Course Material

BALLB IV SEM

ECONOMICS II

UNIT I
Basic Concepts

Macro Economics: - Macroeconomics is the study of aggregate economic variables of an economy.

Consumption goods:- Are those which are bought by consumers as final or ultimate goods to satisfy their
wants. Eg: Durable goods car, television, radio etc. Non-durable goods and services like fruit, oil, milk,
vegetable etc. Semi durable goods such as crockery etc.

Capital goods – capital goods are those final goods, which are used and help in the process of production
of other goods and services. E.g.: plant, machinery etc.

Final goods: Are those goods, which are used either for final consumption or for investment. It includes
final consumer goods and final production goods. They are not meant for resale. So, no value is added to
these goods. Their value is included in the national income.

Intermediate goods intermediate goods are those goods, which are used either for resale or for further
production. Example for intermediate good is- milk used by a tea shop for selling tea.

Stock: - Quantity of an economic variable which is measured at a particular point of time. Stock has no
time dimension. Stock is static concept. Eg: wealth, water in a tank.

Flow: Flow is that quantity of an economic variable, which is measured during the period of time. Flow
has time dimension- like per hr, per day etc. Flow is a dynamic concept. Eg: Investment, water in a
stream.

Investment: Investment is the net addition made to the existing stock of capital. Net Investment = Gross
investment – depreciation. Depreciation: - depreciation refers to fall in the value of fixed assets due to
normal wear and tear, passage of time and expected obsolescence.

Related aggregates

Gross Domestic product at market price It is the money value of all final goods and services produced
during an accounting year with in the domestic territory of a country.

Gross National product at market price: It is a money value of all final goods and services produced by a
country during an accounting year including net factor income from abroad.

Net factor income from abroad: Difference between the factor incomes earned by our residents from
abroad and factor income earned by non-residents with in our country.
Components of Net factor income from abroad • Net compensation of employees • Net income from
property and entrepreneurship (other than retained earnings of resident companies of abroad) • Net
retained earnings of resident companies abroad

Formulas

• NNP Mp = GNP mp – depreciation

• NDP Mp = GDPmp - depreciation Firms House hold Supply of goods and services (Real Flow) Supply
of Factors of Production (Real Flow) Payment for goods and services (Money Flow) Payment for Factor
services (Money Flow)

• NDP Fc = NDP mp – Net indirect taxes (indirect tax – subsidies)

• GDP Fc = NDP fc + depreciation

• NNP Fc = GDP mp - depreciation + Net factor income from abroad – Net indirect taxes

• (NNP FC is the sum total of factor income earned by normal residents of a country during the
accounting year)

• NNP fc = NDP fc + Net factor income from abroad.

Concept of domestic (economic) territory

Domestic territory is a geographical territory administered by a government within which persons, goods
and capital circulate freely. (Areas of operation generating domestic income, freedom of circulation of
persons, goods and capital) Scope identified as *Political frontiers including territorial waters and air
space. *Embassies, consulates, military bases etc. located abroad but including those locates within the
political frontiers. *Ships, aircrafts etc., operated by the residents between two or more countries.
*Fishing vessels, oil and natural gas rigs etc. operated by the residents in the international waters or other
areas over which the country enjoys the exclusive rights or jurisdiction.

Resident (normal resident):- Normal resident is a person or an institution who ordinarily resides in that
country and whose center of economic interest lies in that country. (The Centre of economic interest
implies :-( 1) the resident lives or is located within the economic territory. (2) The resident carries out the
basic economic activities of earnings, spending and accumulation from that location 3. His center of
interest lies in that country.

Relation between national product and Domestic product.

Domestic product concept is based on the production units located within domestic (economic) territory,
operated both by residents and non-residents. National product concept based on resident and includes
their contribution to production both within and outside the economic territory. National product =
Domestic product + Residents contribution to production outside the economic territory (Factor income
from abroad) - Non- resident contribution to production inside the economic territory (Factor income to
abroad)
Circular flow of Income
The circular flow of income and spending shows connections between different sectors of an economy

 It shows flows of goods and services and factors of production between firms and households
 The circular flow shows how national income or Gross Domestic Product is calculated

Businesses produce goods and services and in the process of doing so, incomes are generated for factors
of production (land, labour, capital and enterprise) – for example wages and salaries going to people in
work.

Leakages (withdrawals) from the circular flow

Not all income will flow from households to businesses directly. The circular flow shows that some part
of household income will be:

 1.Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit
 2.Paid to the government in taxation (T) e.g. income tax and national insurance
 3.Spent on foreign-made goods and services, i.e. imports (M) which flow into the economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and
leading to a multiplied contraction of production (output)

Injections into the circular flow are additions to investment, government spending or exports so
boosting the circular flow of income leading to a multiplied expansion of output.

1. Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology
2. The government, i.e. government expenditure (G) e.g. on the NHS or defence
3. Overseas consumers buying UK goods and service, i.e. UK export expenditure (X)

An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular
flow.
Building up the model

In this next series of images we build up the circular flow model from just having a domestic sector and
then adding in an external sector (exports and imports) before including the financial sector which
channels savings and hopefully provides the finance available to fund investment.

The Domestic Circular Flow of Income and Spending

The external sector involves businesses exporting goods and services overseas (X) and consumers and
business buying imported products from other countries (M)

The domestic circular flow

The Circular Flow of Income and Spending with the External Sector added
Circular flow with external sector

Financial Sector Added to the Circular Flow Model

Marginal Efficiency of Capital (MEC) and Investment Demand Function

Businessmen and entrepreneurs are induced to make an investment when the return on investment is
attractive. Before investing, businessmen compare the yield from the investment and the cost incurred in
making the investment. It is only when the return is greater than cost, investment is made.

Producing in a capitalist economy, profit is the primary objective of business firms and manufacturing
companies. So in order to maximize their profit, they seek to invest in those ventures that yield higher
profit. Keynes introduced the concept of marginal efficiency of capital in order to analyze the profitability
of the prospect ventures.
Generally, marginal efficiency of capital or MEC refers to the expected rate of profit or the rate of return
from investment over its cost. Marginal efficiency of a given capital asset is the highest return that can be
yielded from the additional unit of that capital asset.

Keynes defined MEC as ‘The rate of discount which makes the present value of the prospective yield
from the capital asset equal to its supply price’.

Thus, Keynes’ marginal theory of capital is bases on two factors that include

1. Prospective yield from capital assets

The term prospective yield is the aggregate net return the investor expects to receive on the sale of capital
assets after the deduction of running costs incurred for the purchase of capital assets considering its total
expected life.

Usually, when the total expected life of the capital asset is divided into a series of periods, generally
years, the annual return is determined. This is represented as Q1, Q2, Q3… Qn and are termed as annuities.

2. Supply price of this asset

The investor has to consider the supply price of asset that he is planning on investing. Supply price of
asset refers to the cost incurred for the acquisition of the capital asset. Here, the cost incurred is for the
purchase of or production of a new asset and not the price of any of the existing assets.

The present value of a series of expected income from the invested capital asset throughout its life span is
expressed as

Where,

SP= Supply price of new capital asset;

R1 + R2 + … + Rn = Return received annually;

r= Rate of discount applied each year;
R/ (1+r) = Current value of annuity discounted at rate r.

The concept of marginal efficiency of capital can be illustrated with a numerical.

For instance,

Expected lifespan of capital asset= 2 years

Supply price of capital asset= $ 3000

Expected Yield (first year) = $1100

Expected Yield (Second year) = $1210

Then, marginal efficiency of capital (r) is calculated as

SP= R1/ (1+r) + R2/ (1+r)2

2000/ (1+r) = 1100/ (1+e)2 + 1200
Thus, r= 10%

Taking r= 1/10

SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10)2 = 2000

From the above calculation, we can it may be observed that

1. When the expected yield increases to Rn, rate of discount increases

2. Rate of discount or MEC decreases when supply price of capital asset increases with a given amount
of expected annual return on capital asset, and vice versa.

Thus, prospective yields have a direct effect on MEC whereas, supply price has an inverse effect. This
means that the rate of return over cost may vary as a result of changes in cost or change in the amount of
return. Investors would be willing to make investments only when the return from prospective capital
investment is greater than the supply price.

Investment Demand Function

According to J.M. Keynes, investment depends on the market rate of interest and the marginal efficiency
of capital. A schedule that shows the relation between interest rates and marginal efficiency of capital is
termed as investment demand schedule.

A hypothetical schedule can be prepared that shows the investment demand at varying levels of interest
rates and the effect that marginal efficiency of capital has on the demand:

Rate of Interest ( % Volume of Investment Marginal Efficiency of Capital

p.a) Demand ($) (MEC)

10 10 10

9 20 9

8 30 8

7 4 7

6 50 6

5 60 5

From the schedule, it can be observed that investment demand rises as interest rate falls. Generally,
investment is attractive when the rate of interest is lower. When the rate of interest is 5%, the investor
would expect a return of at least 5% on the investment.

In case the marginal efficiency of capital is lower than the current rate of interest, investors would rather
save than make an investment.

The diagrammatical representation of the investment demand curve gives a curve which is known as the
investment demand function or the marginal efficiency of capital curve.
As seen in the diagram, the volume of investment has increased with the decrease in the rate of interest.
Generally, on average, the investment demand curve is inelastic. So, the change in rate of interest has
very minimum effect on the volume of investment.

However, a more important concept to consider is the shift in the investment demand curve. Keynes,
states that rate of interest is relatively constant in the short run, but MEC is highly fluctuating. So, the
investment demand function and the volume of investment moves along with the increases or decrease in
the MEC.

The diagram shows that with the change in the marginal efficiency of capital, the investment demand
curve shifts upward or downwards although the rate of interest remained unchanged.

Balance of Trade and Balance of Payments

After the implementation of globalization policy, world has become a small village and now every contry
freely transacts with the other countries of the world. In this context, two statements are prepared to keep
a record of the transactions made by the country internationally; they are Balance of Trade (BOT) and
Balance of Payments (BOP). The balance of payment keeps a track of transaction in goods, services, and
assets between the country’s residents, with the rest of the world.

On the other hand, the balance of exports and import of the product and services is termed as Balance of
Trade.

The scope of BOP is greater than BOT, or you can also say that Balance of Trade is a major section of
Balance of Payment. Let’s understand the difference between Balance of Trade and Balance of Payment
in the article given below.

Content: Balance of Trade Vs Balance of Payments

1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart
BASIS FOR
BALANCE OF TRADE BALANCE OF PAYMENT
COMPARISON

Meaning Balance of Trade is a statement that Balance of Payment is a statement that

captures the country's export and keeps track of all economic transactions
import of goods with the remaining done by the country with the remaining
world. world.

Records Transactions related to goods only. Transactions related to both goods and
services are recorded.

Capital Transfers Are not included in the Balance of Are included in Balance of Payment.
Trade.

Which is better? It gives a partial view of the It gives a clear view of the economic
country's economic status. position of the country.

Result It can be Favorable, Unfavorable or Both the receipts and payment sides
BASIS FOR
BALANCE OF TRADE BALANCE OF PAYMENT
COMPARISON

balanced. tallies.

Component It is a component of Current Account Current Account and Capital Account.

of Balance of Payment.

Definition of Balance of Trade

Trade refers to buying and selling of goods, but when it comes to buying and selling of goods globally,
then it is known as import and export. The Balance of Trade is the balance of the imports and exports of
commodities made to/by a country during a particular year. It is the most important part of the current
account of the country’s Balance of Payment. It keeps records of tangible items only.

The Balance of Trade shows the variability in the imports and exports of merchandise made by a country
with the rest of the world over a period. If the imports and exports made to/by the country tallies, then this
situation is known as Trade Equilibrium, but if imports exceed exports, then the condition is unfavourable
as it states that the economic status of the country is not good, and so this situation is termed as Trade
Deficit. Now, if the value of exports is greater than the value of imports, this is a favourable situation
because it indicates the good economic position of the country, thus known as trade surplus.

Definition of Balance of Payments

The Balance of Payments is a set of accounts that recognises all the commercial transactions performed
by the country in a particular period with the remaining countries of the world. It keeps the record of all
the monetary transactions done globally by the country on commodities, services and income during the
year.

It combines all the public-private investments to know the inflow and outflow of money in the economy
over a period. If the BOP is equal to zero, then it means that both the debits and credits are equal, but if
the debit is more than credit, then it is a sign of deficit while if the credit exceeds debit, then it shows a
surplus. The Balance of Payment has been divided into the following sets of accounts:

 Current Account: The account that keeps the record of both tangible and intangible items.
Tangible items include goods while the intangible items are services and income.
 Capital Account: The account keeps a record of all the capital expenditure made and income
generated collectively by the public and private sector. Foreign Direct Investment, External
Commercial Borrowing, Government loan to Foreign Government, etc. are included in Capital
Account.
 Errors and Omissions: If in case the receipts and payments do not match with each other then
balance amount will be shown as errors and omissions.
Macroeconomic School Of Thought
Classical School

The Classical school, which is regarded as the first school of economic thought, is associated with the
18th Century Scottish economist Adam Smith, and those British economists that followed, such as Robert
Malthus and David Ricardo.

The main idea of the Classical school was that markets work best when they are left alone, and that there
is nothing but the smallest role for government. The approach is firmly one of laissez-faire and a strong
belief in the efficiency of free markets to generate economic development. Markets should be left to work
because the price mechanism acts as a powerful 'invisible hand' to allocate resources to where they are
best employed.

In terms of explaining value, the focus of classical thinking was that it was determined mainly by scarcity
and costs of production.

In terms of the macro-economy, the Classical economists assumed that the economy would always return
to the full-employment level of real output through an automatic self-adjustment mechanism.

It is widely recognised that the Classical period lasted until 1870.

Keynesian economics

Keynesian economists broadly follow the main macro-economic ideas of British economist John Maynard
Keynes. Keynes is widely regarded as the most important economist of the 20th Century, despite falling
out of favour during the 1970s and 1980s following the rise of new classical economics.

In essence, Keynesian economists are skeptical that, if left alone, free markets will inevitably move
towards a full employment equilibrium.

The Keynesian approach is interventionist, coming from a belief that the self interest which governs
micro-economic behaviour does not always lead to long run macro-economic development or short run
macro-economic stability. Keynesian economics is essentially a theory of aggregate demand, and how
best to manipulate it through macro-economic policy.

With this overview in mind, Keynesian Theory generally observes the following concepts:

 Unemployment: Under the classical model, unemployment is often attributed to high and rigid
real wages. Keynes argues there is more complexity than that, specifically that societies are
highly resistant to wage cuts and furthermore that reducing wages would pose a great threat to
an economy. Specifically, cutting wages reduces spending and may result in a downwards
spiral.
 Excessive Saving: Keynes’s concept here is somewhat complicated, but in short Keynes notes
excessive saving as a threat and prospective cause of economic decline. This is because
excessive saving leads to reduced investment and reduced spending, which drives down
demand and the potential for consumption. This can be another spiraling issue, as money not
 being exchanged is actively reducing prospective employment, revenues, and future
investments.
 Fiscal Policy: The key concept in fiscal policy for Keynes is ‘counter-cyclical’ fiscal policy,
which is the expectation that governments can reduce the negative effects of the natural
business cycle. This is, generally, achieved through deficit spending in recessions and
suppression of inflation during boom times. Simply put, the government should try to curb the
extremes of economic fluctuation through informed fiscal policy.
 The Multiplier Effect: This idea has in many ways already been implied in the atom, but
inversely. Consider the unemployment and excessive savings problems, and how they stand to
lead to spiraling decline. The other side of that coin is that positive economic situations can
spiral upwards. Take for example a government investment in transportation, putting money in
the pockets of various individuals who build trains and tracks. These individuals will spend
that extra capital, putting money in the hands of other business (and this will continue). This is
called the multiplier effect.

Macroeconomic Policy Objectives:

The macroeconomic policy objectives are the following:
(i) Full employment,

(ii) Price stability,

(iii) Economic growth,

(iv) Balance of payments equilibrium and exchange rate stability, and

(v) Social objectives.

(i) Full employment:

Performance of any government is judged in terms of goals of achieving full employment and price
stability. These two may be called the key indicators of health of an economy. In other words, modern
governments aim at reducing both unemployment and inflation rates.

Unemployment refers to involuntary idleness of mainly labour force and other productive resources.
Unemployment (of labour) is closely related to the economy’s aggregate output. Higher the
unemployment rate, greater the divergence between actual aggregate output (or GNP/CDP) and potential
output. So, one of the objectives of macroeconomic policy is to ensure full employment.

The objective of full employment became uppermost amongst the policymakers in the era of Great
Depression when unemployment rate in all the countries except the then socialist country, the USSR, rose
to a great height. It may be noted here that a free enterprise capitalist economy always exhibits full
employment.

But, Keynes said that the goal of full employment may be a desirable one but impossible to achieve. Full
employment, thus, does not mean that nobody is unemployed. Even if 4 or 5 p.c. of the total population
remain unemployed, the country is said to be fully employed. Full employment, though theoretically
conceivable, is difficult to attain in a market-driven economy. In view of this, full employment objective
is often translated into ‘high employment’ objective. This goal is desirable indeed, but ‘how high’ should
it be? One author has given an answer in the following way; “The goal for high employment should
therefore be not to seek an unemployment level of zero, but rather a level of above zero consistent with
full employment at which the demand for labour equals the supply of labour. This level is called the
natural rate of unemployment.”

(ii) Price stability:

No longer the attainment of full employment is considered as a macroeconomic goal. The emphasis has
shifted to price stability. By price stability we must not mean an unchanging price level over time. Not
necessarily, price increase is unwelcome, particularly if it is restricted within a reasonable limit. In other
words, price fluctuations of a larger degree are always unwelcome.

However, it is difficult again to define the permissible or reasonable rate of inflation. But sustained
increase in price level as well as a falling price level produce destabilising effects on the economy.
Therefore, one of the objectives of macroeconomic policy is to ensure (relative) price level stability. This
goal prevents not only economic fluctuations but also helps in the attainment of a steady growth of an
economy.

(iii) Economic growth:

Economic growth in a market economy is never steady. These economies experience ups and downs in
their performance. This objective became uppermost in the period following the World War II (1939-45).
Economists call such ups and downs in the economic performance as trade cycle/business cycle. In the
short run such fluctuations may exhibit depressions or prosperity (boom).

One of the important benchmarks to measure the performance of an economy is the rate of increase in
output over a period of time. There are three major’ sources of economic growth, viz. (i) the growth of the
labour force, (ii) capital formation, and (iii) technological progress. A country seeks to achieve higher
economic growth over a long period so that the standards of living or the quality of life of people, on an
average, improve. It may be noted here that while talking about higher economic growth, we take into
account general, social and environmental factors so that the needs of people of both present generations
and future generations can be met.

However, promotion of higher economic growth is often hampered by short run fluctuations in aggregate
output. In other words, one finds a conflict between the objectives of economic growth and economic
stability (in prices). In view of this conflict, it is said that macroeconomic policy should promote
economic growth with reasonable price stability.

(iv) Balance of payments equilibrium and exchange rate stability:

From a macro- economic point of view, one can show that an international transaction differs from
domestic transaction in terms of (foreign) currency exchange. Over a period of time, all countries aim at
balanced flow of goods, services and assets into and out of the country. Whenever this happens, total
international monetary reserves are viewed as stable.

If a country’s exports exceed imports, it then experiences a balance of payments surplus or accumulation
of reserves, like gold and foreign currency. When the country loses reserves, it experiences balance of
payments deficit (or imports exceed exports). However, depletion of reserves reflects the unhealthy
performance of an economy and thus creates various problems. That is why every country aims at
building substantial volume of foreign exchange reserves.

Anyway, the accumulation of foreign exchange reserves is largely conditioned by the exchange rate the
rate at which one currency is exchanged for another currency to carry out international transactions. The
foreign exchange rate should be stable as far as possible. This is what one may call it external stability in
price.

External instability in prices hampers the smooth flow of goods and services between nations. It also
erodes the confidence of currency. However, maintenance of external stability is no longer considered as
the macroeconomic policy objective as well as macroeconomic policy instrument.

It is, however, because of growing inter- connectedness and interdependence between different nations in
the globalised world, the task of fulfilling this macroeconomic policy objective has become more
problematic.

(v) Social objectives:

The list of objectives that we have referred here is by no means an exhaustive one; one can add more in
the list. Even then we have incorporated the major ones.
Macroeconomic policy is also used to attain some social ends or social welfare. This means that income
distribution needs to be more fair and equitable. In a capitalist market-based society some people get
more than others. In order to ensure social justice, policymakers use macroeconomic policy instruments.

We can add another social objective in our list. This is the goal of economic freedom. This is
characterised by the right of taking economic decisions by any individual (rich or poor, high caste or low
caste).

Business Cycle
Business cycles are characterized by boom in one period and collapse in the subsequent period in the
economic activities of a country.

These fluctuations in the economic activities are termed as phases of business cycles.

The fluctuations are compared with ebb and flow. The upward and downward fluctuations in the
cumulative economic magnitudes of a country show variations in different economic activities in terms of
production, investment, employment, credits, prices, and wages. Such changes represent different phases
of business cycles.

The different phases of business cycles are shown in Figure-1:

There are basically two important phases in a business cycle that are prosperity and depression. The other
phases that are expansion, peak, trough and recovery are intermediary phases.

Figure-2 shows the graphical representation of different phases of a business cycle:

As shown in Figure-2, the steady growth line represents the growth of economy when there are no
business cycles. On the other hand, the line of cycle shows the business cycles that move up and down the
steady growth line. The different phases of a business cycle (as shown in Figure-2) are explained below.
1. Expansion:
The line of cycle that moves above the steady growth line represents the expansion phase of a business
cycle. In the expansion phase, there is an increase in various economic factors, such as production,
employment, output, wages, profits, demand and supply of products, and sales.

In addition, in the expansion phase, the prices of factor of production and output increases
simultaneously. In this phase, debtors are generally in good financial condition to repay their debts;
therefore, creditors lend money at higher interest rates. This leads to an increase in the flow of money.

In expansion phase, due to increase in investment opportunities, idle funds of organizations or individuals
are utilized for various investment purposes. Therefore, in such a case, the cash inflow and outflow of
businesses are equal. This expansion continues till the economic conditions are favorable.

2. Peak:
The growth in the expansion phase eventually slows down and reaches to its peak. This phase is known as
peak phase. In other words, peak phase refers to the phase in which the increase in growth rate of business
cycle achieves its maximum limit. In peak phase, the economic factors, such as production, profit, sales,
and employment, are higher, but do not increase further. In peak phase, there is a gradual decrease in the
demand of various products due to increase in the prices of input.

The increase in the prices of input leads to an increase in the prices of final products, while the income of
individuals remains constant. This also leads consumers to restructure their monthly budget. As a result,
the demand for products, such as jewellery, homes, automobiles, refrigerators and other durables, starts
falling.
3. Recession:
As discussed earlier, in peak phase, there is a gradual decrease in the demand of various products due to
increase in the prices of input. When the decline in the demand of products becomes rapid and steady, the
recession phase takes place.

In recession phase, all the economic factors, such as production, prices, saving and investment, starts
decreasing. Generally, producers are unaware of decrease in the demand of products and they continue to
produce goods and services. In such a case, the supply of products exceeds the demand.

Over the time, producers realize the surplus of supply when the cost of manufacturing of a product is
more than profit generated. This condition firstly experienced by few industries and slowly spread to all
industries.

This situation is firstly considered as a small fluctuation in the market, but as the problem exists for a
longer duration, producers start noticing it. Consequently, producers avoid any type of further investment
in factor of production, such as labor, machinery, and furniture. This leads to the reduction in the prices of
factor, which results in the decline of demand of inputs as well as output.

4. Trough:
During the trough phase, the economic activities of a country decline below the normal level. In this
phase, the growth rate of an economy becomes negative. In addition, in trough phase, there is a rapid
decline in national income and expenditure.

In this phase, it becomes difficult for debtors to pay off their debts. As a result, the rate of interest
decreases; therefore, banks do not prefer to lend money. Consequently, banks face the situation of
increase in their cash balances.

Apart from this, the level of economic output of a country becomes low and unemployment becomes
high. In addition, in trough phase, investors do not invest in stock markets. In trough phase, many weak
organizations leave industries or rather dissolve. At this point, an economy reaches to the lowest level of
shrinking.

5. Recovery:
As discussed above, in trough phase, an economy reaches to the lowest level of shrinking. This lowest
level is the limit to which an economy shrinks. Once the economy touches the lowest level, it happens to
be the end of negativism and beginning of positivism.
This leads to reversal of the process of business cycle. As a result, individuals and organizations start
developing a positive attitude toward the various economic factors, such as investment, employment, and
production. This process of reversal starts from the labor market.

Consequently, organizations discontinue laying off individuals and start hiring but in limited number. At
this stage, wages provided by organizations to individuals is less as compared to their skills and abilities.
This marks the beginning of the recovery phase.

In recovery phase, consumers increase their rate of consumption, as they assume that there would be no
further reduction in the prices of products. As a result, the demand for consumer products increases.

In addition in recovery phase, bankers start utilizing their accumulated cash balances by declining the
lending rate and increasing investment in various securities and bonds. Similarly, adopting a positive
approach other private investors also start investing in the stock market As a result, security prices
increase and rate of interest decreases.

Price mechanism plays a very important role in the recovery phase of economy. As discussed earlier,
during recession the rate at which the price of factor of production falls is greater than the rate of
reduction in the prices of final products.
UNIT II

Economic Growth : Meaning and Factors affecting Growth

The term economic growth is associated with economic progress and advancement.

Economic growth can be defined as an increase in the capacity of an economy to produce goods and
services within a specific period of time.

In economics, economic growth refers to a long-term expansion in the productive potential of the
economy to satisfy the wants of individuals in the society. Sustained economic growth of a country’ has a
positive impact on the national income and level of employment, which further results in higher living
standards.

Apart from this, it plays a vital role in stimulating government finances by enhancing tax revenues. This
enables the government to earn extra income for the further development of an economy. The economic
growth of a country can be measured by comparing the level of Gross National Product (GNP) of a year
with the GNP of the previous year. The economic growth of a country is possible if strengths and
weaknesses of the economy are properly analyzed.

Economic analysis provides an insight into the essentials of an economy. It is a systematic process for
determining the optimum use of scarce resources and selecting the best alternative to achieve the
economic goal. Moreover, economic analysis helps in assessing the causes of different economic
problems, such as inflation, depression, and economic instability. It is performed by taking into
consideration various economic variables, such as demand, supply, prices, production cost, wages, labor,
and capital.

Meaning of Economic Growth:

Economic growth can be defined as a positive change in the level of goods and services produced by a
country over a certain period of time. An important characteristic of economic growth is that it is never
uniform or same in all sectors of an economy For example, in a particular year, the telecommunication
sector of a country has marked a significant contribution in economic growth whereas the mining sector
has not performed well as far as the economic growth of the country- is concerned.

Economic growth is directly related to percentage increase in GNP of a country. In real sense, economic
growth is related to increase in per capita national output or net national product of a country that remain
constant or sustained for many years.
Economic growth can be achieved when the rate of increase in total output is greater than the rate of
increase in population of a country. For example, in 2005-2006, the rate of increase in India’s GNP was
9.1%, while its population growth rate was 1.7%.

In such a case, per capita increase in GNP would be 7.4% (=9.1-1.7). On the other hand, if the rate of
increase in GNP and population is same then the actual growth of GNP would be zero, which implies that
there is a decrease in per capita income.

As a result, there would be no economic growth. Therefore, in such a case, standard of living of people
would not improve even when there is an increase in the total output of a country. However, such a
growth is better than the stagnation of an economy.

The economic growth of a country may get hampered due to a number of factors, such as trade deficit and
alterations in expenditures by governmental bodies. Generally, the economic growth of a country is
adversely affected when there is a sharp rise in the prices of goods and services.

Following are some of the important factors that affect the economic growth of a country:
(a) Human Resource:
Refers to one of the most important determinant of economic growth of a country. The quality and
quantity of available human resource can directly affect the growth of an economy.

The quality of human resource is dependent on its skills, creative abilities, training, and education. If the
human resource of a country is well skilled and trained then the output would also be of high quality.

On the other hand, a shortage of skilled labor hampers the growth of an economy, whereas surplus of
labor is of lesser significance to economic growth. Therefore, the human resources of a country should be
adequate in number with required skills and abilities, so that economic growth can be achieved.

(b) Natural Resources:

Affect the economic growth of a country to a large extent. Natural resources involve resources that are
produced by nature either on the land or beneath the land. The resources on land include plants, water
resources and landscape.

The resources beneath the land or underground resources include oil, natural gas, metals, non-metals, and
minerals. The natural resources of a country depend on the climatic and environmental conditions.
Countries having plenty of natural resources enjoy good growth than countries with small amount of
natural resources.
The efficient utilization or exploitation of natural resources depends on the skills and abilities of human
resource, technology used and availability of funds. A country having skilled and educated workforce
with rich natural resources takes the economy on the growth path.

The best examples of such economies are developed countries, such as United States, United Kingdom,
Germany, and France. However, there are countries that have few natural resources, but high per capita
income, such as Saudi Arabia, therefore, their economic growth is very high. Similarly, Japan has a small
geographical area and few natural resources, but achieves high growth rate due to its efficient human
resource and advanced technology.

(c) Capital Formation:

Involves land, building, machinery, power, transportation, and medium of communication. Producing and
acquiring all these manmade products is termed as capital formation. Capital formation increases the
availability of capital per worker, which further increases capital/labor ratio. Consequently, the
productivity of labor increases, which ultimately results in the increase in output and growth of the
economy.

(d) Technological Development:

Refers to one of the important factors that affect the growth of an economy. Technology involves
application of scientific methods and production techniques. In other words, technology can be defined as
nature and type of technical instruments used by a certain amount of labor.

Technological development helps in increasing productivity with the limited amount of resources.
Countries that have worked in the field of technological development grow rapidly as compared to
countries that have less focus on technological development. The selection of right technology also plays
an role for the growth of an economy. On the contrary, an inappropriate technology- results in high cost
of production.

(e) Social and Political Factors:

Play a crucial role in economic growth of a country. Social factors involve customs, traditions, values and
beliefs, which contribute to the growth of an economy to a considerable extent.

For example, a society with conventional beliefs and superstitions resists the adoption of modern ways of
living. In such a case, achieving becomes difficult. Apart from this, political factors, such as participation
of government in formulating and implementing various policies, have a major part in economic growth.
Obstacles to Economic Development
Obstacle # 1. Interlocking Various Circle:
Rapid economic growth is an historical abnormality. Therefore, any overall approach to development
must take note of the reality, i.e., the various obstacles to growth as also the persistence of secular
stagnation emphasised by A.H. Hansen.

The most fashionable concept here is the vicious circle of poverty, a concept introduced by Nurkse and
others. The essence of the concept is that a country is poor because it is poor. The implication is clear. A
country’s poverty is itself a major obstacle to growth and development. Because a country is poor, it
cannot develop.

And because it cannot develop, it remains poor. In fact, low per capita income is both the cause and the
effect of poverty, as Fig. 7 shows. It is in tune with the prevailing post-war mood of pessimism and
desperation in which ‘vicious circles’ (of poverty and low wages leading to low investment, and low
productivity of labour leading to poverty) loom large in the economists’ vision.

Fig. 7 shows that, many obstacles to development are reinforcing. Low levels of income prevent saving,
retard capital growth, hinder productivity growth, and keep income low. Successful development may
require taking steps to break the chain at many points.

Fig. 7 also illustrates how one hurdle raises yet other hurdles. Low incomes lead to low saving; low
saving retards the growth of capital; inadequate capital prevents introduction of machinery and rapid
growth in productivity; low productivity leads to low incomes. Other elements in poverty are also self-
reinforcing. Poverty is accompanied by low levels of skill and literacy; these in turn prevent the adaption
of new and improved technologies.
Overcoming the barriers of poverty often requires a concerted effort on many fronts, and some
development economists recommended a “big push” forward to break the vicious cycle. If a country is
fortunate, simultaneous steps to invest more, develop skills, and curb population growth can break the
vicious cycle of rapid economic development.

Moreover, the low levels of living in LDCs make for only little capital formation and investment. At low
levels of income, people find it difficult to make a substantial amount of sacrifice of present consumption
in favour of saving.

So, capital formation becomes a difficult task. If peasant productivity could be increased, such sacrifice
might occur and capital could be accumulated. But this constitutes the vicious circle, “For these
improvements in productivity will typically require that peasants have more and better tools—that
is, more capital — to work with. Without capital accumulation, output and productivity will remain
low. With low output and productivity, there will be no substantial savings or capital formation.”
There is the ‘vicious circle of a limited market’. In a poor country where the bulk of the population live in
rural areas, the extent of the market is likely to be very limited. Another obstacle to development is lack
of adequate transport and communication facilities.

However, according to A.O. Hirschman, the key shortage in LDCs is decision-making ability, not capital
or lack of an organisational framework. If this resource can be mobilised, many of the alleged obstacles to
development will disappear. In fact, there is a whole group of ‘vicious circles’.

Large-scale industry requires a big market. But the extent of the market is limited in LDCs in the initial
stage before there occurs a large-scale industrialisation. This may act as a barrier to growth.

There is also a related and more general ‘vicious circle of interdependent production’. Specialised
industry is interdependent industry. “A firm must have not only markets in which to sell its products
but also supplying industries to provide the tools and unlimited goods its productive activities
require”.
So, it becomes difficult to establish one industry when the supporting industries have not yet come into
existence. And, if we cannot succeed in setting up one particular industry it is difficult to see how we can
establish a series of interdependent industries.

Obstacle # 2. Population Problems:

Rapid population growth creates serious problems for poor countries in which the rate of capital
formation is low. This scarce capital simply goes into spreading a larger quantity of tools over a larger
number of people without raising per capita productivity.
Moreover, the increase in population creates serious problems in those countries where population is
already dense in relation to land and other resources. Due to scarcity of capital goods, the growing labour
force cannot find jobs in the urban areas and just adds to the existing labour force in rural areas. The
consequence: open and disguised unemployment as a percentage of labour force increases with the
passage of time — the reverse of successful development.

If we really consider the population problem of LDCs, as visualised by most classical and labour-surplus
theories, we can imagine a ‘vicious circle’ or ‘population trap’ occurring at very low levels of per capita
income. Suppose, in a very poor country (with a per capita income of in Fig. 8) increase in per capita
output causes a sharp reduction in the death rate.

Consequently, there occurs a rapid rate of population growth. It can well be imagined that “for any small
changes of output per capita, the rate of growth of population would tend to exceed the possible
rate of growth of income.”
The implication is clear. Per capita income would again fall back to the original level. In Fig.8 a move
towards the right of T (the trap) would raise the population-growth curve above the growth of the total-
output curve. And, per capita income again falls back to OT.

On the contrary, at higher levels of per capita income, further increases in standards of living would have
little, if any, impact on the growth of population. In other words, growth would tend to be self-
perpetuating. In fact, if we could manage to move to the right of G, the growth in output would exceed
that of population, leading to a higher rising) per capita income (out put).
The point G is the critical point at which income expansion or the contraction process tends to be
cumulative, i.e., if one becomes rich, it becomes richer still; if poor, it stays poor. So, Fig.8 illustrates one
kind of vicious circle of poverty that might occur in LDCs.

No doubt, modern LDCs do have a most potent instrument of growth at their disposal — modern
technology imported from the West. But there are certain problems which create insurmountable
obstacles to material progress.

These make the process of ‘getting started’ more difficult.

Some such obstacles are listed below:

Obstacle # 3. The Difficult of Adapting Western Technology:
The LDCs of the world often face certain difficulties in adapting western technology. It is so because such
technology is not ideally suited to their own conditions. Such technology is mainly of capital-using type.
But LDCs are basically capital-scarce.

So, they cannot utilise this technology effectively due to the use of such technology is also not possible
due to shortage of entrepreneurs and skilled personnel which characterise most LDCs. At the same time,
their own technology is out-dated.

So, they need an intermediate technology which consists of an adaptation of modern methods to their own
special conditions. In the absence of such technology the latest western methods may be imported. The
consequence: coexistence of shortage of certain factors (capital and skilled personnel) and surpluses of
others (large numbers of unemployed and unskilled workers).

Fig. 8 shows that if a poor country moves from the technology suggested by the first marginal
productivity of labour curve (MPL1) to the second (MPL2) it will get a higher total output (the shaded
area), but it will be able to employ fewer labourers at the going wage. Thus, a basic dilemma is
encountered — there is a serious conflict between output and employment objectives, between growth
and job creation.
Obstacle # 4. Lack of Preparation for an Industrial Revolution:
For industrial development to take place the social and economic groundwork must be laid first. But, in
today’s LDCs attempts are being made to accomplish simultaneously both the industrial revolution and
the preparations for such a revolution.
In fact, in such countries agricultural and commercial sectors have not sufficiently developed so as to
sustain rapid industrial progress. Moreover, the existing institutions and value systems are hardly
conducive to material progress.

The basic prerequisites of economic growth — a strong desire for material betterment, a willingness to
work hard and with regularity, seriousness and punctuality, and ability to assess the future benefits of
present sacrifices are conspicuous by their absence in most LDCs.

Obstacle # 5. The International Context:

Most developed countries of today grew with the help of foreign capital in the past. But now the climate
for investment in LDCs is not encouraging due to colonial abuses and a strong upsurge of nationalistic
feeling and various restrictions imposed by capital- importing countries on the kinds and the terms of
foreign investment.

Added to these are dangers of nationalisation and expropriation. This is why, today the flow of private
capital from rich to poor countries is insufficient compared to needs. This hampers the process of growth
inasmuch as economic depends on capital and investment. However, the recent trends toward
globalisation has led to greater informer of financial capital to LDCs.

Infrastructure Development - An imperative for Inclusive Growth

Naresh Wadhwa, President & Country Manager, Cisco India and SAARC

India is one of the fastest growing economies in the world today. A matter of pride indeed, except that
this economic boom appears to be in distress without an infrastructure to match. Everything from good
roads and modern transport to reliable power and clean water are in short supply. This infrastructure
deficit is not only coming in the way of achieving prosperity but is also widening the gap between the rich
and poor, potentially destabilizing the nation.
So, what does it take to build reliable infrastructure? Very simply, it calls for a mix of political will, well
channeled investments and technology innovation.
Historically, investment in infrastructure has provided a fillip to strong economic development. The US
and Western Europe are examples of solid infrastructure helping to lead the world economy, by
encouraging innovation, allowing sustained development and inclusive growth. Our counterparts in South
Asia, including China, Japan and South Korea, have an edge over us in terms of infrastructure, public
amenities and overall quality of life. For India to get there and ensure sustainability, it is important to
focus on inclusive growth.

Challenges in India:
Apart from being a 62 year old democracy with over a billion people, India is a land of vast, disparate
geographic and socio-economic conditions. The country's demographic make-up is in a state of flux, with
widespread migration from rural to urban areas. According to a 2007 UN State of the World Population
report, by 2030, 40.76% of India's population would be living in urban areas compared to about 28.4% in
2007.
A host of infrastructural problems plague our urban and rural pockets - bad roads, traffic congestion,
unreliable and crowded public transport, erratic supply of electricity and water are a few. Issues such as
lack of access to healthcare, education, banking facilities, internet and mobile connectivity also increase
rural migration to urban areas.
How then, do we enable a system that will provide a better quality of life irrespective of these challenges?

The way out:

A common problem with most Indian infrastructure projects is the lack of anticipation of future need and
capacity. As a result, they prove to be inadequate a couple of years after being commissioned.
Investments and resources earmarked for such projects must be channelized properly for successful
implementation. An effective way to do that is to implement projects through Public Private Partnerships
(PPPs). These partnerships help the government and companies share costs, risks, rewards and ensure that
funds are available for construction and maintenance. They infuse efficiency through competition,
provide scope for innovation and enable implementation of international best practices. Mr. Naresh
Wadhwa, President & Country Manager, Cisco India and SAARC
Adoption of technology is a key investment that will determine the future of our public infrastructure.
Information and communications technology (ICT) can be used to enable solutions over a common
platform and help in efficient planning and management of public utilities such as power, water,
broadband, internet telephony and transport. This will in turn improve their cost, access, and quality.
Cities and communities of the future can become sustainable by embracing smart regulation and strategic
public private partnerships with technology as an enabler.
A case in point is the development of 'Lavasa City,' India's first complete e-city. Part of Cisco's
Smart+Connected Communities vision, it is based on the premise that connected communities running on
networked information can achieve economic, social and environmental sustainability.
Technology can also help reduce the disparity between rural and urban India. The Common Service
Centers (CSCs) are an example of how technology can be used for extending services like primary
healthcare, banking and education to the rural population. Increasing broadband penetration and using
'smart broadband' - integrated, fixed, mobile, and Wi-Fi broadband can help to provide the best of
education, healthcare and eGovernance facilities. Better planning, foresight and judicious use of
technology will help India to achieve inclusive growth, sustain it and get closer to becoming an economic
superpower.

Poverty: Meaning, Causes, Effects

Meaning: Poverty can be defined as the lack of basic needs that are necessary for one to lead a relatively
comfortable life. Such requirements may include shelter, clothing, food, education, and healthcare.

Poverty can either be relative or absolute because whereas other people may be comfortable with their
lives, they may be deemed to be living in poverty when compared against those who are extremely
wealthy.
A person can also be described to be living in poverty when he or she is unable to make ends meet. It can
range from not being able to afford things like a good meal or running behind on bill payments and the
inability to service existing debts.

To many people, a life of poverty is one where an individual lacks money or is without material
possession. Poor people mostly live from hand to mouth and have to seek for assistance to make ends
meet.

Life is always a struggle for people who are poor. They experience different hardships and are often
deprived of the simple joys and pleasures that make life worth living. A person living in poverty on many
occasions does not have peace of mind because of always worrying about what tomorrow will bring.

It is a life filled with inadequacies and insufficiencies. From the shortage of resources to the lack of basic
needs, it is a constant struggle to get by through each day.

Causes of Poverty

There are different situations that may cause an individual to live in poverty. Some of these situations are
unique to every person while others are universal. These are some of the causes of poverty:

1. Over-population: When too many people live in a geographical location, they compete for the available
resources. The chances are that the resources are not always going to be enough to support everyone.
Those who miss out will have to struggle to make ends meet. Overpopulation can result in the
unavailability of land which is an important factor of production. Even without formal employment, those
who have land can cultivate crops for food and sale.

2. Illiteracy: Lack of education can lead to poverty in different ways. When people go to school, they
become equipped with skills and techniques that make them employable. They can thus earn good
incomes and lead good lives. On the other hand, people who have not gone to school will either be
employed as casual laborers with minimum wages or completely be without a means of getting income.
Education opens a path to success even for people who are born into low-income families. Illiteracy also
means that an individual lacks the intellectual capacity to make sound financial decisions. It can result in
poor investment moves or bad spending habits that cause poverty.

3. Casteism and Untouchability: Caste systems deny those who are considered as less worthy a fair shot at
success. It condemns them to a mediocre kind of life even when they have the potential to be great and
find success. It means that if one is born into the wrong caste, he or she will be confined to the living
standards of it.

4. Gender inequality: This is still a major problem in the 21st century. Even though there have been some
remarkable improvements in addressing the issue of gender equality, a lot of challenges still exist. The
phenomenon of unequal pay based on gender has caused more women than men to live in poverty. The
failure to educate the girl child by several communities around the world condemns them to a life of
poverty. They have to depend on men to provide for them and sometimes get married just to escape
poverty. Some societies do not let the girl child inherit property such as land from a parent. They,
therefore, have no means to generate income and make a good life for themselves.
5. Economic inequality: Inequal distribution of wealth especially in countries where the ruling elite come
from a certain region usually lives those who are not represented in government wallowing in poverty.
They are denied basic infrastructures that are critical to the development and have to contend with the
little resources available. This creates a cycle of poverty and many socio-economic problems.

6. Natural Causes: Environmental and geographical factors may also cause poverty. Floods, earthquakes,
and droughts can cause devastations and economic hardships as well as poverty. People may lose their
businesses, sources of income, and houses as a result of natural disasters. Change in weather patterns and
soil degradation can sometimes lead to poor agricultural harvests. If the community depends on farming
for income, it will be left without a viable way to generate money.

7. Labor exploitation: Unethical business practices like labor exploitation also result in poverty. There are
business owners who in a bid to increase profit margins, pay workers very little amounts of wages. As
they accumulate wealth, the poor people who break blood and sweat while earning them money live in
very poor conditions.

8. Resistance to change: This can cause poverty in many ways. When the people of a country refuse to
usher in a new and visionary leadership that has good plans to bring socio-economic development, the
nation is left lagging behind in development. A lot of countries have been plagued by bad leadership and
this has caused economic hardships among the citizens. Resisting change such as the need to educate
girls, opening up the country to foreign direct investment and a call to embrace new ways of doing
business can also cause poverty.

9. Unorganized Loans at higher interest rates in rural areas: Such loans that are paid at higher interest
rates reduce profit margins and kill off small businesses. They also encourage consumerism, and this
creates several financial problems especially for those living in rural areas. Unorganized loans can leave
the borrower worse of than he or she was before taking the credit facility.

10. Wastage of resources: Improper utilization of resources by government agencies and individuals can
later lead to poverty. People who are initially rich can also become poor through wasteful expenditure.
This is greatly driven by the culture of consumerism.

Effects of Poverty

Poverty has so many negative effects on both the individual and the society. These are some fo the
reasons why poverty is not a good thing:

1. Hinders economic prosperity of the nation: The economic growth of a country is mostly driven by the
business ventures of its citizens. If many of them are poor, the country will be underdeveloped.

2. Crimes: It has been established that crime rates are usually higher in areas or countries with high levels
of poverty compared to those that are experiencing rapid economic growth and good amounts of income
per household.
3. Malnutrition: Insufficient food and the inability to afford a decent meal results in malnutrition. Many
people who live in poverty forego several meals and sometimes when they eat, the food lacks essential
nutrients necessary for good growth.

4. Health problems: Many people living in poverty are unable to afford good healthcare. They are
therefore plagued by different health problems since they cannot afford treatment. The poor living
conditions may also cause diseases.

5. Less liberty: They say money is not everything but nevertheless, it is important to have it. It can afford
you the best things in life and give you different options to choose from. Poor people do not get to choose
their professions because they have to make do with what is available. Many will get you a good
education and make it possible to study the career of your choice.

6. Moral and self-esteem: This is something that is easy to observe in a social setup. Those who live in
poverty usually feel like they do not have the moral authority to demand better services or ask that they
are treated fairly. Many of them also suffer from low self-esteem because they think that they are not
good enough.

7. Insufficient food and water: To eat, one has to have money to buy the food. That is one luxury that
those who live in poverty do not have. Poor areas have insufficient food and lack clean water to use in the
home.

8. Lack of basic amenities: Important public amenities such as good drainage systems, piped water,
schools, health centers, and personal amenities like heating are things that those who live in poverty lack.

9. Stress: Increased social disturbances can cause stress. The mind will be at constant war thinking of
where to get the next meal, what the future holds or how to overcome the different problems associated
with poverty. A poor person rarely experiences peace of mind.

10. Feminization of poverty: This is where the burdens of poverty are borne by women. They are left with
the responsibility of taking care of the children and holding the family together.

Major Poverty Alleviation Programmes in India

The six poverty alleviation programmes are as follows:
A number of programmes have been initiated to tackle the problem of poverty, specially for the rural
sector.

1. Integrated Rural Development Programme was initiated on October 2, 1980. The programme has been
designed in a manner that the benefits flow to the poorest as the first priority. The small farmers get a
subsidy of 25% of the capital cost while the marginal farmers share is 33.3%. The Landless labourers and
rural artisans are entitled to a 50% subsidy for acquisition of assets.
The programme had set out to generate income of Rs. 2000 per family. However Mid-term appraisal of
the Ninth Plan revealed that the average investment per family remained too inadequate to generate the
target income per family.

The success of the programme would have been much higher but for the fact that selection of families is
not always guided by economic and business considerations. Where the selected family does not have the
requisite aptitude and ability to manage, the gains have not been commensurate with the subsidy made
available under the Plan.

Presently all families having an annual income below Rs. 11,000 have been made eligible for assistance
under IRDP. By the end of the Eighth Plan period, over 89 lakh families had been assisted. 50% families
of the beneficiaries were SC/ST. However the target of assisting 40% women could not be achieved.

2. National Rural Employment Programme is the new name for the Original Food for Work Programme.
It is centrally sponsored with the Central government providing 50% assistance. Under the Programme
the target is to create additional employment of the order 300-400 million men days annually. The
beneficiaries are to be the unemployed and the under-employed persons.

A critical assessment of the performance under the Plan shows that while funds are put in the programme
liberally the output in terms of employment generation remains well below the target. The employment
provided is of short duration and the wages paid are less than the prevailing market rates. Even the
selection of beneficiaries is not always above board.

The most common works undertaken under the programme are development of kutcha road within the
villages. The States are required to contribute 50% of the total Plan expenditure out of their resources. But
what the States have been doing is that instead of pumping new funds, the existing programmes of the
Public Works Department are shown as works under the NREP. In some cases the funds are spent over
constructions involving high priced material components. In such cases to the basic purpose of utilizing
locally available material and labour gets defeated.

3. Rural Landless Employment Guarantee Programme launched in August 1983 is a supplement to the
NREP. Under the programme, the wages to landless labourers are paid partly in money and partly in food
grains. The projects under the Programme are undertaken during the days there is not much to do on the
farms.

The idea behind the programme is that at least one member from each landless family should be provided
with 100 days of gainful employment. The projects undertaken under the Programme include
improvement of minor irrigation facilities, reclamation of waste land, social forestry and soil
conservation. The other projects covered under the Programme include Indira Awas Yojna and the
Million Wells Scheme. NREP and RLEGP have many overlapping areas. It is now proposed to merge the
two Programmes.

4. Jawahar Rozgar Yojna is implemented through the agency of village panchayats. The Central
government provides 80% finance and the States share is a bare 20%. Funds are allocated to the village
panchayats in proportion to the size of population living below the poverty line.

The target is to provide 50-100 days of employment to at least one member of every poor family within
the village with a 30% reservation for women. It was assessed that 50% of the houses constructed under
the Jawahar Rozgar Yojna were of good quality.
The average cost per house came to around Rs.13, 543. This expenditure has since been increased to Rs.
20,000 to cover cost escalation and for improving further the quality of construction work. Rural roads
accounted for 33% of the total expenditure. Another 9% was spent on minor irrigation projects. Other
beneficiaries include social forestry and schools and community buildings like Panchayat halls.

The impact of the Jawahar Rozgar Yojna in creating additional employment has not been satisfactory.
While the target was to create 100 days of employment the achieved target has been just 11 days. (1993-
1994 evaluation).

These programmes have an indirect positive fall out. With more money available for consumption in the
rural sector, there is an increase in rural consumption expenditure. This increased expenditure also helps
in creating new demands and consequently Employment Assurance Scheme was introduced in October
1993.

The aim of the scheme was to provide 100 days of unskilled manual work to the rural poor. All men and
women above 18 years of age were intended to be covered under the scheme. However, the achieved
target was only 41.3 days in a year.

5. Swaranjayanti Gram Swarozgar Yojna was launched in April 1999. Million Wells Scheme, and
Development of Women and Children in Rural Areas have been merged in the Scheme. The scheme
attempts to combine Bank loans with subsidy with a view to enable the beneficiaries to create income
generating assets.

There is no monetary limit for subsidy in case of irrigation projects. In other cases, however, the subsidy
is limited to 30% subject to a maximum of Rs.7500. A higher limit of Rs, 10,000 has been prescribed for
SC/ST beneficiaries. The States have to contribute just 25% while the rest of the funds are being provided
by the Central government.

6. Jawahar Gram Samridhi Yojna is the restructured form of the earlier Jawahar Rozgar Yojna. It aims at
generating additional employment opportunities for the unemployed poor in the rural sector. Wage
employment is limited to those under Poverty Line. The scheme aims at creating village infrastructure and
durable assets at village level such that additional opportunities for sustained employment are generated.

UNEMPLOYMENT – MEANING, TYPES, CONSEQUENCES AND

SOLUTIONS
Unemployment is a condition that occurs when a person who is actively searching for employment is
unable to find one. It is a situation where those who are willing and able to work cannot get a work to do.
Unemployment rate: This is a measure of the prevalence of unemployment. It is calculated as a
percentage by dividing the number of unemployed individuals by all individuals currently in the labour
force. During periods of recession, an economy usually experiences a relatively high unemployment
rate.
Types of unemployment
1. Mass unemployment: Also known as Cyclical Unemployment, occurs because of the ups and downs
of the economy over time. When the economy enters a recession, many of the jobs lost are considered
Mass Unemployment. Cyclical unemployment occurs as a result of general fall in the quantity of
goods demanded.
2. Structural Unemployment: This occurs when there is a mismatch between the number of people
who want to work and the number of jobs that are available. The unemployed workers may lack the
skills needed for the jobs, or they may not live in the part of the country or world where the jobs are
available.
3. Voluntary Unemployment: This is a situation where Unemployed people decided not take a job
probably because the pay is not attractive or because they are getting benefits from the government or
any other legal source.
4. Residual unemployment: This arises as a result of physical or mental disabilities of the person that is
to be employed.
5. Casual unemployment: This is common with the unskilled kind of labours; it involves job that is not
permanent.
6. Frictional unemployment: Also called technological unemployment, occurs as a result of
advancement in technology, where workers are replaced with machines in the process of production.
7. Seasonal Unemployment: This occurs in industries whose production is subject to seasonal
variations i.e. the season or event at a time determine their level of production so when it is not time
for production, workers become unemployed.
Causes of unemployment
 Some people voluntarily quit unfulfilling jobs. They have the luxury to search until they find just the
right opportunity.
 It is also caused when workers must move for unrelated reasons. They are unemployed until they find
a position in the new town.
 It occurs when new workers enter the workforce. That includes students who graduate from high
school, college, or any higher degree programme.
 Technology advances can lead to unemployment. That’s when computers or robots replace workers.
Most of these workers need retraining before they can get a new job in their field.
 Job Outsourcing. That’s when a company moves its manufacturing or call center functions to another
company or location.
 Demand-deficient unemployment – This occurs when there are fewer jobs than the number of job
seekers.
 Large-scale unemployment results when consumers’ demands become very low, and the company
begins to lose profit. If sales is not expected to pick up anytime soon, some staff will be laid off.
Not All Causes of Joblessness Create Unemployment
Someone who voluntarily gives off employment cannot be classified as unemployed. If someone retires,
goes back to school or leaves the work force to take care of children or other family members, that is not
unemployment. That’s because they no longer look for work.

If the economy is growing, more workers are needed. If it shrinks, then workers lose their jobs. During
recessions, unemployment rates tend to grow. The effects of unemployment are wide-ranging and
include high costs to the government, a reduction in spending power for consumers and economic
recession.
Consequences of unemployment
1. Unemployment leads to threat to peace and stability in the society
2. Wastage of human resources
3. There will be high rate of dependency
4. It leads to high migration rate
5. It leads to insecurity amongst employees
6. It leads to increase in the rate of crime.
7. Lose of skills’ usage: The unemployed is not able to put his/her skills to use. And in a situation where
it goes on for too long the person may have to lose some of his/her skills.
Solutions to the problems of unemployment
1. Population control: When the population of a country is reduced, it will help to reduce the number of
those who are looking for job. The population should be able to match up with the available resources.
2. Industrialisation: When there are enough industriess in a country, demand for labour will increase.
3. Incentive to potential investors: investors should be motivated to create jobs. Incentives like tax
holidays, provision of social amenities etc. should be made available to investors.
4. Proper developmental plans: The government should make proper developmental plans for those who
are unemployed in a country.
5. Redesigning of educational system: The educational system should introduce curricula that can help
graduate to create employment.

Inequality of Income and Wealth in India: Causes and Measures

Causes:
In India, inequality in the distribution of income has increased for various reasons.

The main reasons are the following:

1. Unemployment:
The main reason for low level of income of the majority of Indian people is unemployment and
underemployment and the consequent low productivity of labour. Low labour productivity implies low
rate of economic growth which is the main cause of poverty and inequality of the large masses of people.
In fact, inequality, poverty and unemployment are interrelated. Since sufficient employment could not be
created through the process of planned economic development, it was not possible to increase the income
levels of most people.

2. Inflation:
Another cause of inequality is inflation. During inflation, few profit earners gain and most wage earners
lose. This is exactly what has happened in India. Since wages have lagged behind prices, profits have
increased. This has created more and more inequality. Moreover, during inflation, money income
increases no doubt but real income falls. And this leads to a fall in the standard of living of the poor
people since their purchasing power falls.

No doubt, inequality has increased due to rise in prices. During inflation workers in the organised sector
get higher wages which partly offset the effect of price rise. But wages and salaries of workers in
unorganised sectors (such as agriculture and small-scale and cottage industries) do not increase. So their
real income (purchase income) falls. This is how inequality in the distribution of income increases
between the two major sectors of the economy — organised and unorganised.

3. Tax Evasion:
In India, the personal income tax rates are very high. High tax rates encourage evasion and avoidance and
give birth to a parallel economy. This is exactly what has happened in India during the plan period. Here,
the unofficial economy is as strong as (if not stronger than) the official economy. High tax rates are re-
sponsible for inequality in the distribution of income and wealth. This is due to undue concentration of
incomes in a few hands caused by large- scale tax evasion.

4. Regressive Tax:
The indirect taxes give maximum revenue to the government. But they are regressive in nature. Such
taxes have also created more and more inequality over the years due to growing dependence of the
Government on such taxes.
5. New Agricultural Strategy:
No doubt, India’s new agricultural strategy led to the Green Revolution and raised agricultural
productivity. But the benefits of higher productivity were enjoyed mainly by the rich farmers and
landowners. At the same time, the economic conditions of landless workers and marginal farmers
deteriorated over the years. Most farmers in India could not enjoy the-benefits of higher agricultural
productivity. As a result, inequality in the distribution of income in the rural areas has increased.

Reducing Inequality:
Various measures have been adopted by the Government during the plan period to reduce inequality in
the distribution of income.

Four important measures are the following:

1. Payment of Bonus:
Firstly, the payment of bonus (called annual payment) has been made compulsory in every industry.

2. Ceiling on Land Holding:

Secondly, a ceiling on landholdings has been imposed in the rural areas. Each household (or family) is
allowed to hold a certain amount of land. Any surplus above this is taken over by the Government and is
redistributed among the landless workers and marginal farmers. Moreover, in 1976 a ceiling on urban
property has also been imposed.

3. Self-Employment Projects:
Moreover, various self-employment projects have been taken both in rural and urban areas to solve the
growing unemployment problem.

4. Transfer Payments:
Finally, various types of transfer payments (such as unemployment, compensation, soft loans, pensions to
freedom fighters, concessions to senior citizens, etc.) have been made for improving the welfare of certain
weaker sections of the society.
UNIT III

Private and Public Finance

The upcoming discussion will update you about the differences between private and public finance.

1. The pattern and volume of expenditure of an individual is influenced by his total resources — income
and wealth — but in case of government expenditure determines income. Moreover, government
expenditures determine peoples income. If government spends money on road construction, some
employment is automatically generated.

2. Private individuals or firms are mainly concerned with private consumption or profits. The government
aims at promoting the welfare of society rather than that of the individual. The individual (or a firm) is
mainly concerned with his (its) present gains and prospects, not with that of distant future. The
government has to serve society generation after generation.

3. Private firms derive income by selling goods and they pay to factors of production according to the
quantity or quality purchased. The services of governments are usually made available to individuals
quite irrespective of the cost and often at rates that do not cover full costs.

4. The products or financial assets (like bonds) are voluntarily purchased by members of society. There is
no compulsion in this matter. But governments have always a power to force people to do what they want
them to do.

Not only people are faced to make compulsory payments through taxes but governments may also force
people to buy its own bonds (m times of war or emergency) for raising resources or for controlling
inflation.

5. The individual consumer (or firm) must, of necessity, balance his income and expenditure or receipts
and payments. But a government may reduce taxes if its income is greater than its expenditure and can
raise taxes or incur deficits in the budget in the converse case.

Thus, it is said that, in private finance, the coat is cut according to cloth available, but, in public finance
the size of the coat is determined first and then the authorities try to collect the necessary cloth — through
sale of goods and services, taxation and borrowing.

6. An individual can borrow from another individual. But a government can borrow either internally or
externally (i.e., from a foreign country).
Meaning of Tax
A tax is a compulsory payment levied on the persons or companies to meet the expenditure incurred on
conferring common benefits upon the people of a country.

Two aspects of taxes follow from this definition:

(1) A tax is a compulsory payment and no one can refuse to-pay it.

(2) Proceeds from taxes are used for common benefits or general purposes of the State. In other words,
there is no direct quid pro quo involved in the payment of a tax.

This implies that an individual cannot expect or demand that the Government should render him a specific
service in return for the tax paid by him. However, this does not imply that Government does nothing for
the people from whom it receives taxes.

In fact Government spends the tax money for the general or common benefits of all the people rather than
conferring any special benefit on a particular tax payer. To quote Taussig, “The essence of a tax, as
distinguished from the other charges by Government is the absence of any direct quid pro quo between
the tax payer and the public authority.”

Tax should be carefully distinguished from a fee. Fee is also compulsory payment made by a person who
receives in return a particular benefit or service from the Government. For paying fee on a television or
radio, a person gets the benefits of programmes relayed by the Government on television or radio.
Likewise, students who pay the education fee in schools and colleges, obtain the benefits of teaching
arranged by the Government.

The amount of fee is always less than the cost of service rendered by the Government in return and
therefore covers only a part of the cost of service rendered. Thus, even in case of fee, there is a general
public interest or common benefit of the service rendered by the Government. In this case, the
Government undertakes a service for the common benefits of the citizens and obtains a fee from those
who avail of that service to cover a part of the cost of service rendered.

Classification of Taxes:
The taxes have been variously classified. Taxes can be direct or indirect, they can be progressive,
proportional or regressive, and indirect taxes can be specific or ad-valorem. We spell out below the
meanings of these different types of taxes.

Direct and Indirect Taxes:

The distinction between direct and indirect taxes is based on whether or not the burden of a tax can be
shifted wholly or partly to others. If a tax is such that its burden cannot be shifted to others and the person
who pays it to the Government has also to bear it, it is called a direct tax. Income tax, annual wealth tax,
capital gains tax are examples of direct taxes. In case of a direct tax there is a direct contact between the
tax payer and tax levying public authority.

On the other hand, indirect taxes are those whose burden can be shifted to others so that those who pay
these taxes to the Government do not bear the whole burden but pass it on wholly or partly to others. For
instance, excise duty on the production of sugar is an indirect tax because the manufactures of sugar
include the excise duty in the price and pass it on to buyers. Ultimately, it is the consumers on whom the
incidence of excise duty on sugar falls as they will pay higher price for sugar than before the imposition
of the tax.

Thus, though excise duties are on the production of commodities but they can be shifted to the consumers.
Likewise, sales tax on commodities can also be passed on to buyers or consumers in the form of higher
prices charged for the commodities.

Therefore, excise duties and sales taxes on commodities are examples of indirect taxes. They are also
known as commodity taxes. In the case of indirect taxes, there is an indirect relation, between the
Government and those who ultimately bear the burden of the taxes.

Specific and Ad-Valorem Taxes:

Indirect taxes can be either specific or ad-valorem. A specific tax on a commodity is a tax per unit of the
commodity, whatever its price. Thus the amount of total specific tax will vary in accordance with the
changes in total output or sales of the commodity and not with the total value of output or sales.

On the other hand, an ad-valorem type of an indirect tax is levied according to the value of the
commodity. For instance, sales tax in India is an ad-valorem tax as the rate of sales tax in case of several
commodities is 10 per cent of the value of sales of the commodities. Ad-valorem taxes are progressive in
their burden on consumers whereas specific taxes are regressive.

Progressive, Proportional and Regressive Taxes:

According to another classification, taxes can be progressive, proportional or regressive. In case of
proportional tax, the same rate of the tax is charged, whatever be the magnitude of the base on which it is
levied. For instance, if rate of income tax is 25 per cent whatever the size of income of a person, it will
then be a proportional income tax. Likewise, if rate of wealth tax is 5 per cent, it will be proportional
wealth tax.

Thus, in case of proportional tax it is the rate which is fixed and not the absolute amount of the tax. Thus
with the rate of 25 per cent proportional income tax, a person with income of Rs. 25,000 will pay Rs.
6,250 as the tax, and a person with income of 50,000 will pay Rs. 12,500 as the tax. Thus, even under
proportional income tax, a richer person has to pay greater amount of tax though rate of the tax is the
same.

On the other hand, in case of a progressive tax, rate of the tax increases as the amount of the tax base
(income, wealth or any other object) increases. The principle underlying a progressive tax is that greater
the tax base, the higher the tax rate. In India income tax, an important direct tax levied by the Central
Government, is progressive.

Its rate at present (1998-99) varies from 10 per cent in the slab of Rs. 40,000 to 60,000 to 30 per cent in
the slab of income above Rs. 1,50,000. Under progressive income tax, the richer person pays not only
absolutely more tax but also a higher rate of the tax. Thus, the burden of progressive tax falls more
heavily on the richer persons as compared to proportional income tax.

A regressive tax is the opposite of a progressive tax. In case of a regressive income tax, the rate is lowered
as the income rises. Thus, under regressive tax system, the burden of the tax is relatively more on the poor
than on the rich. A regressive tax is therefore inequitable and no civilised Government in the world today
will levy such a tax.
 Objectives and Instruments of Fiscal Policy

The word fiscal comes from a French word Fisc, which means treasure of Government. All the taxation
and expenditure decisions of the government comprise the Fiscal Policy.
Fiscal Policy is different from monetary policy in the sense that monetary policy deals with the supply of
money and rate of interest. The government and RBI use these two policies to steer the broad aspects of
the Indian Economy. While government is conducts Fiscal Policy, RBI is responsible for monetary
policy.RBI also helps the government in implementing its fiscal policy decisions.
Conducting fiscal policy is one of the main duties of the government. Via fiscal policy, the government
collects money from different resources and utilizes it for different expenditures. Since all welfare
projects are carried out under public expenditures, fiscal policy is closely related to the development
policy.

Objectives of Fiscal Policy

The objectives of the fiscal policy of the government are as follows:
Resource Mobilization
Fiscal policy allows the government to mobilize resources for public expenditure and development. There
are three ways of resource mobilization viz. taxation, public savings and private savings through issue of
bonds and securities.
Resource Allocation
The funds mobilized under fiscal policy are further allocated for development of social and physical
infrastructure. For example, the government collected tax revenues are allocated to various ministries to
carry out their schemes for development.
Redistribution of Income
The taxes collected from rich people are spent on social upliftment of the poor and this fiscal policy in a
welfare state tried to reduce inequalities of income using resource allocation.
Price stability, control of Inflation, Employment generation
Government uses fiscal measures such as taxation and public expenditure to stabilize the prices and
control inflation. Government also generates employment by speeding infrastructure development.
Balanced Regional Development
A large part of the government tax revenues are given out to less developed states as statutory and
discretionary grant. This helps in the balanced regional development of the country.
Balance of Payments
Using fiscal policy measures government tries to promote exports to earn foreign exchange. This helps in
maintaining favourable balance of trade and balance of payments.
Capital Formation and National Income
Fiscal policy measures help in increasing the capital formation and economic growth. Increased capital
formation leads to increase in national income al
Components of Fiscal Policy
There are four key components of Fiscal Policy are as follows:
 Taxation Policy
 Expenditure Policy
 Investment & Disinvestment policy
 Debt / surplus management.
 Taxation Policy
We have already discussed in detail about the taxation policy in previous module. The government gets
revenue from direct and indirect taxes. Via its fiscal policy, government aims to keep the taxes as much
progressive as possible. Further, judicious taxation decisions are very important for economy because of
two reasons:
 Higher than usual tax rate will reduce the purchasing power of people and will lead to an decrease in
investment and production.
 Lower than usual tax rates would leave more money with people to spend and this would lead to
inflation.
Thus, the government has to make a balance and impose correct tax rate for the economy.
Expenditure Policy
Expenditure policy of the government deals with revenue and capital expenditures. These expenditures
are done on areas of development like education, health, infrastructure etc. and to pay internal and
external debt and interest on those debts. Government budget is the most important instrument embodying
expenditure policy of the government. The budget is also used for deficit financing i.e. filling the gap
between Government spending and income.
Investment and Disinvestment Policy
Optimum levels of domestic as well as foreign investment are needed to maintain the economic growth.
In recent years, the importance of FDI has increased dramatically and has become an instrument of
integrating the domestic economies with global economy.
Debt / Surplus Management
If the government received more than it spends, it is called surplus. If government spends more than
income, then it is called deficit. To fund the deficit, the government has to borrow from domestic or
foreign sources. It can also print money for deficit financing.
 UNIT IV
Structural Adjustment Definition
Structural Adjustment refers to a set of economic policies often introduced as a condition for gaining a
loan from the IMF.

Structural adjustment policies usually involve a combination of free-market policies such as privatisation,
fiscal austerity, free trade and deregulation. Structural adjustment policies have been controversial with
detractors arguing the free market policies are often unsuitable for developing economies and lead to
lower economic growth and greater inequality. Supporters of structural adjustment (IMF and World
Bank) argue that these free-market reforms are essential for promoting a more open and efficient
economy, which ultimately help to improve living standards and reduce relative poverty.

In recent years, there has been some reform to structural adjustment policies, ‘poverty reduction’ has been
added as an element of structural adjustment.

Structural Adjustment Policies

To be eligible for a loan from IMF, developing countries often have to implement some or all of the
following policies.

 Cutting Government Spending to reduce the budget deficit. Also known as ‘fiscal austerity’
 Raising tax revenues and trying to improve tax collection by clamping down on tax avoidance.
 Control of Inflation. Usually through Monetary policy (higher interest rates) and fiscal austerity – which
have the effect of depressing aggregate demand.
 Privatisation of state-owned industries. This raises money for the government, but also, in theory, can
help improve efficiency and productivity. because private firms have a profit incentive to be more
efficient.
 De-regulation of markets to encourage competition and more firms to enter the industry.
 Opening the economy to free trade – removing tariff barriers which protect domestic industries
 Ending food subsidies. This can distort the market and lead to over-supply and hold back diversification
of the economy to a more industrial based economy.
 Devaluation of currencies to restore competitiveness and reduce current account deficit. This usually
leads to higher import prices.

Criticisms of Structural Adjustment

1. Loss of National Sovereignty. IMF policies need to be implemented otherwise there can be a heavy
financial penalty. This gives foreign bodies great influence over key economic issues in developing
economies.
2. Greater inequality. Structural adjustment policies have often shown a tendency to greater inequality. For
example, privatisation has often benefitted a small rich elite (e.g. Russia 1995) and have not benefitted
wider population.
3. Ignore social benefits. Privatisation of key public utilities like Water (e.g. Bolivia) have led to higher
prices for a key commodity. Arguably market incentives don’t have the same importance when the
industry plays an important social welfare function. But, structural adjustment policies have often stuck to
a certain ideology even when not appropriate.
4. Control of inflation and fiscal austerity has led to higher unemployment and lower economic growth – at
least in the short-term.
5. Social development ignored. To meet fiscal criteria, governments have often cut welfare spending
programs which benefit the poorest members of society.
6. Free trade often hampers diversification. Developing economies often have a comparative advantage in
selling raw materials. But, this prevents economy diversifying. To make things worse, developed
countries often impose tariffs on agricultural exports, but then want developing countries to have free
trade for their exports.

Structural Adjustment in India

Background

In 1991, India faced an unprecedented balance of payments crisis. For almost a decade the
government had borrowed heavily to support an economic strategy that relied on
expansionary public spending to finance growth. From 1980 to 1991 India's domestic
public debt increased steadily, from 36 percent to 56 percent of the GDP, while its
external debt more than tripled to $70 billion.

Political changes, unrest in parts of the country, and the 1990 Persian Gulf crisis
compounded the already volatile situation. The crisis caused oil prices to rise,
substantially increasing the cost of oil imports, and foreign exchange earnings to drop.
India's creditworthiness, already under strain, became even more vulnerable as Indians
from abroad withdrew their substantial foreign currency deposits and commercial banks
reduced their exposure. Toward the end of 1990, India's creditworthiness was
downgraded, effectively cutting its access to sources of commercial credit. By early 1991,
India was on the brink of default.

As the crisis unfolded the debates in India's political and economic circles increasingly
focused on reform. In India's large and highly diverse democracy, those debates proved
important in building political consensus around the voices for reform. Nevertheless, it
took a new government, which came to power in June 1991, to launch India's first
comprehensive economic policy reform program, which the World Bank supported with a
$500 million structural adjustment operation (SAL), approved in December 1991 and
closed in December 1993.

Project goals and implementation

The SAL's objectives were twofold: (1) to help India address its immediate balance of
payments crisis and (2) to support a broad set of policy reforms aimed at liberalizing the
Indian economy and opening it up to more competition both from within and abroad. The
SAL was complemented by an IMF-supported stabilization program. And parallel
financing was provided by other donors, as agreed at consortium meetings convened by
the Bank.

The SAL proved to be the right response at the right time. The program it supported was
bold but carefully sequenced to create a workable balance between economic necessity
and the realities of India's political economy. The reforms focused first on the most
binding constraints, which also produced quick results, helping to strengthen consensus
around the reforms.

Within weeks of announcing the reform package, the government devalued the rupee by
 23 percent, raised interest rates, and revised the 1991/92 union budget, making sharp cuts
in subsidies and transfers to public enterprises. Over the next six months, it abolished the
complex system of industrial and import licensing, liberalized trade policy, and introduced
measures to strengthen capital markets and institutions. The reform agenda, though
ambitious, was nearly fully implemented during the 1991-93 SAL period.

These measures were followed by additional reforms to liberalize investment, further

deregulate trade policy, improve tax administration, and strengthen the financial sector.
By 1995, India had moved from a regime in which private investment was not allowed in
major economic sectors to one whose openness to foreign investment compares favorably
with that of most Asian countries.

Results

The reforms produced immediate results. The timely provision of foreign exchange helped
India weather its balance of payments crisis and improve its creditworthiness. Several key
macroeconomic indicators improved more than projected (see table). After declining in
the first year of the reforms, GDP growth resumed to 5 percent in 1993/94 and 6.3 percent
in 1994/95. Exports increased almost 12 percent. Most important, there was a surge of
foreign investment, which increased almost sevenfold over projections.

Free Trade and Protectionism

• Definition of Free Trade

Free trade is a system that allows countries to trade and transact without government interference (e.g.
through the uses of tariffs, quotas, subsides, etc.). An ideal trading situation is one of the free trade,
because each country has comparative advantages in producing certain things. Comparative advantages
make trade the most efficient method of production and consumption. Free trade differs from other forms,
such as trade policy where the allocation of goods and services amongst trading countries are determined
by artificial prices that may or may not reflect the true nature of supply and demand.

• Tariffs

Tariffs are taxes that are placed on imported goods. They raise revenue for the government, but also raises
the price for the citizens because the domestic equilibrium price is almost always higher than the
international price. This hurts foreign suppliers because it raises their prices, lowering their consumption
and cutting their overall revenue. Tariffs are good for the domestic producers because their goods seem
relatively cheaper with tariffs on foreign goods. Tariffs are also good for the government because of the
money the government collects with the tariff in place. Tariffs are bad for the consumer, the foreign
producer and create a dead weight loss. However, tariffs are in some ways better than quotas, because the
country still gets some revenue out of the tariffs. Still, both are bad since all trade barriers create losses in
the long run.

• Quotas

A quota is a protectionist trade restriction that limits the quantity of a good that can be imported into a
country. Limiting the supply of a good raises the price of the imported good and makes it more expensive
in comparison to the price under free trade. Quotas make it easier for domestic producers to compete with
foreign producers because importing from foreigners is now more expensive than purchasing
domestically. Therefore, quotas can be quite useful in protecting infant industry. In contrast to tariffs,
quotas do not bring in revenue for the government. Quotas are usually a bad idea because they make these
dead weight loss spots where the government can be earning tax money instead of it just going to waste. It
is often a loss for both countries. The net loss for quotas will go to foreign producers.

• Subsidies
A subsidy is defined as a grant paid by the government to an enterprise that benefits the specific business.
Subsidies are a form of financial assistance that are generally given by the government of a country to a
producer in a given industry, usually to keep the industry afloat and help keep production steady.
Common subsidies include money to expand a company or to hire more workers. Subsidies are also a
trade barrier, as subsidizing companies within the country makes it harder for foreign companies to
compete. When a subsidy is in place, the producer gains but the consumer loses without knowing it. From
a consumer's point of view, a good seems cheaper than it actually is, because they are unaware of the
amount they are paying for the good through their taxes. Subsidies are only good for goods with positive
externalities. • Voluntary Export Restraints (VERs)

A trade restriction on the quantity of a good that an exporting country is allowed to export to another
country. This limit is self-imposed by the exporting country. Typically, VERs are a result of requests
made by the importing country to provide a measure of protection for its domestic businesses that produce
substitute goods. VERs are often created because the exporting countries would prefer to impose their
own restrictions than risk sustaining worse terms from tariffs and/or quotas.

• Administrative obstacles:
They usually come in the form of Bureaucracies or VERs which is defined in the above section.
Bureaucracies are organizations with set laws or rules that may intervene with trade in the country. An
example of a bureaucracy is OHSA, this bureaucracy makes sure that certain policies are met within
companies that may or may not interfere with trade. • Health and safety standards: Basically, we are not
accepting goods because of possible health risks. If something was to go wrong, then many lives would
be at stake both in the United States and outside countries. Any industry crucial to national security, such
as producers of military hardware, should be protected. That way the nation will not have to depend on
outside suppliers during political or military crises.

National security is at stake with regard to some industries. Defense is the best example of an industry
that requires protection on the basis of national security. Steel may be another, but the steel industry has
been only partly successful with this argument. Oil is another industry on which national security can
depend, although U.S. consumption of and dependence on foreign oil has been virtually encouraged by
the phase out of fuel efficiency standards for passenger vehicles and low gasoline taxes (relative to those
in Europe).

Although economists disagree about various ways to protect industries on which national security
depends, most agree that some industries warrant such protection. They also agree that some industries
that have claimed this status probably do not warrant it.

It all depends on how much we are willing to sacrifice our health and safety standards in the free trade
and protectionism. If we value our safety more, it will be harder to accept free trade

• Environmental standards:
From an environmental viewpoint, free trade is not necessarily a good thing. It is a generally accepted
concept that the environment will suffer if trade is liberalized. One reason that the standards are bound to
worsen is that the international trade law under WTO regulations gives countries and incentive to
decrease environmental regulation of domestic production, so that the domestic producers will be on the
same level as the foreign competition. Another concern had is that the ideals behind the General
Agreement on Tariffs and Trade (GATT) support the policy of “product, not process”. This prohibits the
discrimination of trade based on how it is produced, which causes producers to use the cheapest methods
available to make their good, which are often the most damaging methods for the environment.

Businesses want to produce as cheaply as possible, and not reducing pollution saves them a lot of money.
Domestic producers can claim that foreign producers have an unfair advantage because of their country’s
lower environmental standards, so the domestic producers lobby for lower standards at home, so they can
still compete. An example of this is the tuna-dolphin scandal between the U.S. and Mexico, which began
in about 1960, but continued far beyond. The U.S. imposed trade restrictions on Mexico because of the
large number of dolphins killed by their tuna fishermen. Mexico appealed to GATT and won, with GATT
deciding that the U.S. was imposing unfair trade practices, and that they had overlooked several less
extreme options when they used an embargo. As a result, U.S. canneries started to print “dolphin-
friendly” on their labels, because people don’t like things that hurt dolphins, and would much rather buy
dead tuna that doesn’t do so.

There is some argument that the predicted environmental consequences of free trade are exaggerated, but
in general, the theory is accepted. Now it’s just a race to see which will win, trade or the environment.

Arguments for Protectionism

• Infant industry argument - If an industry is newly developing in a country, it will not be able
to be competitive with international prices from companies that have been producing the
particular good for a long time. The government sets up trade barriers in order to protect this
industry from foreign businesses until it is developed enough to keep up in the world market.
However, if the industry continues to be protected, it may never become ready for the world
market because it has not had an incentive to be more efficient and therefore cheaper. It is also
impossible to keep track and measure when the business is old enough to "walk on its own."

• Efforts of a developing country to diversify - A country should diversify because if it only

produces a small variety of goods in a few industries, when something bad happens to those
industries they could be in a lot of trouble financially. They would lose those specific exports
with none other to still rely on. This is why with small countries, when there is a destruction of
their limited factories, they suffer greatly. This idea is very similar to the idea of having a
biologically diversified population.

Ex: Instead of specializing in one product like rice in Thailand. They should produce other
products too, so they are not so dependant on the exports of rice.
• Protection of employment -This argument stems, usually from misguided patriotism. The
claim is that buying goods from other countries as opposed to domestic producers will
destroy jobs at home. The counter argument is that buying at the lowest price allows for
higher levels of production and other lost jobs will be made up in other sectors and by
lowered input prices.
• Source of government revenue- tariff equals bringing in government revenue
- Once government has more money from tariffs, tax, etc...they will be able to plug it back into
the economy through government spending or investment, which allows an economy to become
more advanced.
• Strategic arguments- A country should avoid importing weapons and other materials for
national security from other countries. For example, if country A is receiving national security
technology from country B, and they end up in conflict with each other, country A is at risk.
Because now that supply from country B will be cut, leaving country A vulnerable to country B
attacks.
• Means to overcome a balance of payments disequilibrium- A balance of payments
disequilibrium (current account deficit)is a situation where export revenue for a country is less
than import expenditure (trade deficit). The country would then put a tariff on the importing
country so that the consumers would want to buy more domestic goods rather than foreign goods.

• Anti-dumping- When a country sells goods below the production costs-or domestic price level-
then these goods are being dumped on the importing country. When the importing country taxes
these imported goods to reflect the true cost of production, that is called anti-dumping. Usually
anti-dumping action means charging extra import duty on the particular product from the
exporting country in order to bring its price closer to the “normal value” or to remove the injury
to domestic industry in the importing country. The problem with this policy is that it is often
impossible to know whether goods are being sold at prices beneath actual value; therefore anti-
dumping policy may create more problems than it solves.

Arguments against Protectionism

Free trade is always beneficial to the countries involved unless they have exactly the same
production power.
• Inefficiency of resource allocation - When a country produces a good and it does not have a
comparative advantage in producing, the country pays a higher opportunity cost and there is net
welfare loss because of the increased opportunity cost. When a country does have comparative
advantage, it is much less of an opportunity cost to obtain it from them. They could obtain it from
foreigners, decreasing the opportunity cost of making it themselves. with protectionism it will
prevent a country from efficiently allocating their resources.
• Costs of long-run reliance on protectionist methods- Countries who place trade barriers in
place for the infant industry argument assume that eventually the domestic industry will be able
to compete internationally. However, the industry may use the barrier as a crutch and never
properly develop its product. They will rely on these trade barriers to often keep people to buy
domestically. This is oftentimes the case in developing countries who initially intend to transition
from primary to secondary and tertiary goods. A protectionist measure that can be helpful in the
short-run is not lifted and encourages retaliation.

• Increased prices of goods and services to consumers- If trade barriers were placed on input
goods, not only will it increase the price of those input goods but also the product from the input
goods. In the end, consumers are the one paying more for the input costs and the regular cost of
the product.

• The cost effect of protected imports on export competitiveness- By putting up trade barriers,
other countries can retaliate and put up their own trade barriers. This in turn backfires and causes
your goods to now be more expensive also. Decreasing your number of exports, decreasing AD
because exports a factor of aggregate demand, causing AD to shift to the left.
The IMF and the World Bank

The International Monetary Fund (IMF) and the World Bank are institutions in the United Nations
system. They share the same goal of raising living standards in their member countries. Their approaches
to this goal are complementary, with the IMF focusing on macroeconomic issues and the World Bank
concentrating on long-term economic development and poverty reduction.

What are the purposes of the Bretton Woods Institutions?

The International Monetary Fund and the World Bank were both created at an international conference
convened in Bretton Woods, New Hampshire, United States in July 1944. The goal of the conference was
to establish a framework for economic cooperation and development that would lead to a more stable and
prosperous global economy. While this goal remains central to both institutions, their work is constantly
evolving in response to new economic developments and challenges.

The IMF’s mandate. The IMF promotes international monetary cooperation and provides policy
advice and capacity development support to help countries build and maintain strong economies. The
IMF also makes loansand helps countries design policy programs to solve balance of payments problems
when sufficient financing on affordable terms cannot be obtained to meet net international payments. IMF
loans are short and medium term and funded mainly by the pool of quota contributions that its members
provide. IMF staff are primarily economists with wide experience in macroeconomic and financial
policies.

The World Bank’s mandate. The World Bank promotes long-term economic development and poverty
reduction by providing technical and financial support to help countries reform certain sectors or
implement specific projects—such as building schools and health centers, providing water and electricity,
fighting disease, and protecting the environment. World Bank assistance is generally long term and is
funded both by member country contributions and through bond issuance. World Bank staff are often
specialists on particular issues, sectors, or techniques.

Framework for cooperation

The IMF and World Bank collaborate regularly and at many levels to assist member countries and work
together on several initiatives. In 1989, the terms for their cooperation were set out in a concordat to
ensure effective collaboration in areas of shared responsibility.

High-level coordination. During the Annual Meetings of the Boards of Governors of the IMF and the
World Bank, Governors consult and present their countries’ views on current issues in international
economics and finance. The Boards of Governors decide how to address international economic and
financial issues and set priorities for the organizations.

A group of IMF and World Bank Governors also meet as part of the Development Committee, whose
meetings coincide with the Spring and Annual Meetings of the IMF and the World Bank. This committee
was established in 1974 to advise the two institutions on critical development issues and on the financial
resources required to promote economic development in low-income countries.

Management consultation. The Managing Director of the IMF and the President of the World Bank
meet regularly to consult on major issues. They also issue joint statements and occasionally write joint
articles, and have visited several regions and countries together.
Staff collaboration. IMF and Bank staffs collaborate closely on country assistance and policy issues that
are relevant for both institutions. The two institutions often conduct country missions in parallel and staff
participate in each other’s missions. IMF assessments of a country’s general economic situation and
policies provide input to the Bank’s assessments of potential development projects or reforms. Similarly,
Bank advice on structural and sectoral reforms is considered by the IMF in its policy advice. The staffs of
the two institutions also cooperate on the conditionality involved in their respective lending programs.

The 2007 external review of Bank-Fund collaboration led to a Joint Management Action Plan on World
Bank-IMF Collaboration (JMAP) to further enhance the way the two institutions work together. Under
the plan, Fund and Bank country teams discuss their country-level work programs, which identify
macroeconomic and sectoral issues, the division of labor, and the work needed in the coming year.
A review of Bank-Fund Collaboration underscored the importance of these joint country team
consultations in enhancing collaboration.

Reducing debt burdens. The IMF and World Bank have also worked together to reduce the external debt
burdens of the most heavily indebted poor countries under the Heavily Indebted Poor Countries (HIPC)
Initiativeand the Multilateral Debt Relief Initiative (MDRI).

They continue to help low-income countries achieve their development goals without creating future debt
problems. IMF and Bank staff jointly prepare country debt sustainability analyses under the Debt
Sustainability Framework (DSF) developed by the two institutions.

Reducing poverty. In 1999, the IMF and the World Bank launched the Poverty Reduction Strategy Paper
(PRSP) approach as a key component in the process leading to debt relief under the HIPC Initiative and
an important anchor in concessional lending by the Fund and the Bank. While PRSPs continue to
underpin the HIPC Initiative, the World Bank and the IMF adopted in July 2014 and July 2015,
respectively, new approaches to country engagement that no longer requires PRSPs. The IMF streamlined
its requirement for poverty reduction documentation for programs supported under the Extended Credit
Facility (ECF) or the Policy Support Instrument (PSI).

Setting the stage for the 2030 development agenda. Between 2004 and 2015 the IMF and the Bank
jointly published the annual Global Monitoring Report (GMR), which assessed progress towards meeting
the Millennium Development Goals (MDGs). In 2015, with the replacement of the MDGs with
the Sustainable Development Goals (SDGs) under the 2030 Global Development Agenda, the IMF and
the Bank have actively engaged in the global effort to support the Development Agenda. Each institution
has committed to new initiatives, within their respective remits, to support member countries in reaching
their SDGs. They are also working together to better assist the joint membership, including through
enhanced support of stronger tax systems in developing countries, and support of the G-20 Compact with
Africa—in collaboration with the African Development Bank—to promote private investment in Africa.

Assessing financial stability. The IMF and the World Bank are also working together to make financial
sectors in member countries resilient and well regulated. The Financial Sector Assessment Program
(FSAP) was introduced in 1999 to identify the strengths and vulnerabilities of a country's financial system
and recommend appropriate policy responses.
Special Economic Zone (SEZ)

The Special Economic Zone (SEZ) policy in India first came into inception on April 1, 2000. The prime
objective was to enhance foreign investment and provide an internationally competitive and hassle free
environment for exports. The idea was to promote exports from the country and realising the need that
level playing field must be made available to the domestic enterprises and manufacturers to be
competitive globally.

A legislation has been passed permitting SEZs to offer tax breaks to foreign investors. Over half a decade
has passed since its inception, but the SEZ Bill has certain drawbacks due to the omission of key
provisions that would have relaxed rigid labour rules. This has lessened India's chance of emulating the
success of the Chinese SEZ model, through foreign direct investment (FDI) in export-oriented
manufacturing.

The policy relating to SEZs, so far contained in the foreign trade policy, was originally implemented
through piecemeal and ad hoc amendments to different laws, besides executive orders. In order to avoid
these pitfalls and to give a long-term and stable policy framework with minimum regulation, the SEZ Act,
'05, was enacted. The Act provides the umbrella legal framework, covering all important legal and
regulatory aspects of SEZ development as well as for units operating in SEZs.

What is a Special Economic Zone(SEZ)?

Special Economic Zone (SEZ) is a specifically delineated duty-free enclave and shall be deemed to be
foreign territory for the purposes of trade operations and duties and tariffs. In order words, SEZ is a
geographical region that has economic laws different from a country's typical economic laws Usually the
goal is to increase foreign investments. SEZs have been established in several countries, including China,
India, Jordan, Poland, Kazakhstan, Philippines and Russia. North Korea has also attempted this to a
degree

Where are SEZs located in India?

At present there are eight functional SEZs located at Santa Cruz (Maharashtra), Cochin (Kerala), Kandla
and Surat (Gujarat), Chennai (Tamil Nadu), Visakhapatnam (Andhra Pradesh), Falta (West Bengal) and
Noida (Uttar Pradesh) in India. Further an SEZ in Indore (Madhya Pradesh) is now ready for operation.

In addition 18 approvals have been given for setting up of SEZs at Positra (Gujarat), Navi Mumbai and
Kopata (Maharashtra), Nanguneri (Tamil Nadu), Kulpi and Salt Lake (West Bengal), Paradeep and
Gopalpur (Orissa), Bhadohi, Kanpur, Moradabad and Greater Noida (UP), Vishakhapatnam and Kakinada
(Andhra Pradesh), Vallarpadam/Puthuvypeen (Kerala), Hassan (Karnataka), Jaipur and Jodhpur (
Rajasthan) on the basis of proposals received from the state governments.

Who can set up SEZs? Can foreign companies set up SEZs?

Any private/public/joint sector or state government or its agencies can set up an SEZ.

Yes, a foreign agency can set up SEZs in India.

What is the role of state governments in establishing SEZs?

State governments will have a very important role to play in the establishment of SEZs. Representative of
the state government, who is a member of the inter-ministerial committee on private SEZ, is consulted
while considering the proposal. Before recommending any proposals to the ministry of commerce and
industry (department of commerce), the states must satisfy themselves that they are in a position to supply
basic inputs like water, electricity, etc.
Are SEZ's controlled by the government?

In all SEZs the statutory functions are controlled by the government. Government also controls the
operation and maintenance function in the seven central government controlled SEZs. The rest of the
operations and maintenance are privatised.

Are SEZs exempt from labour laws?

Normal labour laws are applicable to SEZs, which are enforced by the respective state governments. The
state governments have been requested to simplify the procedures/returns and for introduction of a single
window clearance mechanism by delegating appropriate powers to development commissioners of SEZs.

The performances of the SEZ units are monitored by a unit approval committee consisting of
development commissioner, custom and representative of state government on an annual basis.

What are the special features for business units that come to the zone?

Business units that set up establishments in an SEZ would be entitled for a package of incentives and a
simplified operating environment. Besides, no license is required for imports, including second hand
machineries.

How do SEZs help a country's economy?

SEZs play a key role in rapid economic development of a country. In the early 1990s, it helped China and
there were hopes (perhaps never very high ones, admittedly) that the establishment in India of similar
export-processing zones could offer similar benefits -- provided, however, that the zones offered
attractive enough concessions. Traditionally the biggest deterrents to foreign investment in India have
been high tariffs and taxes, red tape and strict labour laws. To date, these restrictions have ensured that
India has been unable to compete with China's massively successful light-industrial export machine.
India's goods exports in 2004 were an estimated $68 bn compared with $594 bn for China, and the stock
of inward FDI, at $42 bn, was less than a tenth of China's $544 bn.

Foreign Direct Investment

Foreign direct investment is when an individual or business owns 10 percent or more of a foreign
company. If an investor owns less than 10 percent, the International Monetary Fund defines it as part of
his or her stock portfolio.
A 10 percent ownership doesn't give the investor a controlling interest. It does allow influence over the
company's management, operations, and policies. For this reason, governments track who invests in their
country's businesses.
In 2016, global FDI was $1.75 trillion, according to the United Nations. It had fallen 2 percent from
2015's record of $1.76 trillion.
Importance of FDI
Foreign direct investment is critical for developing and emerging market countries. Their companies need
the multinationals' funding and expertise to expand their international sales. Their countries need private
investment in infrastructure, energy, and water to increase jobs and wages. The UN report warned
that climate change would hit them the hardest.
In 2016, developing countries received 37 percent of total global FDI. They had 43 percent in 2015. The
downturn was due to slower growth in the developed world. The United States economy only grew 1.5
percent, compared to 2.9 percent in 2015. The UN forecast that an improving economy in 2017 will
increase world FDI to $1.8 trillion.
The developed economies, such as the European Union and the United States, also need FDI.
Their companies do it for different reasons. Most of these countries' investment is via mergers and
acquisitions between mature companies. These global corporations' investments were for either
restructuring or refocusing on core businesses.
Advantages
Foreign direct investment benefits the global economy, as well as investors and recipients.
Capital goes to the businesses with the best growth prospects, anywhere in the world. That's because
investors seek the best return with the least risk. This profit motive is color-blind and doesn't care about
religion or politics.
That gives well-run businesses, regardless of race, color or creed, a competitive advantage. It reduces the
effects of politics, cronyism, and bribery. As a result, the smartest money rewards the best businesses all
over the world. Their goods and services go to market faster than without unrestricted FDI.
Individual investors receive the extra benefits of lowered risk. FDI diversifies their holdings outside of a
specific country, industry or political system. Diversification always increases return without increasing
risk.
Recipient businesses receive "best practices" management, accounting or legal guidance from their
investors. They can incorporate the latest technology, operational practices, and financing tools. By
adopting these practices, they enhance their employees' lifestyles. That raises the standard of living for
more people in the recipient country. FDI rewards the best companies in any country. It reduces the
influence of local governments over them.
Recipient countries see their standard of living rise. As the recipient company benefits from the
investment, it can pay higher taxes. Unfortunately, some nations offset this benefit by offering tax
incentives to attract FDI.
Another advantage of FDI is that it offsets the volatility created by "hot money." That's when short-term
lenders and currency traders create an asset bubble. They invest lots of money all at once, then sell their
investments just as fast.
That can create a boom-bust cycle that ruins economies and ends political regimes. Foreign direct
investment takes longer to set up and has a more permanent footprint in a country.
Disadvantages
Countries should not allow foreign ownership of companies in strategically important industries. That
could lower the comparative advantage of the nation, according to an IMF report.
Second, foreign investors might strip the business of its value without adding any. They could sell
unprofitable portions of the company to local, less sophisticated investors. They can use the company's
collateral to get low-cost, local loans. Instead of reinvesting it, they lend the funds back to the parent
company.
Free Trade Agreements and FDI
Trade agreements are a powerful way for countries to encourage more FDI. A great example of this
is NAFTA, the world's largest free trade agreement. It increased FDI between the United States, Canada,
and Mexico to $452 billion by 2012. That was just one of NAFTA's advantages.