estimated on the basis of the prevailing prices is called grossdomestic product at current prices. GDP measured on the basis of some fixed prices,in some base year is known as GDP at constant prices or real gross domestic product.GNP (Gross National Product) is measured as GDP plus income of residents frominvestments made abroad minus income earned by foreigners in domestic market. i.e.If we add net factor income from abroad to the GDP, we get Gross National ProductGNP = GDP + NFIAGross National Product Deflator

It is a Price Index Number used to correct the money value of Gross National Product(GNP) for price changes so as to isolate the changes which have taken place in thephysical output of goods and services.Net Factor Income from Abroad (NFIA) is the difference between the income earnedand received by nationals for rendering factor services in foreign countries and theincome earned by foreign nationals for rendering the factor services in domestic territoryof the country.It better indicates the production potential of the nationals as against GDP. In Indias caseGNP is less than GDP. In other words, net factor income is negative in India.


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National Income is the money value of all the final goods and services produced in acountry during the year. In the simplest way it can be defined as factor income accruingto the national residents of a country. It is the sum of domestic factor income and netfactor income earned from abroad. Net national product at factor cost is called nationalincome.

National Income = NNP at market prices Indirect Taxes+ SubsidiesNet National Product (NNP) = GNP Depreciation.When depreciation is deducted from GNP i.e., Gross National Product, we get NetNational Product (NNP).Per Capita Income is the per head income of the country and can be obtained bydividing gross national product(GNP) or national income of the country by its population.Per capita income as a measure of peoples standard of living is flawed as it does notindicate the distribution of income and the non monetary elements of lifestyle.Personal Income is the sum of all incomes actually received by individuals during agiven year.Personal Disposable Income = Consumption + Saving.

A Tax is an important source of revenue of the govt. It is a compulsory contribution fromhouseholds, firms or other industrial units to the expenses incurred by the state incommon interest of all without reference to specific benefits conferred on any individual.If a person fails to pay tax, he is liable to penal action.Types of Taxes

Proportional Tax implies that the rate of tax remains constant as the income of tax-payerincreases. Here, all incomes are taxed at a single uniform rate irrespective of whether taxpayers income is high or low.Progressive Tax implies that the rate of tax increases with an increase in tax payersincome. Here, less income is taxed at a lower rate, whereas higher income is taxed at ahigher rate. Progressive taxes are equitable and their real burden is more on the rich andless on the poor.Regressive Tax implies that the rate of taxation falls with an increase in tax payersincome. In regressive taxation incidence falls more on people having lower incomes(i.e.poor) than that of those having higher incomes(rich).Ad-valorem Tax

Ad-valorem tax is a kind of indirect tax in which goods are taxed by their values. In thecase of ad-volorem tax, the tax amount is calculated as the proportion of the price of thegoods. Value added Tax (VAT) is an ad-volorem Tax.Specific Taxation System (Unit Tax)

When a tax is levied on a commodity on the basis of its units, size or weight, it is calledthe specific tax. It is a tax imposed per unit of a commodity rather than on the value ofthe commodity compare ad-valorem.Single Tax System is a system in which all tax revenues are raised from one form oftaxation.Lump Sum Tax

Lump sum tax is a fixed amount which has imperative nature irrespective of the incomelevel. This tax is not equitable in nature.Basic Difference between Direct and Indirect Tax


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A shopkeeper pays sales tax to the govt., but usually recovers it from the customers as apart of price of commodity sold. So, impact of sales tax (an indirect tax) is ultimatelyshifted to the consumers. But, the impact of income tax (direct tax) is to be finally borneby the tax payer himself. He cant shift its burden on to others.Direct Tax

This type of tax is paid directly by someone to taxing authority. They are not shifted tosomebody else. The person who pays it in the first instance is also excepted to bear it.

They are imposed according to the ability of the person to pay. The person payingknows clearly how much he has paid. There is direct contact between the tax payer andtax levying public authority.

E.g. Income Tax, Corporation Tax, Gift Tax, Wealth-Tax,Indirect Tax

This type of tax is imposed on one person but paid partly or wholly by another. It isactually passed on to the other in the form of increased cost.

Indirect taxes are those which are demanded from one person in the expectation andintention that he shall indemnify himself at the expense to another.

It is to be initially paid by the producers/traders but its final burden can be passed on tothe final buyers by way of increase in price of the taxed commodity (e.g. sales tax).

Since the tax is included in the price and the amount of tax on each item is so small thatthe consumer may not even realize that he is paying a tax.

They are levied on goods and services produced or purchased and thus only indirectlyon people.

There is an indirect contact between the govt. and those who ultimately bear the burdenof the taxes.E.g. Excise Tax, Custom Duty, Service Tax, Sales Tax, VAT (value added tax), GoodsServices Tax, etc.

Types of Direct TaxIncome Tax is a tax on the income of an individual or an entity within a given financialyear. The income tax department is governed by the Central Board for Direct Taxes(CBDT) and is part of the Department of Revenue under the Ministry of Finance, govt. ofIndia. It was introduced in India in 1860, discontinued in 1873 and reintroduced in 1886.Personal income tax and corporate income tax are two important types of it.a) Personal Income Tax

Levied on the income of Individuals, Hindu Undivided Family (HUF), UnregisteredFirms and other association of people. Incomes from all the sources are added.

Certain rebates, deductions, expenditure etc., on account of life insurance, medicalInsurance, savings in public provident fund (PPF), etc are allowed.

Whole income is divided into different slabs and taxed on the basis of slab into which itfalls. Tax slabs are different for men, women and senior citizens.b) Corporation Income Tax

Levied on the income of registered companies and corporations. The rationale for thecorporation tax is that a joint stock company has a separate entity and thus should betaxed separately.


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A corporation was required to pay income tax on behalf of shareholders on dividendspaid to them, and each shareholder got a credit to this effect.

It is a tax calculated on company's profits after interest payments and allowance (i.e.,Capital allowance) have been deducted but before dividends are allowed for.

Corporations are taxed at a flat rate, but various kinds of rebates and exemptions are

provided. Tax rates are different for Indian companies and foreign companies. Certaintypes of companies (e.g. export houses) are given tax exemptions and tax holidays.Estate Duty or Death duty or Death Tax

It is a tax which is levied on the estate of a decreased person. It is levied on the totalproperty passing to the heirs on the death of a person. The ownership of state changeshands only after the payments of the estate duty.

From the point of view of proceeds, estate duty is a minor source of revenue. It is aprogressive tax in nature.Annual Tax on Wealth or Wealth Tax

Wealth tax is levied on the benefits derived from property ownership. The tax is to bepaid year after year on the same property on its market value, whether or not such

property yields any income.An assesse or a person, who is liable to pay wealth tax under the wealth tax act, includeslegal envoy, perpetrator or administrator of a deceased person and a person deemed to bean agent of a non-resident.

Levied on wealth such as land, bonds, shares etc. of people. Certain types of propertiessuch as agriculture land and funds in provident account are exempt.

With effect from 1.4.1993, wealth tax has been abolished on all assets except certainspecified assets such residential houses, farm houses, urban land, jewellery, bullion,motor car etc.Gift Tax

Levied on all donations to recognized charitable institutions, gifts to women dependents

and gifts to wife. Gift tax was abolished in 1998.Types of Indirect Tax

Custom Duty

Custom duties are levied on exports and imports. The importer or the exporter payscustom duties. Custom duty is a duty that is imposed on the products received fromexporting nations of the world. It is also called protective duty as it protects the homeindustries. The maximum rate of custom duty is now just 10%. The highest rate ofcustom duty applicable on an item is called peak rate. From the point of view ofrevenue, importance of export duty is limited.Import Duty

Import duties are levied on imports imposed on an ad valorem basis which means they

are determined as a percentage of the price of the commodity. In other words, they arefixed in the form of a percentage on the value of the commodity imported.Ad-valorem tax is a kind of indirect tax in which goods are taxed by their values.Excise Duty

It is a tax which is imposed on certain indigenous production of goods (e.g., petroleumproducts, cigarettes, alcoholic drinks, etc.) within the country and has absolutely noconnection with its actual sales.


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Excise duty may be imposed to raise revenue and are often levied at higher rates ongoods whose consumption is believed to have adverse effects on public health, publicorder, or the environment.Sales Tax

Sales tax is a tax on business transactions. Levied on the sale of a commodity which is

produced or imported and sold for the first time. If the product is sold subsequentlywithout being processed further, it is exempt from sales tax.

Sales tax is more in case of luxury items and less or almost nil in case of necessities.

Under sales tax, the registered trading concerns are required to pay the sales tax to thegovt. that shift the burden to the customers.VAT (Value Added Tax)

VAT involves invoice method. This method involves taxation at each stage ofproduction. It is collected at stages between the point of production and the point of finalsale. Value added refers to the difference between value of output and value ofintermediate consumption of each producing unit.

VAT seeks to tax the value added at every stage of manufacturing and sale, with a

provision of refunding the amount of VAT already paid at the earlier stages to avoiddouble taxation. In other words, the tax already paid can be claimed at the next stage ofvalue addition.

VAT is usually called is a sales tax which increases the price of goods. It means everyseller of goods and service provider charges the tax after availing the input tax credit. It isthe form of collecting sales tax under which tax is collected in each stage on the valueadded of the goods.Service Tax

Levied on services rendered by a person and the responsibility of payment of the tax iscast on the service provider. It can be recovered from the service receiver by the serviceprovider in course of his business transactions.

Service tax extends to whole of India, except the state of Jammu and Kashmir. A servicetax at the rate of 5% has been levied on services of telephones, insurance (other than lifeinsurance) and stock brokers.

Budget document

Written instrument used by budget making authority to supplement the main documentin form of an explanatory statement.Budget is a statement of expected revenue and expenditure of the govt. over the period ofa financial year, April 1 March 31. It is a comparative table giving the accounts of thereceipts to be realized and of the expenses to be incurred. It is prepared by Ministry offinance (govt. of India).

Objectives of preparing budget

Redistribution of income and wealth with a view to increasing equality.

Allocation of resources in a manner such that there is a balance between the goals ofprofit maximization and social welfare.

To combat the situations of deflation and inflation and achieve economic stability.

To accelerate growth through public sector enterprises.Types of Budget


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If receipts are equal to expenditure, the budget is said to be balanced one.If receipts are less to expenditure, the budget is said to be deficit one.If receipts are higher than the expenditure, the budget is said to be surplus one.Balanced Budget

When the total revenue of the government exactly equals the total expenditure incurred

by the government, the budget becomes a balanced budget.Feature of balanced budget

A balanced budget ensures financial stability. The govt. does not indulge in wastefulexpenditure.

Balance budget is recommended when the economy is close to the situation of fullemployment. It does not offer any solution to the problem of unemployment duringdepressions in developed countries.

Balanced budget is a good strategy during periods of modest recession when aggregatedemand needs a modest rise.

A balanced budget change in policy or behaviour is one in which the component of thegovt. budget, usually taxes, is adjusted as necessary to maintain a balanced budget.

Budget DeficitBudget may take a shape of deficit when the public revenue falls short to publicexpenditure. Budget deficit is the difference between total receipts and total expenditure.The government meets this deficit by way of printing new currency or by borrowing.In India, Deficit financing refers to issuing of more currency to meet budgetary deficit.It increases the supply of money in the economy.Features of budget deficit

Deficit budget raises the level of aggregate demand in two ways:Directly by way of high govt. expenditure and indirectly by inducing greater (investmentand consumption) expenditure by people.

It is recommended during periods of depression when the govt. needs to increase the

amount of expenditure in the economy.Surplus Budget

When the total revenue of the government exactly is greater than the total expenditureincurred by the government, the budget becomes a surplus budget.Features of surplus budget

It helps in correction of inflationary gap by lowering the level of AD in the economy.AD (aggregate demand)

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