5 th unit

INDIAN ECONOMIC ENVIRONMENT

Prepared By Dr Virupaksha Goud

Indian Economic Environment: Overview of Indian Economy, Recent changes in Indian

Economy. Measurement of National Income: Basic Concepts, Components of GDP- Measuring
GDP and GNP, Difficulties in measuring National Income, Growth Rate. Business Cycle –
Features, Phases, Economic Indicators, Inflation: Types, causes, Measurement, Kinds of Price
Indices, Primary, Secondary and Tertiary Sectors and their contribution to the Economy, SWOT
Analysis of Indian Economy.

OVERVIEW OF INDIAN ECONOMY:

The economy of India is a developing mixed economy. It is the world's sixth-largest economy by
nominal GDP and the third-largest by purchasing power parity (PPP). The country ranks 141st in
per capita GDP (nominal) with $1723 and 123rd in per capita GDP (PPP) with $6,616 as of
2016. After 1991 economic liberalization, India achieved 6-7% average GDP growth annually.
In FY 2015 and 2017 India's economy became the world's fastest growing major economy
surpassing China.

The long-term growth prospective of the Indian economy is positive due to its young population,
corresponding low dependency ratio, healthy savings and investment rates, and increasing
integration into the global economy. India topped the World Bank's growth outlook for the first
time in fiscal year 2015–16, during which the economy grew 7.6%. Growth is expected to have
declined slightly to 7.1% for the 2016–17 fiscal year. According to the IMF, India's growth is
expected to rebound to 7.2% in the 2017–18 fiscal and 7.7% in 2018–19.

India has one of the fastest growing service sectors in the world with an annual growth rate
above 9% since 2001, which contributed to 57% of GDP in 2012–13. India has become a major
exporter of IT services, Business Process Outsourcing (BPO) services, and software services
with $154 billion revenue in FY 2017. This is the fastest-growing part of the economy. The IT
industry continues to be the largest private-sector employer in India. India is the third-largest
start-up hub in the world with over 3,100 technology start-ups in 2014–15 The agricultural sector
is the largest employer in India's economy but contributes to a declining share of its GDP (17%
in 2013–14). India ranks second worldwide in farm output. The industry sector has held a steady
share of its economic contribution (26% of GDP in 2013–14). The Indian automobile industry is
one of the largest in the world with an annual production of 21.48 million vehicles (mostly two
and three-wheelers) in 2013–14. India had $600 billion worth of retail market in 2015 and one of
world's fastest growing e-commerce markets.

 India is a developing country and our economy is a mixed economy. In a mixed economy
the public sector co-exists with the private sector.
 Low per capita income. High poverty
 Inequalities in income distribution.
  Predominance of agriculture. More than 2/3rd of India’s working population Is engaged
in agriculture. But in USA only 2% of The working population is engaged in agriculture.)
 Agriculture sector in India employs about 64% of the work force, contributes 20% of
GDP and accounts for about 18% share of the value of the country’s export
 Rapidly growing population.
 Chronic unemployment
 Low rate of capital formation.
 Dualistic Nature of Economy (features of a Modern economy, as well as traditional).
 Mixed Economy
 Follows Labor Intensive Techniques.
 Low Export and Low participation in the international Trade
 License Raj Economic Policy
 Low Rate of economic Growth
 High Fiscal Deficit
 Low savings and Low capital formation
 Low standard of living
 Low urbanization
 Low Financial Literacy and Low penetration of Banking in rural areas
 Illiteracy and Low education levels
 Domination of Public sector enterprises in Transportation, Railways, Electricity, Defense
Production
 Low Productivity for Public Sector Enterprises
 Corruption and Red Tape for Business Licensing
 The labor participation of women in India is 20%

RECENT CHANGES IN INDIAN ECONOMY

An important feature of India's reform programme, when compared with reforms underway in
many other countries, is that it has emphasized gradualism and evolutionary transition rather than
rapid restructuring or "shock therapy". This gradualism has often been the subject of unfavorable
comment by the more impatient advocates of reform both inside and outside the country. Before
considering the contents and design of the Indian reform programme, it is useful to review some
of the main reasons why India's reforms have followed a gradualist path.

One reason for gradualism is simply that the reforms were not introduced in the background of a
prolonged economic crisis or system collapse of the type which would have created a widespread
desire for, and willingness to accept, radical restructuring. The reforms were introduced in June
1991 in the wake a balance of payments crisis which was certainly severe. However, it was not a
prolonged crisis with a long period of non-performance. On the contrary, the crisis erupted
suddenly at the end of a period of apparently healthy growth in the 1980s, when the Indian
economy grew at about 5.5% per year on average. This may appear modest by East Asian
standards, but it was much better than India's previous experience of 3.5 to 4% growth and was
also better than the average growth rate of all developing countries taken together in the same
period.
The main elements of the reform are summarized in this section, which also indicates differences
in the pace and sequencing of individual elements in the package.
NEW ECONOMIC POLICY (NEP)
 LPG - ie. Liberalization Privatization & Globalization are the three steps in NEP.’
 Globalization of Indian Economy means that the Indian Economy is having
minimum possible restrictions on economic relations with other countries.
 Privatization is the forecast of the Removal of state interference in the economic
programme.
 The New Economic Liberalization Policy was launched in India in July 1991.
 LERMS - Liberalization Exchange Rate Money System.
 Devaluing the Indian Currency is considered to a step towards liberalization.
 Under LERMS 16% of the foreign exchange reserve could be converted into the
market.

Fiscal Stabilization:
The Central Government fiscal deficit had expanded steadily during the eighties and had reached
a peak level of 8.4% of GDP in 1990-91. Allowing for deficits of the State Governments, this
meant an overall Government fiscal deficit of around 10% which is high by any standard. A
reduction in the Central Government's fiscal deficit was therefore critical for the reforms to take
off. Government of India with its continuous efforts arrested the fiscal deficit at 3.5% which is
one of the significant achievements of India.

Industrial Policy and Foreign Investment

Perhaps the most radical changes implemented in the reform package have been in the area of
Industrial Policy removing several barriers to entry in the earlier environment. The system of
pervasive industrial licensing prevalent earlier, which required Government permission for new
investments as well as for substantial expansion of existing capacity, has been virtually
abolished. Licensing is now needed only for a small list of industries, most of which remain
subject to licensing primarily because of environmental and pollution considerations. The
parallel but separate controls over investment and expansion by large industrial houses through
the Monopolies and Restrictive Trade Practices (MRTP) Act have also been eliminated.

The list of industries reserved for the public sector has been drastically pruned and many critical
areas have been opened up to private sector participation. Electric power generation has been
opened up for private investment, including foreign investment, and several State Governments
are actively negotiating with various foreign investors for establishing private sector power
plants. The hydrocarbon sector, covering petroleum exploration, production and refining has also
been opened up to the private sector including foreign investment and has attracted significant
investor interest. Air transport, which until recently was a public sector monopoly, has been
opened up to the private sector and some new entrants have begun operations. The
Telecommunication sector has also been opened up for certain services such as cellular
telephones, though the modalities for inducting private sector participants have yet to be worked
out.

Trade and Exchange Rate Policy

In keeping with the objective of greater openness and outward orientation, trade policy has been
very substantially liberalized for all except final consumer goods. The complex import control
regime earlier applicable to imports of raw materials, other inputs into production and capital
goods has been virtually dismantled. Today, all raw materials, other inputs and capital goods, can
be freely imported except for a relatively small negative list. The removal of quantitative
restrictions on imports has been accompanied by a gradual lowering of customs duties is one of
the major reforms pertaining to international trade. India's customs duties before the reforms
were very high, with the average rate of duty being as high as 100% and very substantial
variations around this average. The Government has made a series of downward adjustments in
customs duties in each of the four Budgets since 1991.

Public Sector Policy

Reform of the public sector is a critical element in structural adjustment programmes all over the
world and is also included on India's reform agenda. However, this is an area where changes are
being implemented slowly. Unlike the case in many other countries, where public sector reform
has involved explicit programmes of outright privatisation of public sector units combined with
closures of unviable units, the approach adopted in the Indian reform programme is more limited.

Tax Reform
Reform of the tax system has been an important element in the Government's reform programme
with major changes contemplated in both direct and indirect taxes. The broad directions of tax
reform have been spelt out in the Report of the Taxation Reforms Committee.

Financial Sector Reform

As far as banking system reform is concerned, the Government has announced a package of
reforms to be implemented over a three year period based on the report of the Committee on the
Financial System. The Government has announced that ‘CRR and SLR’s’ high reserve
requirements will be progressively reduced, and the process has already begun. Parallel with the
reduction in the requirements for compulsory investments by banks in Government securities,
the interest rates on Government securities are increasingly market determined. Interest rate
regulation in the banking system is also being reduced and rationalized.

Special Economic Zone

A policy was introduced on April 1, 2000 for setting up Special Economic Zone (SEZ) in the
country with a view to provide an internationally competitive and hussle free environment for
exports. Units may be set up in SEZ for manufacturing of goods and rendering of services. Some
of the existing Export Processing Zones (EPZ) including one at Kochi were converted to SEZ.
Currently, the country has 15 SEZs. The government has approved as many as 164 or more
SEZs. A comprehensive Special Economic Zone Act, 2005 was passed by the parliament in May
2005. It came into force on February 10, 2006. A host of concessions have been allowed to
attract investments and set up SEZs in various parts of the country. Andra Pradesh, Maharashtra,
Haryana and Gujarat leads in proposed SEZ commitments.

Telecom Revolution
 TRAI – Telecom Regulatory Authority of India formed to regulate Telecom industry
 DOT – Department of Telecommunications diluted
  DOT has been corporatized with effect from 1 October 2000 to form Bharat Sanchar
Nigam Limited (BSNL) and MTNL – Mahanagar Telephones Nigam Limited.
 A National Task Force on Information Technology and Software Development was
formed under the Chairmanship of Jaswant Singh.

National Rural Employment Guarantee Programme (Nregp)

The programme accepts a right based approach to work. The NREGP empowers the poor
households to demand employment of at least 100 days from government. Rs. 11,300 crore has
been provided to NREGP in 2006-07. The scheme is protected by the National Rural
Employment Guarantee Act. Gradually Project expenditure increased to uplift to rural economy
and increase the rural wages. The project has brought the significant change in Rural India.

NATIONAL INCOME:-
The national income is the sum total of the value of all the final goods produced and services of
the residents of the country in an accounting year.

 For comparison purposes the national income is measured at constant prices with a base
year. The base year at present is now 1993 - 94 and current prices are converted to the
prices of the base year (Base year was originally 1960-61 but later periodically revised.)
 CSO: Central Statistical Organisation is under the Department of Statistics. Govt. of India
is responsible for estimating the national income. CSO is assisted by the National Sample
Survey Organisation (NSSO) in estimating National Income. Dadabhai Naoroji was the
first to calculate the national income of India.
 Gross Domestic Product (GDP) is the money value of final goods and services produced
in the domestic territory of a country during the accounting year.
 In India Gross Domestic Product (GDP) is larger than national income because net factor
income from abroad is negative, i.e. foreign payment is larger than the foreign receipt.
 Net National Product (NNP) at market prices = Gross National Product at Market Prices -
Depreciation
 Net National Product at factor cost NNP (fc) = NNP at market prices - Net Indirect taxes.
 Net National Product at factor cost is the actual National income.

Concepts of National Income:

There are a number of concepts pertaining to national income. They are:
1. Gross National Income (GNP)
2. Net National Income (NNP)
3. Gross Domestic Product (GDP)
4. Personal Income
5. Disposable Personal Income
6. per Capita Income

1. Gross National Income:

GNP is the total measure of the flow of goods and services at market value resulting from current
production during a year in a country, including net income from abroad, GNP includes four
types of final goods and services: (1) Consumer’s goods and services to satisfy the immediate
wants of the people. (2) Gross Private Domestic Investment in capital goods consisting of fixed
capital formation, residential construction and inventories of finished and unfinished goods.(3)
goods and services produced by the government and (4) net exports of goods and services that is,
the difference between value of exports and imports of goods and services, known as net income
from abroad.

In this concept of GNP there are certain factors that have to be taken into consideration.
 First, GNP is the measure of money, in which all kinds of goods and services produced in
a country during one year are measured in terms of money at current prices and then
added together.
 Second, in estimating GNP of the economy, the market price of only the final products
should be taken into account.
 Third, goods and services rendered free of charge are not included in GNP, because, it is
not possible to have a correct estimate of their market prices.
 Fourth, the transactions which do not arise from the produce of current year or which do
not contribute in any way to production are not included in GNP
 Fifth, the profits earned or losses incurred on account of changes in capital assets as a
result of fluctuations in market prices are not included in the GNP if they are not
responsible for current production or economic activity.
 Lastly, the income earned through illegal activities is not included in GNP.

GNP is the most frequently used national income concept. It is a better index than any other
concept because it expresses the actual condition of production and employment in a country
during a specific period. It provides a general idea of the performance of the economy.

2. Net National Income (NNP):

GNP includes the value of total output of consumption and investment goods. But the process of
production uses up a certain amount of fixed capital. Some fixed equipment wears out, its other
components are damaged or destroyed and still others are rendered obsolete through
technological changes. All this process is termed as depreciation or capital consumption
allowance. In order to arrive at NNP, we deduct depreciation from GNP. The word ‘net’ refers
to the exclusion of that part of total output which represents depreciation. So , NNP = GNP-
Depreciation.

3, Gross Domestic Product:

Income generated by the factors of production within the county from its own resources is called
domestic income or domestic product. Gross domestic product includes:
1. Wages and salaries
2. Rents, including imputed house rents
3. Interest
4. Dividends
5. Undistributed corporate profits including surpluses of public sector undertakings
6. Mixed incomes consisting of profits of unincorporated firms, self-employed persons,
partnerships etc. and
7. Direct taxes
Since gross domestic product or income does not include income earned from abroad, it can also
be shown as:
Domestic Income = National Income – Net Income from Abroad

Thus the difference between domestic income and national income is the net income earned from
abroad may be positive or negative. If exports exceed imports, net income from abroad is
positive. In this case national income is greater than domestic income. On the other hand, when
inputs exceed exports, net income earned from abroad is negative and domestic income is greater
than national income.

4. Personal Income:
Personal income is the total income received by the individuals of a country from all sources
before direct taxes in one year. The entire national income will not be available for
consumption. National income is different from personal income. In order to arrive at personal
income several deductions are to be made. For example, corporations have to pay income-tax
from the corporate profits before declaring dividends. Likewise a part of the corporate profits
available for distribution is reduced. Similarly salaried persons and wage earners pay a certain
percentage of their income towards social security contribution. To that extent income available
to the employees and workers is reduced. Against this, the government may give social security
benefits such as unemployment allowances, old age pensions etc. These payments are called
transfer payments are called transfer payments. These are to be added to arrive at personal
income. Therefore.

Personal Income = National Income – Corporate income taxes – undistributed corporate profits-
social security contributions + transfer payments.
The concept of personal income is a useful concept. It helps in estimating the potential
purchasing power of the households in an economy. The weakness of this concept is that it does
not clearly tell us the actual amount of money available for disposable personal income.

5. Disposable personal income:

Disposable income or personal disposable income means the actual income which can be spent
on consumption by individuals and families. The whole of the personal income cannot be spent
on consumption, because it is the income that accrues before direct taxes have actually been
paid. Therefore, in order to obtain the disposable income, direct taxes are deducted from
personal income. Thus:
Disposable income = personal income – direct taxes
But the whole of the disposable income is not spent on consumption and a spent on consumption
and a part of it is saved. Thus,
Disposable income = consumption expenditure + savings expenditure.

6. Per capita income:

The average income of the people of a country in a particular year is called per capita income for
that year. This concept also refers to the measurement of income at current prices and at
constant prices. For instance, in order to find out the per capita income at current prices, the
national income of a country is divided by the population of the country in that year.
Per capita Income = National income÷ population
This concept enables us to know the average income and the standard of living of the people.
But it is not very reliable, because in every country due to unequal distribution of national
income a mojor portion of it goes to the richer sections of the society and thus income received
by the common man is lower than the per capita income.

Methods of measuring National income:

In preparing the national income estimate it is necessary to add the values of all final goods and
services produced and exchanged during a year. Thus whatever is produced is either used for
consumption or saving. There are three methods of estimating national income. They are:
1. The census of products method
2. The census of income method
3. The expenditure method

1. The census of products method:

This is also called inventory or output method. Under this method, the value of aggregate
production of final goods and services in an economy in a year is considered. The economy is
divided into different sectors such as agriculture, mining, manufacturing, small enterprises,
commerce, transport, communication and services etc. Then the gross product is found out by
adding the net values of all production that has taken place in these sectors during a year. The
aggregate of all these is called the gross national product at market price. While calculating the
gross national product under this method, care must be taken to avoid double counting.

2. The census of income method:

This method approaches the national income from the distribution side. The incomes accruing to
all the factors of production during the process of production are aggregated together. This is
called national income at factor cost. National income is calculated by adding the following:
1. Wages and salaries
2. Social security
3. Earning of self-employed or professional income
4. Dividends
5. Undistributed profits
6. Interest
7. Rent
8. Profits of public sector enterprises and
9. Subsidies and transfer payments have to be deducted. All unpaid services are to be excluded.
Financial investments in the form of equity shares, sales of old property etc. are to be excluded.
Direct tax revenue to the government should be subtracted from the total income. Government
subsidies should be deducted. In India the national income committee is using this method in
calculating national income.

The expenditure method:

Expenditure method arrives at national income by adding up, all expenditure made on goods and
services during a year. Income can be spent on consumer goods or capital goods. Again,
expenditure can be made by private individuals and households or by government and business
enterprises. Further, people of foreign countries spend on the goods and services which a
country exports to them. Similarly people of a country spend on imports of goods and services
from other countries. We add up the following types of expenditure by households, government
and by productive enterprises to obtain national income.

1. Expenditure on consumer goods and services by individuals and households. This is called
final private consumption expenditure and is denoted by ’C’.

2. Government expenditure on goods and services to satisfy collective wants. This is called
government’s final consumption expenditure and is denoted ‘G’.

3. The expenditure by productive enterprises on capital goods and inventories or stocks. This is
called gross domestic capital formation, which, is denoted by ‘I'. Gross domestic capital
formation is divided into two parts.
a. Gross fixed capital formation.
b. Addition to the stocks or inventories of goods.

4. The expenditure made by foreigners on goods and services of a country exported to other
countries, which are called exports and are denoted by ‘x’. We deduct from exports ‘x’ the
expenditure by people, enterprises and government of a country on imports (M) of goods and
services from other countries. That is, we have to estimate net exports (that is exports- imports)
or (x-m)
Thus we add up the above four types C+G+I+(x-m) to get final expenditure on gross domestic
product. On deducting consumption of fixed capital, we get net domestic product.
Difficulties in the measurement of national income:
There are a number of difficulties in the measurement of national income of a country. The
following are the important difficulties of national income analysis:

1. National income is always measured in terms of money, but, there are certain goods and
services whose money measurement is not possible. For example: the services performed by
housewife for her family, voluntary services performed with a charitable object, etc. such items
are excluded from the national income figures. This leads to an underestimate of the national
income.
2. Income obtained from illegal activities is not included in the national income and their
exclusion results in an under-valuation of the national income.
3. It is difficult, to obtain accurate statistics. This is the reason, why there is big differences
between the national income statistics collected by the different institutions.
4. The collection of depreciation on capital consumption, presents another formidable difficulty.
There are no accepted standard rates of depreciation applicable the various categories of capital
goods. Thus, the national income estimate will not be correct.
5. The difficulty of avoiding double counting in the national income. To avoid this difficulty,
final goods and services are to be included in the national income, but it is not an easy task.
6. The difficulty of price changes arises in the national income estimate. When the general price
index increases, the national income will also increase, even if the national output is reduced.
Similarly, if general price index decreases, the national income will also decrease, although,
there may be an increase in national output. Therefore, due to price changes, we may not find an
accurate estimate of national income.
7. The prevalence of non-monetized transactions in underdeveloped countries creates an
important problem in the measurement of national income. A considerable part of the output
does not come into the market at all. In agriculture, a major part of output is consumed by the
farmer themselves which reduces the national income figure to a great extent.
8. Due to illiteracy, most of the producers in less developed countries have no idea of the
quantity and value of their output and do not keep regular accounts, which, creates difficulties in
national income measurement.

Importance of national income analysis

Today, national income statistics are collected by all the countries of the world for a number of
years. Raising national income is the important goal of all economic activity. Economic welfare
of a country depends upon what goods and services are available for the consumption of its
individuals. The changes in national income statistics show how the economy is developing and
enables the government to lay down the appropriate economic policy necessary under the
circumstances. With the help of national income statistics it is possible to chart cyclical
movements, find out the inflationary gap, measure economic growth and development, and
evaluate the country’s material standard of living in comparison with other countries. The
following are the main uses of national income.

1. Since income is a flow of wealth changes in the national income give some indication of
economic welfare.
2. National income is used to compare standards of living in different countries.
3. National income figures are used to measure the rate of growth of a country.
4. The national income accounts make it possible for an analysis of the behaviour of the different
sectors of the economy.
5. Inflationary and deflationary pressures can be estimated with the help of national income
statistics.
6 National income statistics can be used to forecast the level of business activity at later date, and
to find out trends in other annual data.
7. The national income figures are useful in providing a correct sense of proportion about the
structure of the economy.
8. In war time, the study of components of national income is of great importance because they
show the maximum possible production possibilities of the country.
9. National income statistics can be used to determine how an international financial burden
should be an apportioned between different countries. The quantum of national income
measures the ability of a country to pay contributions for international purposes, just as the
income of a person measures his ability to pay for the upkeep of his country.
10. Above all the national income statistics are used for planned economic development of a
country. In the absence of such data, planning will not be possible.

In the words of Prof. Samuelson,” By means of statistics of national income, we can chart the
movements of a country from depression to prosperity, its steady long-term rate of growth and
development, and finally, its material standard of living in comparison with other nations.”
THE BUSINESS CYCLE
1. Definition and phases
The Business cycle is defined as periodical fluctuations of aggregate demand around the level of
the potential GDP.
The aggregate demand is measured by the level of real GDP and presents the economic activity
in the country.
The Business cycles trace out a wavelike pattern with a length between 3.5 and 8 years.
The business cycle is identified as a sequence of four phases:
• Contraction (a slowdown in the pace of economic activity)
• Trough (The lower turning point of a business cycle, where a contraction turns into an
expansion)
• Expansion (A speedup in the pace of economic activity. It has two parts - recovery and
boom. The boom starts when the level of real GDP rises above the level of its previous peak)
• Peak (The upper turning of a business cycle)

A recession occurs if the level of the real GDP declines during the contraction. The standard
definition of a recession is a decline in the Gross Domestic Product for two or more consecutive
quarters. A deep trough is called a slump or a depression. The difference between a recession and
a depression is marked by the change in the level of real GDP. While during the recession it falls,
during the depression the decline in aggregate demand stops and stays at a low level for more
than two consecutive quarters.

The standard phases are presented on Figure 1.

Fig. 1. The phases of the business cycle.

ECONOMIC INDICATORS OF THE BUSINESS CYCLE
The phases of the business cycle describe the behaviour of a variety of economic indicators
which reflect basic business conditions. To achieve precision these data are taken weekly or
monthly; together they trace out a reference cycle which maps the congruence of peaks and
troughs in an attempt to indicate average business cycle behaviour.

The business cycle indicators are classified into three groups:

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

b) Coincident: A coincident economic indicator is one that simply moves at the same time
the economy does. The Gross Domestic Product is a coincident indicator.
c) Lagged: A lagged economic indicator is one that does not change direction until a few
quarters after the economy does. The unemployment rate is a lagged economic indicator as
unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.

Main Leading Indicators

• Hours of production workers in manufacturing
• New claims for unemployment insurance
• New orders for plant and equipment
• Building permits for private houses
• Car sales
• Change in inventories
• Change in commodity prices
• Money growth rate

Main Coincident Indicators

• Real GDP
• Consumption
• Exports
• GDP deflator
• Nonagricultural employment
• Index of industrial production
• Personal income
• Personal savings rate
• Manufacturing and trade sales

Main Lagging Indicators

• Unemployment rate
• Commercial and industrial loans
• Ratio of consumer debt to personal income

3. The business cycle in the real sector and in the financial markets

During the recovery and the boom, aggregate demand is greater than aggregate supply. Firms are
happy to sell more and make greater profits. They increase production and order more raw
materials from their suppliers. Everybody has optimistic expectations about the future,
unemployment falls, income rises and aggregate demand rises even further.

The higher profitability in the real sector raises prices of the firms and their shares become more
expensive. The increase in production and income raises the demand for durables (machines,
equipment, housing, etc.) and the demand for credit rises too. The optimistic expectations push
upwards the prices of securities in the financial markets. This is a bull market. Everyone expects
the demand to increase further and securities increase in price. Everyone is trying to make money
on speculation – buy now in order to sell later at a higher price. Everyone wants to invest more in
such deals in order to get greater profits. Often, the money invested is borrowed from the banks.
Thus, the prices of the financial assets go much beyond the value of the real goods, presented by
the securities.
The increase in aggregate demand drives up the aggregate supply. However, supply cannot grow
forever. Resources are scarce. Firms have limited production capacity and when they operate
above their full capacity, the cost of production starts rising. Because of the high demand for
labor and high employment rate workers would work more if only their wages and salaries are
raised. Any further increase in production involves greater costs and prices start rising faster than
production and income. Aggregate demand falls below aggregate supply. Firms cannot sell as
much as they have expected and their inventories increase. They reduce their orders of new
supplies and all firms start producing less. Unemployment rises, income falls and demand
decreases even more. This is the recession.

The first signals for the recession come usually from the financial markets. The increase in the
cost of production and oversupply creates pessimistic expectations about the future and prices of
securities fall sharply. This is a bear market. Investors lose money and they are not able to pay
for the losses. Everyone needs money from the banks. The banks have difficulties to collect the
credits and to serve their clients. This could lead to bankruptcy. Since banks offer and borrow
money from each other, the bankruptcy of one bank creates risks for the entire financial system.
The confidence in the financial markets is lost. Everyone is reluctant to put money in the
financial system. Everyone prefers liquidity (real money), not securities.

Shortly, this is the picture in the financial markets today. It started with the inability of many
American households to pay for their mortgage loans. It is not a big deal for the society if some
people cannot pay back their loans. They lose their houses, cars, etc. However, when it comes to
many households and firms, which cannot pay, the financial institutions that have landed the
money cannot survive either. Here comes the crisis.

The current situation in the financial markets is so critical, because during the boom period
money was too cheap. It was very easy and cheap to borrow and optimistic expectations pumped
the financial balloon too much. If the central banks had raised the price of the money a few years
ago, the speculative demand for securities and real estate would have not gone that away from
the real value of the assets and the losses would be much lower. Anyway, the contraction could
not have been prevented, but the slowdown in the level of economic activity might have been
quite smaller.

The recession is the most important phase of the business cycle. It sweeps away the inefficient
businesses and motivates technological progress.

INFLATION: TYPES, CAUSES AND EFFECTS

Meaning of Inflation:
Inflation means a considerable and persistent rise in the general level of prices of goods and
services in an economy over a period of time.

Inflation has been defined in several ways by different economists.

According to Keynes, ‘Inflation is the form of taxation which the public finds hardest to
evade.’
According to Samuelson, ‘Inflation denotes a rise in general level of prices’.
According to Milton Friedman, ‘Inflation is always and everywhere a monetary
phenomenon.’

Inflation can be described as a decline in the real value of money—a loss of purchasing power
in the medium of exchange. When the general price level rises, each unit of currency buys
fewer goods and services. In simple terms, inflation is a situation where too much money
chases too few goods.

It is not high prices but rising price level that constitute inflation. It constitutes, thus, an over-all
increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other
words, inflation reduces the purchasing power of money. A unit of money now buys less.
Inflation can also be seen as a recurring phenomenon.

While measuring inflation, we take into account of a large number of goods and services used by
the people of a country and then calculate average increase in the prices of those goods and
services over a period of time. A small rise in prices or a sudden rise in prices is not inflation
since they may reflect the short term workings of the market.

Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was 193.6
and, in December 2008, it was 223.8. Thus, the inflation rate during the last one year was
223.8- 193.6/ 193.6 x 100 = 15.6

Types of Inflation
Creeping inflation: - the rate of inflation doesn’t exceed the rate of production growth; Creeping
inflation is < 10%

Galloping inflation: - the rate of inflation exceeds the rate of production growth; Galloping
inflation is from 10% to 100%. Money loose purchase power, people hold as little money as
possible.

Hyperinflation:- is inflation that is "out of control", a condition in which prices increase rapidly
as a currency loses its value. Hyperinflation is over 100% per year. Prices as well as wages are
extremely erratic. Money has no value and barter trade emerges (barter means the exchange of
good for good). Example: Germany after I.WW, Hungary after II.WW.

Open inflation  if economic imbalance is accompanied with rising price level.

Suppressed inflation  if state authorities damp or even stop the rise of price level by
administrative means. Such situation is followed by existence of scarce commodities, shadow
economy etc.  In such cases the provision of basic necessities such as agricultural products is
set by the government by introducing price controls on commodities

Hidden inflation  government imposes strict controls to curb price inflation; producers are
forced to sell the products at the prices required.  Producers cannot sell the commodity at
higher prices to get the profit, therefore, lower on the quality of products. This means that
employers are selling lower quality products at higher prices -> inflation is hidden.
Demand-pull inflation
 Arises when aggregate demand in an economy outpaces aggregate supply
 It involves inflation rising as real gross domestic product rises and unemployment falls. This is
commonly described as "too much money chasing too few goods".
 Possible causes of demand-pull inflation:
 Excessive investment expenditures
 Excessive growth of consumption expenditures
 Low-cost loans
 Tax cutting
 Augmentation of government expenditures

Cost-push inflation (or supply-shock inflation)

 Is a type of inflation caused by large increases in the cost of important goods or services where
no suitable alternative is available?
 Possible causes of cost-push inflation:
 Imperfect competition
 Increased taxes
 Rising wages
 Political incidents (like oil crises)

Imported Inflation
A depreciation in the exchange rate will make imports more expensive. Therefore, the prices will
increase solely due to this exchange rate effect. A depreciation will also make exports more
competitive so will increase demand.

Built-in inflation (or Anticipated inflation)

 Induced by adaptive expectations, often linked to the "price/wage spiral“
 it involves workers trying to keep their wages up with prices and then employers passing
higher costs on to consumers as higher prices as part of a "vicious circle.“
 Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Stagflation: It is an economic situation in which inflation and economic stagnation or

recession occur simultaneously and remain unchecked for a period of time. Stagflation was
witnessed by developed countries in 1970s, when world oil prices rose dramatically.

Deflation: Deflation is the reverse of inflation. It refers to a sustained decline in the price
level of goods and services. It occurs when the annual inflation rate falls below zero percent
(a negative inflation rate), resulting in an increase in the real value of money. Japan suffered
from deflation for almost a decade in 1990s.

Core Inflation:- One measure of inflation is known as ‘core inflation‘ This is the inflation
rate that excludes temporary ‘volatile’ factors, such as energy and food prices.
MAIN CAUSES OF INCREASED AGGREGATE DEMAND:
Increase in Money Supply:
Inflation is caused by an increase in the supply of money which leads to increase in aggregate
demand. The higher the growth rate of the nominal money supply, the higher is the rate of
inflation. Modem quantity theorists do not believe that true inflation starts after the full
employment level. This view is realistic because all advanced countries are faced with high
levels of unemployment and high rates of inflation.

2. Increase in Disposable Income:

When the disposable income of the people increases, it raises their demand for goods and
services. Disposable income may increase with the rise in national income or reduction in taxes
or reduction in the saving of the people.

3. Increase in Public Expenditure:

Government activities have been expanding much with the result that government expenditure
has also been increasing at a phenomenal rate, thereby raising aggregate demand for goods and
services. Governments of both developed and developing countries are providing more facilities
under public utilities and social services, and also nationalising industries and starting public
enterprises with the result that they help in increasing aggregate demand.

4. Increase in Consumer Spending:

The demand for goods and services increases when consumer expenditure increases. Consumers
may spend more due to conspicuous consumption or demonstration effect. They may also spend
more whey they are given credit facilities to buy goods on hire-purchase and instalment basis.

5. Cheap Monetary Policy:

Cheap monetary policy or the policy of credit expansion also leads to increase in the money
supply which raises the demand for goods and services in the economy. When credit expands, it
raises the money income of the borrowers which, in turn, raises aggregate demand relative to
supply, thereby leading to inflation. This is also known as credit-induced inflation.

6. Deficit Financing:
In order to meet its mounting expenses, the government resorts to deficit financing by borrowing
from the public and even by printing more notes. This raises aggregate demand in relation to
aggregate supply, thereby leading to inflationary rise in prices. This is also known as deficit-
induced inflation.

7. Expansion of the Private Sector:

The expansion of the private sector also tends to raise the aggregate demand. For huge
investments increase employment and income, thereby creating more demand for goods and
services. But it takes time for the output to enter the market.
8. Black Money:
The existence of black money in all countries due to corruption, tax evasion etc. increases the
aggregate demand. People spend such unearned money extravagantly, thereby creat-ing
unnecessary demand for commodities. This tends to raise the price level further.

9. Repayment of Public Debt:

Whenever the government repays its past internal debt to the public, it leads to increase in the
money supply with the public. This tends to raise the aggregate demand for goods and services.

10. Increase in Exports:

When the demand for domestically produced goods increases in for-eign countries, this raises the
earnings of industries producing export commodities. These, in turn, create more demand for
goods and services within the economy.

Factors Affecting Supply:

There are also certain factors which operate on the opposite side and tend to reduce the
aggre-gate supply. Some of the factors are as follows:

1. Shortage of Factors of Production:

One of the important causes affecting the supplies of goods is the shortage of such factors as
labour, raw materials, power supply, capital, etc. They lead to excess capacity and reduction in
industrial production.

2. Industrial Disputes:
In countries where trade unions are powerful, they also help in curtail-ing production. Trade
unions resort to strikes and if they happen to be unreasonable from the employ­ers’ viewpoint’
and are prolonged, they force the employers to declare lock-outs. In both cases, industrial
production falls, thereby reducing supplies of goods. If the unions succeed in raising money
wages of their members to a very high level than the productivity of labour, this also tends to
reduce production and supplies of goods.

3. Natural Calamities:
Drought or floods is a factor which adversely affects the supplies of agricultural products. The
latter, in turn, create shortages of food products and raw materials, thereby helping inflationary
pressures.

4. Artificial Scarcities:
Artificial scarcities are created by hoarders and speculators who indulge in black marketing.
Thus they are instrumental in reducing supplies of goods and raising their prices.

5. Increase in Exports:
When the country produces more goods for export than for domestic consumption, this creates
shortages of goods in the domestic market. This leads to inflation in the economy.
6. Lop-sided Production:
If the stress is on the production of comforts, luxuries, or basic products to the neglect of
essential consumer goods in the country, this creates shortages of consumer goods. This again
causes inflation.

7. Law of Diminishing Returns:

If industries in the country are using old machines and out-moded methods of production, the
law of diminishing returns operates. This raises cost per unit of production, thereby raising the
prices of products.

8. International Factors:
In modern times, inflation is a worldwide phenomenon. When prices rise in major industrial
countries, their effects spread to almost all countries with which they have trade relations. Often
the rise in the price of a basic raw material like petrol in the international market leads to rise in
the price of all related commodities in a country.

MEASURES TO CONTROL THE INFLATION

There are broadly two ways of controlling inflation in an economy:

I).Monetary Measures
The most important and commonly used method to control inflation is monetary policy of the
Central Bank. Most central banks use high interest rates as the traditional way to fight or
prevent inflation.

(a) Credit Control:

One of the important monetary measures is monetary policy. The central bank of the country
adopts a number of methods to control the quantity and quality of credit. For this purpose, it
raises the bank rates, sells securities in the open market, raises the reserved ratio, and adopts a
number of selective credit control measures, such as raising margin requirements and regulating
consumer credit. Monetary policy may not be effective in controlling inflation, if inflation is due
to cost-push factors. Monetary policy can only be helpful in controlling inflation due to demand-
pull factors.
Bank rate policy is used as the main instrument of monetary control during the period
of inflation. When the central bank raises the bank rate, it is said to have adopted a
dear money policy. The increase in bank rate increases the cost of borrowing which
reduces commercial banks borrowing from the central bank. Consequently, the flow of
money from the commercial banks to the public gets reduced. Therefore, inflation is
controlled to the extent it is caused by the bank credit.

Cash Reserve Ratio (CRR) : To control inflation, the central bank raises the CRR
which reduces the lending capacity of the commercial banks. Consequently, flow of
money from commercial banks to public decreases. In the process, it halts the rise in
prices to the extent it is caused by banks credits to the public.
 Open Market Operations: Open market operations refer to sale and purchase of
government securities and bonds by the central bank. To control inflation, central bank
sells the government securities to the public through the banks. This results in transfer
of a part of bank deposits to central bank account and reduces credit creation capacity
of the commercial banks.

(b) Demonetisation of Currency:

However, one of the monetary measures is to demonetise currency of higher denominations.
Such a measure is usually adopted when there is abundance of black money in the country.

(c) Issue of New Currency:

The most extreme monetary measure is the issue of new currency in place of the old currency.
Under this system, one new note is exchanged for a number of notes of the old currency. The
value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an
excessive issue of notes and there is hyperinflation in the country. It is a very effective measure.
But is inequitable for it hurts the small depositors the most.

2. Fiscal Measures:
Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented
by fiscal measures. Fiscal measures are highly effective for controlling government expenditure,
personal consumption expenditure, and private and public investment.

The principal fiscal measures are the following:

(a) Reduction in Unnecessary Expenditure:
The government should reduce unnecessary expenditure on non-development activities in order
to curb inflation. This will also put a check on private expenditure which is dependent upon
government demand for goods and services. But it is not easy to cut government expenditure.
Though economy measures are always welcome but it becomes difficult to distinguish between
essential and non-essential expenditure. Therefore, this measure should be supplemented by
taxation.

(b) Increase in Taxes:

To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes
should be raised and even new taxes should be levied, but the rates of taxes should not be so high
as to discourage saving, investment and production. Rather, the tax system should provide larger
incentives to those who save, invest and produce more.

Further, to bring more revenue into the tax-net, the government should penalise the tax evaders
by imposing heavy fines. Such measures are bound to be effective in controlling inflation. To
increase the supply of goods within the country, the government should reduce import duties and
increase export duties.

(c) Increase in Savings:

Another measure is to increase savings on the part of the people. This will tend to reduce
disposable income with the people, and hence personal consumption expenditure. But due to the
rising cost of living, people are not in a position to save much voluntarily. Keynes, therefore,
advocated compulsory savings or what he called ‘deferred payment’ where the saver gets his
money back after some years.

For this purpose, the government should float public loans carrying high rates of interest, start
saving schemes with prize money, or lottery for long periods, etc. It should also introduce
compulsory provident fund, provident fund-cum-pension schemes, etc. compulsorily. All such
measures to increase savings are likely to be effective in controlling inflation.

(d) Surplus Budgets:

An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the
government should give up deficit financing and instead have surplus budgets. It means
collecting more in revenues and spending less.

(e) Public Debt:

At the same time, it should stop repayment of public debt and postpone it to some future date till
inflationary pressures are controlled within the economy. Instead, the government should borrow
more to reduce money supply with the public.
Like the monetary measures, fiscal measures alone cannot help in controlling inflation. They
should be supplemented by monetary, non-monetary and non-fiscal measures.

3. Other Measures:
The other types of measures are those which aim at increasing aggregate supply and
reducing aggregate demand directly:
(a) To Increase Production:
The following measures should be adopted to increase production:
(i) One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on preferential basis to
increase the production of essential commodities.
(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace
should be maintained through agreements with trade unions, binding them not to resort to strikes
for some time.
(iv) The policy of rationalisation of industries should be adopted as a long-term measure.
Rationalisation increases productivity and production of industries through the use of brain,
brawn and bullion.
(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc.
should be provided to different consumer goods sectors to increase production.

(b) Rational Wage Policy:

Another important measure is to adopt a rational wage and income policy. Under hyperinflation,
there is a wage-price spiral. To control this, the government should freeze wages, incomes,
profits, dividends, bonus, etc. But such a drastic measure can only be adopted for a short period
and by antagonising both workers and industrialists. Therefore, the best course is to link increase
in wages to increase in productivity. This will have a dual effect. It will control wages and at the
same time increase productivity, and hence increase production of goods in the economy.
(c) Price Control:
Price control and rationing is another measure of direct control to check inflation. Price control
means fixing an upper limit for the prices of essential consumer goods. They are the maximum
prices fixed by law and anybody charging more than these prices is punished by law. But it is
difficult to administer price control.

(d) Rationing:
Rationing aims at distributing consumption of scarce goods so as to make them available to a
large number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar,
kerosene oil, etc. It is meant to stabilise the prices of necessaries and assure distributive justice.
But it is very inconvenient for consumers because it leads to queues, artificial shortages,
corruption and black marketing. Keynes did not favour rationing for it “involves a great deal of
waste, both of resources and of employment.”

KINDS OF PRICE INDICES

Wholesale Price Index:-
The Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. The
wholesale price index is an index that measures and tracks the changes in the price of goods in
the stages before the retail level. WPI shows the average price change of goods included in the
index and is often expressed as a ratio or percentage, and the change is one indicator of a
country's level of inflation. WPI compares the total costs of the goods being considered in one
year with the total costs of goods in the base year.

Wholesale Price Index (WPI) measures the average change in the prices of commodities for bulk
sale at the level of early stage of transactions. The index basket of the WPI covers commodities
falling under the three major groups namely Primary Articles, Fuel and Power and Manufactured
products. (The index basket of the present 2011-12 series has a total of 697 items including 117
items for Primary Articles, 16 items for Fuel & Power and 564 items for Manufactured
Products.) The prices tracked are ex- factory price for manufactured products, mandi price for
agricultural commodities and ex-mines prices for minerals. Weights given to each commodity
covered in the WPI basket is based on the value of production adjusted for net imports. WPI
basket does not cover services. To illustrate, imagine 2012 is the base year. The total prices for
that year are equal to 100 on the scale. Prices from another year are compared to that total and
expressed as a percentage of change.

In India WPI is also known as the headline inflation rate. In India, Office of Economic Advisor
(OEA), Department of Industrial Policy and Promotion, Ministry of Commerce and Industry
calculates the WPI. WPI figures are available every week, inflation for a particular week. Hence
we get weekly inflation rates in India.

The main uses of WPI are the following:

• to provide estimates of inflation at the wholesale transaction level for the economy as a
whole. This helps in timely intervention by the Government to check inflation in particular, in
essential commodities, before the price increase spill over to retail prices.
• WPI is used as deflator for many sectors of the economy including for estimating GDP
by Central Statistical Organisation (CSO).
• WPI is also used for indexation by users in business contracts.
• Global investors also track WPI as one of the key macro indicators for their investment
decisions.

The new series with base 2011-12=100, was based on the recommendations of the Working
Group which was constituted on 19th March 2012 under the chairmanship of Late Dr. Saumitra
Chaudhuri, Member, erstwhile Planning Commission.

The Consumer Price Index (CPI)

The Consumer Price Index (CPI) is a measure of change in retail prices of goods and services
consumed by defined population group in a given area with reference to a base year. This basket
of goods and services represents the level of living or the utility derived by the consumers at
given levels of their income, prices and tastes. The consumer price index number measures
changes only in one of the factors; prices. This index is an important economic indicator and is
widely considered as a barometer of inflation, a tool for monitoring price stability and as a
deflator in national accounts. Consumer price index is used as a measure of inflation in around
157 countries. The dearness allowance of Government employees and wage contracts between
labour and employer is based on this index. The formula for calculating Consumer Price Index is
Laspeyre’s index which is measured as follows;

 Measures the price of a selection of goods purchased by a "typical consumer".

 It is a statistical time-series measure of a weighted average of prices of a specified set
of goods and services purchased by consumers.
 It is a price index that tracks the prices of a specified basket of consumer goods and
services, providing a measure of inflation.

(1) Selection of the Base Year (CPI = 100)

(2) Selection of CPI basket, Example of Consumer Basket, weightage (to measure the
importance of one item in the basket)
(3) Collection of data on prices
(4) Calculation of CPI

[Total cost of a fixed basket of goods and services in the current period * 100] divided by Total
cost of the same basket in the base period

The origin of Consumer Price Index can be traced to the period after first world war when there
was a sharp rise in prices and cost of living. The erosion in the real wages of the workers led to a
demand by the workers for compensation. This led to the conduct of socio-economic surveys
among the working classes as a preliminary to the measurement of cost of living. Consumer
price index numbers were known as “ Cost of Living Index Numbers” prior to July 1955. The
Sixth International Conference of Labour Statisticians recommended the change in nomenclature
from Cost of Living Index to Consumer Price index. The Cost of living index is a more broader
term which includes not only changes in prices but several other factors like change in
consumption habits and standard of living.
Presently the consumer price indices compiled in India are CPI for Industrial workers CPI(IW),
CPI for Agricultural Labourers CPI(AL) and; Rural Labourers CPI(RL) and (Urban) and
CPI(Rural). Consumer Price Index for Urban Non Manual Employees was earlier computed by
Central Statistical Organisation. However this index has been discontinued since April 2008.The
CPI(IW) and CPI(AL& RL) compiled are occupation specific and centre specific and are
compiled by Labour Bureau. This means that these index numbers measure changes in the retail
price of the basket of goods and services consumed by the specific occupational groups in the
specific centres. CPI(Urban) and CPI(Rural) are new indices in the group of Consumer price
index and has a wider coverage of population. This index compiled by Central Statistical
Organisation tries to encompass the entire population and is likely to replace all the other indices
presently compiled. In addition to this, Consumer Food Price Indices (CFPI) for all India for
rural, urban and combined separately are also released w.e.f May, 2014.

Price data are collected from selected towns by the Field Operations Division of NSSO and from
selected villages by the Department of Posts. Price data are received through web portals being
maintained by the National Informatics Centre (NIC).

The Reserve Bank of India (RBI) has started using CPI-combined as the sole inflation measure
for the purpose of monetary policy. As per the agreement on Monetary Policy Framework
between the Government and the RBI dated February 20, 2015 the sole of objective of RBI is
price stability and a target is set for inflation as measured by the Consumer Price Index-
Combined.

GDP deflator
In economics, the GDP deflator (implicit price deflator) is a measure of the level of prices of all
new, domestically produced, final goods and services in an economy. GDP stands for gross
domestic product, the total value of all final goods and services produced within that economy
during a specified period.

Like the consumer price index (CPI), the GDP deflator is a measure of price inflation/deflation
with respect to a specific base year; the GDP deflator of the base year itself is equal to 100.
Unlike the CPI, the GDP deflator is not based on a fixed basket of goods and services; the
"basket" for the GDP deflator is allowed to change from year to year with people's consumption
and investment patterns.

Measurement in national accounts

In most systems of national accounts the GDP deflator measures the ratio of nominal (or current-
price) GDP to the real (or chain volume) measure of GDP. The formula used to calculate the
deflator is:

GDP Deflator = (Nominal GDP / Real GDP ) * 100

The nominal GDP of a given year is computed using that year's prices, while the real GDP of
that year is computed using the base year's prices.
The formula implies that dividing the nominal GDP by the GDP deflator and multiplying it by
100 will give the real GDP, hence "deflating" the nominal GDP into a real measure.

It is often useful to consider implicit price deflators for certain subcategories of GDP, such as
computer hardware. In this case, it is useful to think of the price deflator as the ratio of the
current-year price of a good to its price in some base year. The price in the base year is
normalized to 100. For example, for computer hardware, we could define a "unit" to be a
computer with a specific level of processing power, memory, hard drive space and so on. A price
deflator of 200 means that the current-year price of this computing power is twice its base-year
price - price inflation. A price deflator of 50 means that the current-year price is half the base
year price - price deflation. This can lead to a situation where official statistics reflect a drop in
prices, even though they have stayed the same.

Unlike some price indices (like the CPI), the GDP deflator is not based on a fixed basket of
goods and services. The basket is allowed to change with people's consumption and investment
patterns.[2] Specifically, for the GDP deflator, the "basket" in each year is the set of all goods
that were produced domestically, weighted by the market value of the total consumption of each
good. Therefore, new expenditure patterns are allowed to show up in the deflator as people
respond to changing prices. The theory behind this approach is that the GDP deflator reflects up
to date expenditure patterns. For instance, if the price of chicken increases relative to the price of
beef, it is claimed that people will likely spend more money on beef as a substitute for chicken.

In practice, the difference between the deflator and a price index like the Consumer price index
(CPI) is often relatively small. On the other hand, with governments in developed countries
increasingly utilizing price indexes for everything from fiscal and monetary planning to
payments to social program recipients, even small differences between inflation measures can
shift budget revenues and expenses by millions or billions of dollars.

PRIMARY, SECONDARY AND TERTIARY SECTORS AND THEIR CONTRIBUTION

TO THE ECONOMY

The three sectors constituting an economy are the Agricultural or Primary sector, the Industry or
Secondary sector and the Services or Tertiary sector. The primary sector is directly concerned
with natural resources of the country. Agricultural, forestry, fishing and mining constitute the
primary sector. The primary sector utilizes the natural resources and produces raw materials and
basic goods which may be used by the industries or by the end-users. Hence, it can be said that
the primary sector serves as a basic sector assisting the growth of the secondary and tertiary
sectors. The Secondary sector consists of the industrial sector, engaged in construction activities
and manufacturing of finished goods and tangible products. The secondary sector performs the
vital role of catering to the needs of potential consumers of the nation. The Tertiary sector is
intangible in nature, concentrating on the services sector. This sector consists of provision of
services such as education, medical, hotel and finance needed by the consumers.

Services sector is the largest sector of India. Gross Value Added (GVA) at current prices for
Services sector is estimated at 73.79 lakh crore INR in 2016-17. Services sector accounts for
53.66% of total India's GVA of 137.51 lakh crore Indian rupees. With GVA of Rs. 39.90 lakh
crore, Industry sector contributes 29.02%. While, Agriculture and allied sector shares 17.32%
and GVA is around of 23.82 lakh crore INR.

At 2011-12 prices, composition of Agriculture & allied, Industry, and Services sector are
15.11%, 31.12%, and 53.77%, respectively.

According to CIA Fackbook sector wise Indian GDP composition in 2014 are as follows :
Agriculture (17.9%), Industry (24.2%) and Services (57.9%). Total production of agriculture
sector is $366.92 billion. India is 2nd larger producer of agriculture product. India accounts for
7.68 percent of total global agricultural output. GDP of Industry sector is $495.62 billion and
world rank is 12. In Services sector, India world rank is 11 and GDP is $1185.79 billion.
Contribution of Agriculture sector in Indian economy is much higher than world's average
(6.1%). Contribution of Industry and Services sector is lower than world's average 30.5% for
Industry sector and 63.5% for Services sector.

At previous methedology, composition of Agriculture & allied, Industry, and Services sector was
51.81%, 14.16%, and 33.25%, respectively at current prices in 1950-51. Share of Agriculture &
allied sector has declined at 18.20% in 2013-14. Share of Services sector has improved to
57.03%. Share of Industry sector has also increased to 24.77%

Role of Agriculture in Indian Economy

 Today, India ranks second worldwide in farm output.
 As per estimates by the Central Statistics Office (CSO), the share of agriculture
and allied sectors (including agriculture, livestock, forestry and fishery) was 15.35 per
cent of the Gross Value Added (GVA) during 2015–16 at 2011–12 prices.
 India is the largest producer, consumer, and exporter of spices and spice products.
 India's fruit production has grown faster than vegetables making it the second
largest fruit producer in the world.
 India's horticulture output, comprising fruits, vegetables, and spices, has reached a
record high of 283.5 million tonnes (MT) in 2014-15.
 It ranks third in farm and agriculture outputs.
 Agricultural export constitutes 10 per cent of the country’s exports and is the
fourth-largest exported principal commodity.
 The agro-industry in India is divided into several sub-segments such as canned,
dairy, processed, frozen food to fisheries, meat, poultry, and food grains.
 The Department of Agriculture and Cooperation under the Ministry of Agriculture
is responsible for the development of the agriculture sector in India. It manages several
other bodies, such as the National Dairy Development Board (NDDB), to develop other
allied agricultural sectors.
 As per the 3rd Advance Estimates, India's food grain production has increased
marginally to 252.23 million tonnes (MT) in the 2015-16 crop year. Production of pulses
is estimated at 17.06 million tonnes.
 With an annual output of 146.31 MT, India is the largest producer of milk,
accounting for 18.5 percent of the total world production.
 It also has the largest bovine population. India, the second-largest producer of
sugar, accounts for 14 percent of the global output. It is the sixth -largest exporter of
sugar, accounting for 2.76 per cent of the global exports.
 The Spices Board of India has decided to set up a spice museum at Willingdon
Island in Kochi to attract and educate tourists and seafarers about the history and growth
of Indian spices industry.

Role of Manufacturing Sector in Indian Economy

 Manufacturing has emerged as one of the high growth sectors in India. Industry
accounts for 26% of GDP and employs 22% of the total workforce.
 According to the World Bank, India's industrial manufacturing GDP output in
2015 was 6th largest in the world on current US dollar basis ($559 billion), and 9th
largest on the inflation adjusted constant 2005 US dollar basis ($197.1 billion).
 Prime Minister of India, Mr Narendra Modi, had launched the ‘Make in India’
program to place India on the world map as a manufacturing hub and give global
recognition to the Indian economy.
 India’s manufacturing sector has the potential to touch US$ 1 trillion by
2025. There is potential for the sector to account for 25-30 percent of the country’s GDP
and create up to 90 million domestic jobs by 2025.

Role of Service Sector in Indian Economy

 The services sector is not only the dominant sector in India’s Gross Domestic
Product (GDP) but has also attracted significant foreign investment flows, contributed
significantly to exports as well as provided large-scale employment.
 Indian service sector grew at approximately 8 per cent per annum and contri buted
to about 64 percent of India's GDP in FY 2015-16.
 The services sector is the key driver of India’s economic growth. The sector
contributed around 66.1 per cent of its Gross Value Added growth in 2015 -16, thereby
becoming an important net foreign exchange earner and the most attractive sector for FDI
(Foreign Direct Investment) inflows.
 India is the eighth largest services exporter in the world.
 Out of overall services sector, the sub-sector comprising financial services, real
estate and professional services contributed 21.6 per cent to the GDP, and grew the
fastest among all sub-segments at 10.3 per cent year-on-year in 2015-16.
 The sub-sector of trade, hotels, transport, communication and services related to
broadcasting contributed 12.6 percent the GDP. The third-largest sub-segment comprising
public administration, defence,and other services contributed nearly 12.6 % to the GDP.

SWOT Analysis of Indian Economy

 SWOT is an acronym (Short Form) for Strength, Weakness, Opportunities and Threats.
 SWOT analysis is an important tool for audit and analysis of overall strategic position of
business as well as its environment.
 It takes into account all positive and negative factors, Inside and outside of firm that
affects success.
 SWOT analysis provides information that helps in synchronizing firm’s resources and
capabilities with competitive environment where firm operates.
About Indian Economy
 India is the 8th largest economy in world in terms of Nominal GDP, and 3rd largest by
purchasing power parity (PPP).
 India is one of the fastest Developing Economic Superpower with potential to become the
world's 3rd largest economy by 2020.
 India is the16th-largest exporter and the 8th-largest importer in the world.

STRENGTHS
 High percentage of cultivable land.
 Huge pool of labour force
 Huge English speaking population, availability of skilled manpower
 Extensive higher education system, third largest reservoir of engineers
 Rapid growth of IT and BPO sector bringing valuable foreign exchange
 Abundance of natural resources
 The external debt condition is within safe limits and there is no possibility of slippage
from the fiscal discipline and consolidation path is also followed for the last few years
 The forex reserves have registered a grown of $400 billion by December 2016 which is
more than the standard reserve adequacy norms.
 India is receiving one of the largest inflows of foreign direct investment (FDI) due to FDI
reform measures were taken in the last couple of years, which as the proportion of GDP
  The Goods and Service Tax bill has been passed by the Parliament and its
implementation will result in a single nationwide market; better tax compliance; higher
investment and growth; and good governance practices.
 A very extensive network and infrastructure are created in the country by JAM —Jan-
Dhan Yojana, Aaadhaar cards and Mobile phones, particularly to reach the target groups
and remote areas directly and effectively.

WEAKNESS
 Very high percentage of workforce involved in agriculture which contributes only 17.2%
of GDP.
 Around a quarter of a population below the poverty line
 High unemployment rate
 Poor infrastructural facilities
 Low productivity
 Huge population leading to scarcity of resources
 India has very and inefficient delivery of necessary public services like delivery of health
and education does not endow with any good replicable model across states.
 Low literacy rates
 Rural-urban divide, leading to inequality in living standards
 The corporate sector and commercial banks are experiencing with their respective
stressed balance sheets and the firms are unable to squander on fresh investments because
they have already defaulted on their borrowings and the banks are unable to lend more
because they have accumulated huge Non-Performing Assets (NPAs).
 The fiscal deficits in the state government budgets have been rising of late due to the
implementation of the UDAY scheme.

OPPORTUNITY
 Scope for entry of private firms in various sectors for business
 Inflow of Foreign Direct Investment is likely to increase in many sectors
 Huge foreign exchange earning prospect in IT and ITES sector
 Huge population of Indian Diaspora in foreign countries (NRIs)
 Huge domestic market: Opportunity for MNCs for sales
 Vast forest area and diverse wildlife
 Huge agricultural resources, fishing, plantation crops, livestock
 The reform in the bankruptcy laws for exits of various corporations to release locked up
resources for which the Government has already reformulated an ‘Insolvency and
Bankruptcy Code, 2016’ and now, its efficient implementation will matter the most.
 Strengthening of the legal basis for Aadhaar scheme and allow inter-operability to
encourage digitalization payments for the efficient functioning of government schemes to
achieve inclusion and equity. Now, the Aadhaar scheme has a legal backup through the
Aadhaar Act, which is already passed by the Parliament.
 The demographic dividend in the Peninsular States would reach the peak around 2020,
but the Hinterland States would reach the peak only around 2040. Thus, the demographic
dividend would be enjoyed by the country over a much longer duration than most other
 countries. This also offers a natural opportunity to close the economic gap existing across
the states over time.

THREATS
 Global economy recession/slowdown
 High fiscal deficit
 Threat of government intervention in some states
 Volatility in crude oil prices across the world
 Growing Import bill
 Population explosion, rate of growth of population still high
 Agriculture excessively dependent on monsoon
 The competitive populism politics in the federal democracy can damage fiscal discipline
and governance standards.
 The demographic dividend India is likely to retreat soon because the peak is likely to be
attained by 2020 and the peak is relatively lower than the one reached in China and
Brazil.

Key Vocabulary
aggregate employment interest price indexes
base year expansion exports intermediate good price level
business factor markets intermediate service product market
business cycle factors of production investment rationale
circular flow final goods & services expenditures real GDP
closed economy financial market labor force real interest rates
CPI – Consumer fluctuations labor participate rate recession
Price frictional labor productivity rent
Index unemployment long-run resource market
cost-push inflation GDP means of production salaries
consumption GDP deflator natural rate of short-run
contraction GNP unemployment stabilization
current dollars government natural resources stagflation
cyclical expenditures net exports standard of living
unemployment household nominal GDP structural
debt human capital nominal interest rates unemployment
deficit hyper-inflation open economy transfer payments
deflation imports paradox of thrift trough
demand-pull income peak underground economy
unemployment inflation per capita underemployment
depreciation inputs Phillips Curve unemployment
depression interdependence PPI – Producer Price value added
discouraged worker indicator Index wage rate
disposable income