Macroeconomic Environment of Business

Introduction to Macroeconomics

Definitions:

In the words of Boulding, " Macroeconomics is that part of economics which studies the overall averages and aggregates of the system."

According to Shapiro, "Macroeconomics deals with the functioning of the economy as a whole."

Scope & Importance of Macroeconomics

To understand the working of the Economy

Framing Economic Policies Study of Unemployment National Income Economic Growth Monetary Problems Business Cycles

Objectives of Macroeconomic Policy

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

Instruments of Macroeconomic Policy

Fiscal Policy

Monetary Policy

Exchange Rate Policy

Trade Policy

Price and Income Policies

Objectives Instruments/Tools

High output level Monetary Policy

Low unemployment rate Fiscal Policy

Stable price level Exchange rate Policy

Maintenance of Balance of Payments

International Trade Policy

Steady economic growth Price and Income Policy

Basic Concepts in Macroeconomics

Stock and Flow Concepts: A stock variable is measured at a specific point in time

–it signifies the level of a variable at a point in time Money supply, consumer price index, unemployment

level and foreign exchange reserves are examples A flow variable is measured over a specific period of

time- it represents the change in the level of a variable over a period of time

GDP, inflation, exports, imports, consumption and investments are examples

Economic EnvironmentEconomic stages that exists at a given time in a country Economic system that is adopted by a country for example.

Capitalistic, Socialistic or Mixed EconomyEconomic planning, such as five year plans, budgets, etc.Economic Indices such as National Income, Per Capital

Income, Disposable Income, Rate of growth of GNP, Distribution of Income, Rate of savings, Balance of Payments etc.

Economic policies for example, monetary, industrial and fiscal policies

Phases of business cycleStructure of economy

Economic System

Types of Economic System

Capitalism

Communism/Socialism

Mixed Economy

What is Capitalism?

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

Features of Capitalism

Right to Private Property

Freedom of Enterprise

Freedom of Choice by Consumer

Profit Motive

Competition

Importance of Price System

Socialism

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

Features of Socialism

Social Ownership of Means of Production

No Private Enterprise

Economic Planning

Classless Society

Consumer is not sovereign

Mixed Economy

Co- Existence of Public and Private Property

Price System and Government Directives

Government Regulates and Controls the Private Sector

Consumers' sovereignty is protected

Government Protects Labor Interest

Economic Planning & Budget

Objectives of Five Year Plans

1st Plan (1951-56)It gave importance to agriculture, irrigation and power projects to decrease the countries reliance on food grain imports, resolve the food crisis The focus was to maximize the output from agriculture, which would then provide the impetus for industrial growth.

2nd Plan (1956-61)The second five year plan mainly focused on hydroelectric projects, steel Mills, production of coal, railway tracks.

Contd..

8th Plan (1992-97)-Post Economic ReformsThe eighth plan was initiated just after a severe balance of payment crisis, which was intensified by the Gulf war in 1990.several structural modification policies were brought in to put the country in a path of high growth rate. They were devaluation of rupees, dismantling of license prerequisite and decrease trade barriers.

The plan targeted an annual growth rate of 5.6% in GDP and at the same time keeping inflation under control.

Contd..

9th Plan (1997-2002)It was observed in the eighth plan that, even though the economy performed well, the gains did not percolate to the weaker sections of the society. The ninth plans therefore laid greater impetus on increasing agricultural and rural incomes and alleviate the conditions of the marginal farmer and landless laborers.

The main objectives of the ninth five year plan were agriculture and rural development, food and nutritional security, empowerment of women, accelerating growth rates, providing the basic requirements such as health, drinking water, sanitation etc.

Contd..

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

Eleventh Five-Year Plan- (2007-12)

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

What is Union Budget?

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

Economic Indicators

What is an Economic Indicator???

An economic indicator is a statistic about the economy.

Economic indicators allow analysis of economic performance and predictions of future performance.

Nature of Economic indicators can be described in two ways:Relation with the economy

Timing

Nature of Economic indicators

Relation to the Business cycle or EconomyProcyclic: A procyclic economic indicator is one that moves in the same direction as the economy. So if the economy is doing well, this number is usually increasing, whereas if we're in a recession this indicator is decreasing. The Gross Domestic Product (GDP) is an example of a procyclic economic indicator.

Countercyclic: A countercyclic economic indicator is one that moves in the opposite direction as the economy. The unemployment rate gets larger as the economy gets worse so it is a countercyclic economic indicator.

Nature of Economic indicatorsTiming: Economic Indicators can be leading, lagging, or coincident which indicates the timing of their changes relative to how the economy as a whole changes.

Leading: Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines and they improve before the economy begins to pull out of a recession. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.Examples Stock price Housing Markets Inflation Interest rates

Contd…

Lagged: trail behind the general economic activity. Example: Unemployment rate GDP (sometimes)

Coincident: A coincident economic indicator is one that simply moves at the same time the economy does. The Gross Domestic Product is a coincident indicator.

General Economic IndicatorsTotal Output, Income, and Spending (GDP, Consumer Spending)

Employment, Unemployment, and Wages

Production and Business Activity (Index of Industrial production)

Prices (Inflation rate)

Money, Credit, and Security Markets (Interest rates)

Federal Finance (Fiscal deficit)

International Statistics (BOP status, Exchange rate)

What is National Income??

It represents the total income accrued to all factors of production

Wages + Interest + Rent + Profit

Measures of Aggregate Income

Gross Domestic Product (GDP)

Gross National Product (GNP)

Net National Product (NNP)

Calculating Aggregates

At Market Price

At Factor Cost

Factor costs are really the costs of all the factors of production such as labor , capital, energy, raw materials like steel etc that are used to produce a given quantity of output in an economy.

Factor costs are also called factor gate costs since all the costs that are incurred to produce a given quantity of goods and services take place behind the factory gate ie within the walls of the firms, plants etc in an economy.

Gross Domestic ProductThe GDP of a country is defined as the market value of all final

goods and services produced within a country in a given period of time usually a year

Includes only goods and services purchased by their final users, so GDP measures final production.

Counts only the goods and services produced within the country's borders during the year, whether by citizens or foreigners.

Excludes transfer payments since they do not represent current production.

It provides the measure of aggregate output and its comparison over time enables us to calculate the rate of growth (usually calculated both at current and constant prices)

GDP at Market Price

GDP@ market price = GNP@ factor cost – Subsidies + Indirect Taxes

GDP@ market price refers to the total final output of all final goods and services produced within the national frontiers of a country by its citizens and the

foreign residents who reside within those frontiers that are sold at market prices in various markets.

GDP at factor Cost

GDP@ factor cost = GDP@ market price + Subsidies - Indirect Taxes

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

IMF's GDP forecast same as Govt's: Arvind Virmani

The International Monetary Fund’s (IMF) recent 9.4% GDP growth forecast for the current year surprised economy watchers as its far upbeat version of what the traditionally pessimistic fund has had to say for the growth of the Indian economy. The government reacted with caution and said India would be happy with 8.5% growth.

Explaining the difference Arvind Virmani, India's Executive Director at the fund said these forecasts were for the calendar year. “Our forecasts are for GDP at market prices as against the official forecasts which are for GDP at factor cost,” he said adding, a 9.4% GDP at market price implies a 8.5% GDP at factor cost.

Nominal GDP

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

Real GDP

GDP data is also calculated at constant prices taking the year in the past as base year to filter our the impact of current prices.

Real GDP is the physical quantity of goods and services produced in a given period changes in real GDP measure changes in living standard

Example

Assume economy only produces apples and pears. The price for an apple is $2 in 2000, whereas the price for a pear is $3. Same year we produce 100 apples and 50 pears. In 2005, because of the inflation the price for an apple goes up to $3, whereas the price for a pear is $4 at the same production levels.

The nominal GDP in 2000 is $350 and the nominal GDP in 2005 is $500. However real GDP did not change, because real GDP only changes with the changing production level and therefore is a better size measure for economy.

Gross National Product (GNP)

Total market value of all final goods and services produced by citizens of a country no matter where they are residing

Is total Income received by residents for their contributions as factors of production anywhere in the world

GDP measures output within the borders of a country no matter regardless of citizenship of the producer, GNP measures output of the country’s citizens regardless where they live

GNP at factor cost =GDP at factor cost + Net Income from abroad

Examples - GNP  The income of an Indian working in Bahrain is part of Bahrain's GDP as well as India's GNP

Suppose Toyota owns a plant in Bahrain to produce Camry's using Bahraini workers. How to count the product of this plant in the GDP and GNP of Bahrain and Japan?

  With GDP, Bahrain gets all of it, because the plant and the workers are all located in Bahrain. With GNP, the capital share  goes to Japan

Net National Product

NNP equals GNP less replacement investment

NNP = GNP – Depreciation

This is an estimate of how much the country has to spend to maintain the current GNP

If the country is not able to replace the capital stock lost through depreciation, then GNP will fall.

Contd….

In addition, a growing gap between GNP and NNP indicates increasing obsolescence of capital goods, while a narrowing gap would mean that the condition of capital stock in the country is improving.

NNP at factor cost = GNP at factor cost- Depreciation which is accurate measure of National Income

Approaches used to calculate GDP

Production Approach

Income Approach

Expenditure Approach

Expenditure Approach

Considers total spending on all final goods & services during the year

It is a demand based concept Includes:

Personal Consumption Durable Goods & Non-Durable Goods and Services Gross Private Investment Government Consumption and Gross Investment Net Exports of Goods and Services

So, GDP = C + I + G + (X-M)

Income Approach

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

Major Limitations of GDP

The GDP fails to measure or express changes in a nation's:

Quality of life

Unpaid labor

Wealth distribution

Underground economy

Externalities

Money Supply

Money supply is another important indicator of macroeconomic environment

This refers to the total volume of money circulating in the economy, and conventionally comprises currency with the public and demand deposits (current account + savings account) with the public.

Money supply in an economy determines liquidity conditions in the market, which in turn impacts interest rate structure and hence the cost of capital to the firms.

Contd..

Money supply is basically determined by the central bank of a country (e.g. Reserve Bank of India) and the commercial banking network.

RBI has adopted four measures of money supply viz.-Ml, M2, M3 and M4 .

M3 (broad money) is most popular from operational point of view. M3 includes time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1.

Factors affecting Money supply

Bank credit

Deficit financing

Foreign exchange reserves

Inflation

A sustained increase in the general level of prices so that a given amount of money buys less and less.

Reasons of inflation

1. inflation caused by monetary expansion (monetary inflation)

2. inflation caused by real demand expansion

3. inflation caused by aggregate supply contraction

Money supply & Inflation – Monetary inflation

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

Types of Inflation

Demand pull inflation: Arises when aggregate demand outpaces aggregate supply in an economy. It involves inflation rising as the real gross domestic product rises and unemployment falls

Cost Push inflation: This is because of large increases in the cost of important goods or services where no suitable alternative is available. A situation of this kind has been cited during oil crisis in 1970s

Hyperinflation: Hyperinflation is also known as runaway inflation or galloping inflation. This type of inflation occurs during or soon after a war

Remedies - Real Demand Inflation

If inflation is caused by strong real demand, the best response may be to support aggregate supply growth. Part of the solution may be to let prices rise.  Suppliers need incentives to invest in new capacity.

Stimulating aggregate supply include encouraging business investment; reducing input costs; and increasing competitive intensity.

If aggregate supply is sufficiently stimulated, inflation may be converted into balanced economic growth:

If instead money supply is tightened in the face of strong real demand, the result will be a surge in interest rates, which may be counterproductive in this case, as it will be harder for aggregate supply to expand when borrowing costs are high.

Remedies – Monetary Inflation

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

Real v/s Money Inflation

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

Measurement of Inflation

Inflation is measured by the

Wholesale Price Index (WPI)

Consumer Price Index (CPI)

A Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods.

Some countries use the changes in this index to measure inflation in their economies, in particular India – The Indian WPI figure is released weekly

WPI as a measure of inflation in India

WPI is preferred to CPI

wider commodity coverage

available on weekly basis

computed at all-India basis

WPI Inflation is divided into three broad categories

Primary Articles

Fuel Products and

Manufacturing Items.

Headline inflation

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

WPI is the measure of headline inflation in India

Core inflation

Core inflation has emerged as an alternative for measuring inflation. In this, volatile items like food prices and fuel items are excluded.

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

Consumer Price Index

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

CPI in India based on different economic groups.

CPI UNME (Urban Non-Manual Employee)

CPI AL (Agricultural Labourer)

CPI RL (Rural Labourer)

CPI IW (Industrial Worker).

While the CPI UNME series is published by the Central Statistical Organization, the others are published by the Department of Labor.

Effects of inflation

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

Real & Nominal Interest rates

Real Interest Rate = Nominal Interest Rate – Inflation

Real interest rate, is one where the effects of inflation have been factored in. A nominal variable is one where the effects of inflation have not been accounted for.

Economic Policies

Economic Policies

Monetary Policy

Fiscal Policy

Industrial Policy

Foreign Trade Policy

Monetary policy

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

What is Monetary Policy??

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

Monetary policy provides

a) an overview of economy

b) specifies measures that RBI intends to take to influence such

key factors like…money supply….interest rates….inflation

c)lays down norms for financial institutions like banks, financial companies etc. relating to CRR, capital adequacy

Monetary policy & Inflation

When inflationary pressures build up:

raise the short-term interest rate (the policy rate)

which raises real rates across the economy

which squeezes consumption and investment.

Monetary Policy Instruments

Open Market Operations

Bank rate

Cash Reserve Ratio

Statutory Liquidity Ratio

Repo rate

Reverse Repo rate

Open Market Operations

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

What is the outcome on account of OMO?

When the RBI buys bonds from the market and infuses liquidity, the consequences are:

It tends to soften the interest rates

It enables corporates to borrow at favorable interest rates

It prevents the rupee from strengthening unnecessarily and thereby protects the interest of exporters

It may tend to increase inflation

Consequently… If the RBI were to sell bonds instead and suck in liquidity, the effect would exactly be the opposite!!

Bank rate

Rate at which Central Bank lends money to commercial Banks

The bank rate signals the central bank's long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and vice-versa.

Any increase in Bank rate results in an increase in interest rate charged by Commercial banks which in turn leads to low level of investment and low inflation

Cash Reserve Ratio

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

Statutory Liquidity Ratio

Commercial Banks have to maintain liquid assets cash, gold and approved securities equal to not less than 25% of their total demand and time deposit liabilitiesObjectives of SLRTo restrict expansion of Bank creditTo augment bank’s investment in government securitiesTo ensure solvency of banks

Meaning of Repo

The term Repo is used as an abbreviation for Repurchase Agreement or Ready Forward. A Repo involves a simultaneous "sale and repurchase" agreement.

It enables collateralized short term borrowing and lending through sale/purchase operations in debt instruments

Repo Rate

In current monetary policy RBI raised repo rate by 25 basis points to 5.75%

Repo rate is the interest rate charged by the Central bank when banks borrow money from it against pledging its securities

If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

Reverse Repo

The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate.

If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk)

Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy

Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.

Importance of Repo & Reverse Repo

It helps borrower to raise funds at better ratesAn SLR surplus and CRR deficit bank can use the Repo deals as a convenient way of adjusting SLR/CRR positions simultaneously.

RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system

Reverse Repo is undertaken to earn additional

income on idle cash.

Major Players in Repos/Reverse Repos

The major players in the repo and reverse repurchase market tend to be banks who have substantially huge portfolios of government securities as approved by RBI (Treasury Bills, Central/State Govt securities).

Besides these players, primary dealers who often hold large inventories of tradable government securities are also active players in the repo and reverse repo market.

DFHI is very active in the Repo Market. It has been selling and purchasing on repo basis T-Bills and eligible dated Government Securities.

Call Rate – Short term Inter bank rate

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

Liquidity Adjustment Facility

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

Liquidity Adjustment Facility

Objective : The funds under LAF are used by the banks for their day-to-day mismatches in liquidity. Tenor :Under the scheme, Reverse Repo auctions (for absorption of liquidity) and Repo auctions (for injection of liquidity) are conducted on a daily basis (except Saturdays). Eligibility : All commercial banks (except RRBs) and PDs having current account and SGL account with RBI. Minimum bid Size : Rs. 5 cr and in multiple of Rs.5 cr Eligible securities: Repos and Reverse Repos in transferable Central Govt. dated securities and treasury bills.

Discretion to RBI : Under the revised Scheme, RBI will continue to have the discretion to conduct overnight reverse repo or longer term reverse repo auctions at fixed rate or at variable rates depending on market conditions and other relevant factors. RBI will also have the discretion to change the spread between the repo rate and the reverse repo rate as and when appropriate. (As per an IMF 1997 publication, “the sale and repurchase transactions (reverse repo), are sales of assets by the central bank under a contract providing for their repurchase at a specified price on a given future date; they are used to absorb liquidity”. On the contrary, prior to above change, in the Indian context, “repo” denotes liquidity absorption by the Reserve Bank and “reverse repo” denotes liquidity injection).

Highlights of RBI Monetary Policy Review for first quarter of the financial year FY2010-11

The Bank Rate has been retained at 6.0%

Repo rate increased by 25 bps from 5.5% to 5.75% with immediate effect

Reverse repo rate increased by 50 bps from 4.0% to 4.50% with immediate effect

Cash Reserve Ratio (CRR) of scheduled banks has been retained at 6.0% of their net demand and time liabilities (NDTL)

The projection for WPI inflation for March 2011 has been raised to 6.0% from 5.5%

Baseline projection of real GDP growth for FY2010-11 is revised to 8.5%, up from 8.0% with an upside bias

Contd..

The move was aimed to moderate inflation by reining in demand pressures and reduce the volatility of short-term rates, RBI governor Subbarao was quoted as saying. "Inflation is now being significantly driven by demand-side factors," Subbarao said. "It is imperative that we continue in the direction of normalizing our policy instruments to a level consistent with the evolving growth and inflation scenarios."

The RBI said that the Monetary Policy actions are expected to:Moderate inflation by reining in demand pressures and inflationary expectations.

Maintain financial conditions conducive to sustaining growth.

Generate liquidity conditions consistent with more effective transmission of policy actions.

Public Finance

and

Fiscal Policy

Public Finance

Study of State Finance is called Public Finance Deals with the income and expenditure of central, state

and local governments. Raising of necessary funds for incurring expenditure for

public goods constitutes the subject matter of Public Finance

Components of Public Finance Public Revenue Public Expenditure Public Debt Fiscal Policy

Meaning of Fiscal Policy

Fiscal policy is also called Budgetary policy. It is primarily concerned with the receipts and expenditures of the Central government; it also relates to the study of economic effects of these receipts and expenditures

Fiscal policy refers to government policy that attempts to influence the direction of the economy through changes in taxation, public borrowing and public expenditure with specific objectives in view.

Contd..

Changes in the level and composition of taxation and government spending can impact on the following variables in the economy: Aggregate Demand and the level of

economic activity The pattern of resource allocation The distribution of income.

Importance of Fiscal Policy –Post Great Depression

The ineffectiveness of monetary policy as a means of overcoming the severe unemployment of the Great Depression

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

Main Concern of Fiscal Policy in LDCs

Development Allocation of resources for development Reduction in economic inequality Inducing savings and investment Control of inflation Reduction in regional inequalities

Budget

The main instrument of fiscal policy is the budget, presented annually by the Minister of finance to Parliament.

Budget means ‘plans of government finances submitted for the approval of the Legislature’

It is a time bound financial program systematically worked out and ready for execution in the ensuing fiscal year. It is a comprehensive plan action which brings together in one consolidated statement allfinancial requirements of the government.

Budget has four major Functions-Prof Musgrave

Proper allocation of resources or the provision of social goods

Equitable distribution of income and wealth

Securing economic stability or full employment

Long term economic growth

Public Revenue :Major Sources For Centre

Revenue Receipts Capital Receipts

Tax revenue: Direct Taxes Income Tax Corporate Tax Wealth Tax

Indirect Taxes Customs Excise Others

Market Borrowing-internal debt Disinvestment of PSUs Recoveries of loans Borrowing from external markets

External loans/Debts from world institutions

Non tax Revenue Interest receipts Dividend Profits of PSUs Revenue from social services like

education and hospitals External Grants

Public Revenue :Major Sources For States

Revenue Receipts Capital Receipts

Tax revenue land revenue, stamp duties and registration fees, Urban immovable property tax

Indirect Taxes Sales tax on goods Entertainment tax Luxury tax

Market Borrowing Loans which flow from Centre

Interest receipts Dividend from state enterprises Share in Central taxes Grants in aid from Centre And other contributions from Centre

Like those given for central schemes

Public ExpenditureRevenue Expenditure Capital Expenditure

Plan Expenditure

Central Plan such as agriculture, rural development, social service and others

Central Assistance for plans to States and UTs

Plan Expenditure

Developmental Projects

Non – Plan Expenditure

Interest Payments

Subsidies

Debt relief to farmers

Grant to states and UTs

Others

Non – Plan Expenditure

Loans to PSUs

Loans to states and UTs

Defense

Meaning of Public Debt

It represents government borrowing from public. Government debt can be categorized as internal debt,

owed to lenders within the country, and external debt, owed to foreign lenders.

Internal Debt is comprised of market borrowings, special securities issued to RBI, Provident funds, Small savings collections, Treasury bills, Ways and Means Advances

Government Borrowing leads to Crowding out effect

Crowding out Effect

In economics, when the government expands its borrowing to finance increased expenditure, crowding out occurs of private sector investment by way of higher interest rates

If increased borrowing leads to higher interest rates by creating a greater demand for money and loanable funds and hence a higher "price" (ceteris paribus), the private sector, which is sensitive to interest rates will likely reduce investment due to a lower rate of return. This is the investment that is crowded out.

More importantly, a fall in fixed investment by business can hurt long-term economic growth of the supply side, i.e., the growth of potential output.

Features of Public Debt

Size of debt has been on increase Internal debt constituted a larger proportion in

first and Second Plans and position was reversed in Third Plan where external loans contributed to a larger proportion

However from 4th till 10th plans greater reliance has been placed on internal borrowings

Market Borrowings form a significant portion

Indicators of Fiscal Imbalances

Revenue Deficit Fiscal Deficit

Revenue Deficit

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

Revenue Deficit = Revenue expenditure – Revenue receipts

Fiscal Deficit

It is the difference between the government's total receipts (excluding borrowing) and total expenditure. Fiscal deficit gives the signal to the government about the total borrowing requirements from all sources.

Components of fiscal deficit revenue deficit and capital expenditure.

Fiscal Deficit

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

Methods of raising funds or financing Deficit

Borrowing from market or external sources

Government may print currency or govt issue adhoc treasury bills to RBI(deficit financing)

Ad hoc Treasury bills

Under this old system started in 1955 government was allowed to draw money from RBI automatically and to an unlimited extent

It stipulated that whenever the government’s cash balances with went below Rs 50 crore adhoc treasury bills would be issued to raise the cash balance Rs 50 crore. It became an attractive source of financing since it was available at interest rate of 4.6% since 1974

However over a period of time the limit got extended to an ever increasing amount

According to C.Rangarajan this operational arrangement opened up the floodgates of automatic monetization which changed the entire course of monetary history for the next 40 years

Monetized Deficit

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

Ways and Means Advances-New Scheme

Under the new scheme RBI provides facilities for temporary accommodation up to a ceiling fixed in advance

The limit for WMA and rate of interest on WMA will be mutually agreed to between the Reserve Bank and govt from time to time

The credit thus drawn has to be repaid or in technical language Govt vacates WMA from time to time.

As a result WMA will be reduced to zero at the end of financial year

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

Deficit Financing in India

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

The FRBM Act, 2003

It became effective from July 5, 2004

eliminate revenue deficit by March, 2009 and

to reduce fiscal deficit to an amount

equivalent to 3 per cent of GDP by

March,2008.

BUDGET ESTIMATES 2010-11

The Gross Tax Receipts are estimated at Rs. 7,46,651 crore

The Non Tax Revenue Receipts are estimated at Rs. 1,48,118 crore.

The total expenditure proposed in the Budget Estimates is Rs. 11,08,749 crore, which is an increase of 8.6 per cent over last year.

The Plan and Non Plan expenditures in BE 2010-11 are estimated at Rs. 3,73,092 crore and Rs. 7,35,657 crore respectively. While there is 15 per cent increase in Plan expenditure, the increase in Non Plan expenditure is only 6 per cent over the BE of previous year.

Fiscal deficit for BE 2010-11 at 5.5 per cent of GDP, which works out to Rs.3,81,408 crore.

Taking into account the various other financing items for fiscal deficit, the actual net market borrowing of the Government in 2010-11 would be of the order of Rs.3,45,010 crore. This would leave enough space to meet the credit needs of the private sector.

Fiscal Consolidation- Budget -2010 -11

With recovery taking root, there is a need to review public spending, mobilize resources and gear them towards building the productivity of the economy.

Fiscal policy shaped with reference to the recommendations of the Thirteenth Finance Commission, which has recommended a calibrated exit strategy from the expansionary fiscal stance of last two years.

It would be for the first time that the Government would target an explicit reduction in its domestic public debt-GDP ratio.

Meaning of Business Cycle

The business cycle or economic cycle refers to the fluctuations of economic activity about its long term growth trend.

The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), and periods of relative stagnation or decline (contraction or recession).

Phases of Business Cycle Prosperity Recession Depression Recovery

Prosperity Phase

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

Recessionary Phase

Recession is turning point ie when prosperity ends recession begins

Liquidation in stock market, fall in prices are symptoms

Banks & People try to gain greater liquidity so credit sharply contracts

Business expansion stops

Depression Phase

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

Recovery Phase

Rise in demand for consumption goods which in turn lead to demand for capital goods and new investment is induced

This will give rise to increase in income and employment

Phases of Business Cycle

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Year

ProsperityPeak

Trough Trough

Peak

Peak

2005 2010 2015

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