ESI 1-Macroeconomics PDF

MICRO
versus MACRO Economics

Economics is defined as the study of how humans work together to convert limited
resources into goods and services to satisfy their wants (unlimited) and how they distribute
the same among themselves. In economics, the major assumption is that resources are
limited but demands or needs are unlimited. The challenge lies in distributing limited
resources in a way that maximizes satisfaction and needs of everyone.
Economics has been divided into two broad parts i.e. Micro Economics and Macro
Economics. The former is the study of economic behavior of a particular individual, firm, or
household, i.e. it studies a particular unit whereas the latter is the study of aggregates i.e.
not a single unit but the combination of all.

Comparison between Micro and Macro Economics:

BASIS MICRO ECONOMICS MACRO ECONOMICS
Meaning The branch of economics The branch of economics
that studies the behavior that studies the behavior
of an individual consumer, of the whole economy,
firm, family is known as (both national and
Microeconomics international) is known as
Macroeconomics

Scope Covers various issues like Covers various issues like,
demand, supply, product national income, general
pricing, factor pricing, price level, distribution,
production, consumption, employment, money etc
economic welfare, etc

Importance Helpful in determining the Maintains stability in the
prices of a product along general price level and
with the prices of factors resolves the major
© Anuj Jindal successrbigradeb@gmail.com 1

of production (land, labor, problems of the economy

capital, entrepreneur etc.) like inflation, deflation,
within the economy reflation, unemployment
and poverty as a whole

Equilibrium Microeconomics works on In Macroeconomics, the
the principle that markets economy may be in a state
soon create Equilibrium. of equilibrium/
For a long time, it was disequilibrium for a longer
assumed that period (boom or
macroeconomics also recession)
performed similarly and
always returned to
equilibrium. Before 1930s,
there was no separate
branch of
Macroeconomics.


Macroeconomics as a separate branch:

Macroeconomics, as a separate branch of economics, emerged after the John Maynard
Keynes published his celebrated book “The general theory of employment, interest and
money” in 1936.

Before Keynes, it was assumed that all laborers willing to work would find work and all
factories would run at full capacity. This thought was called as “classical thought”.

Following The Great Depression in 1929, countries in the west faced huge unemployment
and fall in output. There was fall in demand for goods and services, which led to fall in
output and resulting unemployment due to idle factories. J M Keynes studied this
phenomenon by analyzing the economy as a whole for the first time and thus
macroeconomics as a field of study was born.

Contribution of Keynes:

Prior to Keynesian economics, classical economic thinking held that cyclical swings in
employment and economic output would be modest and self-adjusting. According to this
classical theory, if aggregate demand in the economy fell, the resulting weakness in
production and jobs would precipitate a decline in prices and wages. A lower level
of inflation and wages would induce employers to make capital investments and employ
more people, stimulating employment and restoring economic growth.

The depth and severity of the Great Depression, however, severely tested this hypothesis.
Keynes brought out that structural rigidities and certain characteristics of market
economies would increase economic weakness and cause aggregate demand to plunge
further.

For example, Keynesian economics refutes the notion held by some economists that lower

wages can restore full employment, by arguing that employers will not add employees to
produce goods that cannot be sold because demand is weak. Similarly, poor business
conditions may cause companies to reduce capital investment, rather than take advantage
of lower prices to invest in new plant and equipment; this would also have the effect of
reducing overall expenditures and employment.

Keynes thus advocated increased government expenditures and lower taxes to stimulate
demand and pull the global economy out of the Depression. Subsequently, the term
“Keynesian economics” was used to refer to the concept that optimal economic
performance could be achieved – and economic slumps prevented – by
influencing aggregate demand through activist stabilization and economic intervention
policies by the government. Keynesian economics is considered to be a “demand-side”
theory that focuses on changes in the economy over the short run by government
intervention in stimulating demand.

Causes/ Reasons for The Great Depression:

Current theories may be broadly classified into two main points of view:
First, there are demand-driven theories, from Keynesian and institutional economists who
argue that the depression was caused by a widespread loss of confidence that led to under
consumption.
The demand-driven theories argue that the financial crisis following the 1929 crash led to a
sudden and persistent reduction in consumption and investment spending. Once panic and
deflation set in, many people believed they could avoid further losses by keeping clear of
the markets. Holding money therefore became profitable as prices dropped lower and a
given amount of money bought ever more goods, exacerbating the drop in demand.
Second, there are the monetarists, who believe that the Great Depression started as an
ordinary recession, but that significant policy mistakes by monetary authorities (especially
the Federal Reserve) caused a shrinking of the money supply which greatly exacerbated the
economic situation, causing a recession to descend into the Great Depression. Related to

this explanation are those who point to debt deflation “causing those who borrow to owe
ever more in real terms”.
In reality, it was a combination of above reasons that resulted in the great depression of
1929. In simple terms, the causes were:
1. High Income Inequality- Companies made record profits in 1920s. markets expanded
fast and widely. While profits soared, wages or workers increased only
incrementally. This widened the distribution of wealth. The richest 1 percent of
americans owned one-third of total wealth. The result of income inequality was that
large volume of money was saved by the rich rather than investing back into the
economy. Fair distribution to the middle class would have made the economy more
sustainable and stronger.
2. Stretched debt capacities of the middle class- In 1920s, consumption soared with
high economic growth in America. However, this consumption was based on high
debt levels of middle class rather than higher income levels. The middle class bought
more without having enough money to buy consumables by taking high debt. With
stock market crash and panic in the economy, consumption levels fell further
resulting in a fall in aggregate demand for goods and services in the economy.
3. Fundamental reasons- there was no guarantee on bank deposits. In tough times,

people started taking out their money from banks due to lack of trust.
4. Lack of money supply- As the recession set in, the federal bank decided not to supply
money to the economy. This worsened the situation as lack of money supply
increased value of money and people started hoarding cash rather than investing
money (deflation causes an increase in value of money in the future). This caused a
contraction in production and employment, resulting into a depression. Due to Fed’s
policy, there were widespread bank runs and bank failures in US economy.

Basics of national income accounting
In order to understand level of production, investment and growth of a country and the
world as a whole, we need to understand basic terms of macroeconomics:
1. Final goods and Intermediate goods- Every good passes through various levels to
arrive at the final level of consumption. For example, wheat is planted by a farmer
and sold to bread maker who makes bread out of it. The bread maker then sells the
bread to a distributor who packs and transports the bread to the market for final
consumption by the consumer. The bread at different stages will be called an
intermediate good but when the consumer consumes this bread finally, it becomes a
final good and the economic value of bread at that level is important for an
economy. If the bread is purchased by a restaurant for making food for customers,
the final economic value of bread changes to what is being paid by the customer in
the restaurant. In the process of calculating GDP, the value of only final economic
good is to be considered for calculation.
2. Consumption and capital goods- goods like food, clothing, private transport and
services like recreation that are consumed when purchased by the ultimate
consumers are called consumption goods or consumer goods. Consumption goods
that last longer (a car, a bike, a TV) are called consumer durables. On the other hand,
goods or services that are purchased for further production like machines purchased
by an entrepreneur for making textiles or computers purchased by an IT company
for creating softwares are called capital goods. Capital goods form an important
backbone of production processes in an economy and they result in value addition
and money multiplication because they are not just consumed but help in further
production. The importance of consumption versus capital goods will be highlighted
when we talk about “History of Indian Planning”.
3. Gross and net investment- we have just talked about “capital goods”. Final output of
capital goods in an economy in a year is called gross investment because these goods
are used as investments to produce further (intermediate or final) goods. For
example, machines purchased to produce cars in a factory are capital goods meant
for producing Cars (which can be intermediate or final goods). These machines are
investments by the owner/ entrepreneur in his enterprise. Therefore, they are also

called as gross investments. Capital goods last multiple accounting years and require
regular maintenance for satisfactory performance. The part of capital goods
production that is meant for maintenance of existing capital goods is deducted from
gross investments to arrive at net investments. The deduction is termed as
“depreciation”.
Net Investment = Gross Investment – Depreciation

Circular flow of income
Four kinds of contributions can be made during production of goods and services by factors
of production. Four kinds of remunerations are received by these factors:
• Land- remuneration received in terms of rent
• Labor- remuneration received in terms of wage
• Capital- remuneration received in terms of Interest
• Entrepreneurship- remuneration received in terms of profit
In a simple economy, after a good or service is produced, it is assumed that it is consumed

entirely by households. There are no savings, no taxation and no purchase of imported
goods.
Similarly, the amount of remuneration paid to 4 factors of production by businesses is equal

to consumption expenditure by households that industries receive as sales revenue.
In circular flow of income, there are a total of 4 flows, out of which 3 become important in
our future understanding of calculating national income.

• Individuals provide factor services/ labor for which they get income/ factor
payments from businesses.
• Individuals spend this income by purchasing goods and services produced by the
businesses. So goods are provided to individuals in return for expenditure by these
households.
Since the same amount of money, representing aggregate value of goods and services is
moving in a circular way, if we want to estimate the aggregate value of goods and services
produced during a year, we can measure it by 3 methods-
1. Aggregate value of expenditure by households (CALLED EXPENDITURE METHOD)
2. Aggregate value of goods and services provided by businesses and (CALLED

PRODUCT METHOD/ VALUE ADDED METHOD)
3. Aggregate value of factor payments/ income to households (CALLED INCOME

METHOD)
Now, let us calculate national income/ aggregate value of goods and services through these
3 methods:
1. Value Added Method/ Product Method:
In value added method, we calculate the aggregate annual value of goods and services
produced. It is called value added method because only the additional value of a product is
added to find its final value in total production in the economy. For example, there is a
farmer producing wheat. He makes wheat worth Rs 100, out of which wheat worth Rs 50 is
provided to a bread maker who produces bread out of wheat. The rest Rs 50 wheat is
consumed directly by the consumer. The bread maker sells bread worth Rs 200.
According to value added method, total product value of wheat and bread combined will
be:
Farmer Baker
Total production 100 200

Intermediate goods used 0 50
Value added 100 150
Total value added will be 100 + 150 = Rs. 250
The value added in an economy is measured/ calculated using the same fundamental
method as used above.
As we saw, to calculate value added, we reduce value of intermediate goods from final
goods so that there is no double counting. If this method is not followed, the total value of
product would be 100 + 200 = 300. The value of wheat worth Rs 50 is calculated twice in
such a scenario. In order to avoid such double counting, we rely on value added method to
find out gross value added in an economy.
Therefore, we can write-
Gross value added of a firm = gross value of output produced by the firm – value of
intermediate goods used by the firm
Net value added of the firm = gross value added – depreciation of the firm/ consumption of
fixed capital
To calculate Gross Domestic Product (GDP), we make sum total of gross value added of all
the firms in the economy.
So, GDP = GVA1 + GVA2 + GVA3.... + GVAn

!
GDP = !!! GVA !
2. Expenditure Method:
An alternative way to calculate GDP is by looking at the demand side of the products. This
method is referred to as expenditure method.
In expenditure method, we calculate the final expenditure made by households to purchase

different products. We do not consider intermediate expenditure by businesses to produce
further products. For example, according to previous example, expenditure of 50 by baker

on purchasing wheat from the farmer will not be considered because it is not final
expenditure by the baker.
In expenditure method, the following expenditures are included to calculate final GDP.
a) Consumption expenditure for final consumption
b) Investment expenditure on capital goods for producing further goods or services
c) Expenditure made by government on final goods and services
d) Export revenues by selling goods abroad
Therefore, total value of revenues of a firm according to expenditure method (RV) = C + I +

G + X
As we are taking exports in this case, we will also consider imports by households,
government and businesses (Investment)
Therefore, RV = C – Cimport + I – Iimport + G – Gimport + X
RV = C + I + G + (Exports – Imports)
RV = C + I + G + (X - M)
GDP = sum of revenues of all firms in the economy = expenditures by households, firms and
government in the economy
3. Income Method:
Income method uses aggregate income of all households in an economy to find out GDP.
Aggregate income of households includes income from wages, rent, entrepreneurship
(profits) and interest from capital investment.
GDP = W + P + In + R
Considering expenditure and income method together, we get
GDP = C + I + G + X-M = W + P + In + R

There are only three major ways in which households can spend their Incomes i.e.
consumption, savings and taxes
Since total spending is supposed to be equal to total income,
GDP = C + S + T
Now if we compare expenditure method with income method again, we will get
GDP = C + I + G + X-M = C + S + T
Rewriting it, we get
(I – S) + (G – T) = M – X
The above equation means that
I – S is excess of investment over saving in an economy,
G – T is excess of government expenditure over tax revenues. This can also be stated as
budget deficit
M – X is excess of imports over exports. This can also be stated as Trade Deficit
Further, we had assumed in the starting of this chapter of circular flow of income that there
is no government, no foreign trade. We assumed that there is only households and
businesses. Keeping that in mind now, we get
G = T = M = X = 0
Therefore, S = I
This means that savings will be equal to investments in a simple economy.

MACROECONOMIC IDENTITIES OR TERMS
The following macroeconomic terms will be covered under this heading:
1. Gross domestic product
2. Gross national product
3. Net national product
4. Net national product @ factor cost
5. Personal income
6. Personal disposable income
7. National disposable income
8. Private Income
9. Gross value added @ basic prices
10. Gross value added @ market prices
11. GDP @ constant market prices
12. GDP Deflator
13. Consumer price index (CPI)
14. Wholesale price index (WPI)

Gross Domestic Product (GDP):
GDP refers to aggregate value of production of final goods and services taking place within
the domestic economy during a year. There are 3 important terms to remember under GDP.
a) Final goods and services- intermediate goods and services are not considered in
calculating GDP. Only goods and services consumed by final customer are to be
added together to arrive at GDP. For example- whatever paneer (cottage cheese) is
made and sold in an economy, the usage of milk to make cottage cheese is not to be
considered in calculation of GDP as milk in this case is an intermediate good and not
final good.
b) Domestic economy- domestic economy means economic activity going on within

territorial boundaries of a country. In case of India, the entire landmass (including
islands) and 12 nautical miles of water surrounding the landmass is a part of indian
territory, so this area is certainly a part of domestic economy. Further, 200 nautical
miles from coast or 188 nautical miles from territorial waters comes under Exclusive
Economic Zone (EEZ) where only Indian residents can carry out economic activity.
Therefore, this area also comes under domestic economy.
c) Economic activity carried out by Residents- The entire production of final goods and
services may not accrue to only citizens of the country. Multi National Companies,
foreign residents in India, foreign immigrants working in India (often we see Nepali
citizens working in Indian Urban Areas) et cetera also contribute towards final
production of goods and services. As per definition of GDP, economic activity of all
residents in India, whether Indian citizen or foreign citizen is to be combined
together to arrive at GDP. Therefore, GDP does not differentiate between indian
citizen and foreign citizen.

Gross National Product:
Gross National Product takes into consideration the third term/ point under GDP i.e.
economic activity carried out by residents.
In Gross National Product, we change residents to “citizens”. This means that any economic
contribution of foreign citizens in India is to be removed from calculation of GNP and
economic contribution of Indian citizens abroad is to be added in calculation of GNP.
Numerically, it can be defined as:
GNP = GDP + factor income by indian citizens in the rest of the world – factor income earned
by foreign citizens in India
Or,
GNP = GDP + net factor income from abroad
Net National Product:
We have already discussed the difference between Gross and Net. As a part of capital is
consumed during a year due to wear and tear, it is to be removed to arrive at “Net” value.
This wear and tear is called depreciation.
Therefore, Net National Product = Gross National Product – Depreciation
Net National product @ Factor Cost:
Whenever nothing is mentioned ahead of variables like GDP, GNP et cetera, it is assumed
that calculation has been done at “Market Price”. To arrive at factor cost, it is important to
understand the difference between factor cost and market price.
Factor cost is the value/ cost of a product that accrues or belongs to the factors of
production. This means that factor cost is the value on which a company makes profit, labor

makes wages and other costs to be paid by a company are paid. We have already talked
about factors of production in detail.
When we add value accruing to the government or costs to be borne by the government,
we arrive at market price of a product.
Numerically,
NNP @ market price = NNP @ factor cost + Indirect taxes - subsidies
NNP @ factor cost = NNP @ market price – Indirect taxes + subsidies
In equation 1, we arrive at market value by adding taxes to a product and subtracting

subsidies from the product. Taxes are added as they increase market price of a product and
subsidies are subtracted as they reduce market price of the product. Both “indirect taxes
and subsidies” accrue to the government and therefore it becomes important to separate
them from value accruing to the producer.
In equation 2, we deduct indirect taxes because they have been added to factor cost to
arrive at market price of a product. These are earnings accruing to the government.
Similarly, we add back subsidies because they result in reduction in market price of a
product and are borne by the government.
Personal Income:
Personal income is the income accruing to households and received by them. Personal
income is a sub part of national income/ Net national product @ factor cost.
In order to understand derivation of personal income, we need to understand the following

terms:
a) Undistributed profits- a part of profit of enterprises is not distributed among factors

of production. It is retained by enterprises for future investments et cetera. This is
called undistributed profits. Since undistributed profit does not accrue to
households, it has to be reduced from national income to arrive at personal income.

b) Corporate tax- corporate tax is imposed on earnings made by firms. It accrues to the
government and is paid by enterprises to arrive at net profits. Corporate tax is also
removed from national income as it does not accrue or belong to households.
c) Interest receipts and payments- households receive interest on loans provided to

the government or private firms. Similarly, households pay interest on loans taken
from firms or the government. We reduce interest payments made by households
and increase interest receipts made by households.
d) Transfer payments- households receive transfer payments from government and

firms in the form of pensions, scholarships, prizes etc. these receipts of households
are added to calculate personal income.
Numerically,
Personal Income (PI) = National Income – undistributed profits – (interest payments made
by households – interest receipts by households) – corporate tax + transfer payments
made to households
Personal Disposable Income:
PDI is that part of personal income, which is available to households for all kinds of
expenditures. After calculating personal income, we have to reduce personal tax and non-
tax (fines) payments to arrive at personal disposable income.
Numerically,
PDI = PI – personal tax payments- non tax payments
Personal Disposable Income belongs completely to households. They may decide to spend it
or save it according to their preferences.

National Disposable Income:
National disposable income tells us ‘what is the maximum amount of goods and services the
domestic economy has at its disposal.’
Numerically,
National disposable income = net national product at market prices + other current
transfers from the rest of the world
Private Income:
Whatever accrues to the private sector in the country comes under private income. It
considers income by “citizens” and not residents.
Numerically.
Private income = factor income of private sector + interest + net factor income from abroad
+ transfers from government + other net transfers from rest of the world

The Below three mentioned identities belong to the latest method of National Income
Accounting:
Gross value added @ basic prices,
Gross value added @ market prices, and
GDP @ constant market prices
To understand these 3 identities, it’s important to understand the latest method of National
Income Accounting:
New method of national income accounting:
The Central Statistics Office (CSO) has introduced the new series of national accounts
statistics with base year 2011-12, in place of the previous series with base year 2004-05.
The new series on National Accounts Statistics has been introduced after a comprehensive
review of both the database and the methodology employed in the estimation of various
aggregates.
The reason for changing the base year of the national accounts periodically is to take into
account structural changes, which have been taking place in the economy and to depict a
true picture of the economy through macro aggregates like Gross Domestic Product (GDP),
National Income, consumption expenditure of Government and individuals, capital
formation etc. To examine the performance of the economy in real terms, estimates of
these macro-economic aggregates are prepared at the prices of selected year known as
base year. While output level of current year is used, prices of base year are used to
eliminate “inflation” from GDP estimates. (real versus nominal GDP)
The estimates at the prevailing prices of the current year are termed as “at current prices”,
while those prepared at base year prices are termed as “at constant prices”. The
comparison of the estimates at constant prices, which means “in real terms”, over the years

gives the measure of real growth. After revision in method of GDP calculation, growth rate
will now be measured by “GDP at constant market prices”, which means market prices of
base year. Previously, the method used was “GDP at constant factor cost”.
The method to calculate sector wise estimates of Gross value added has also been changed.
Previously, it was GVA at factor cost, but now it has been changed to GVA at basic prices.
To understand relation between market price, basic prices and factor cost, it is important to
understand product taxes and subsidies as well as production taxes and subsidies:
Production taxes and subsidies are those that are levied or received with relation to
production. They are independent of volume/ quantity of production. For example, stamp
duty and professional tax are charged irrespective of volume of activity. Examples of
Production subsidies are subsidies to farmers, small industries, railway subsidies etc.
On the other hand, product subsidies and taxes are those that are levied or received on per
unit of product. For example, food subsidy, petroleum subsidy, interest subsidy etc. GVA at
basic prices takes into consideration “production taxes and subsidies”. GVA at basic prices =
(employee compensation + mixed income + consumption of fixed capital) + (production
taxes – production subsidies)
(NOTE: Remember that CSO used to add rent, wages, interest and profit to calculate GDP.
As per revisions, it has been changed to “compensation, consumption of fixed capital and
mixed income/operating surplus.” This is inspired by system of national accounts created by
UN, IMF, WB, OECD and European commission) GVA at market prices = GVA at basic prices +
product taxes – product subsidies
Improvements in the new method over older method of GDP calculation:
• Efforts have been made to implement recommendations of the System of National

Accounts (SNA) 2008 to bring GDP calculation in line with global practices. This will make
the estimates more comparable over space and time.
• There are many unincorporated enterprises, which tend to behave in the same way as
corporations. These enterprises are called as “quasi corporations” as per SNA 2008. The new

method has expanded the list of enterprises to be included under “quasi corporations”. As
India has a large base of unincorporated, household run enterprises, expansion of the list
would give a clearer picture of GDP.
• Under the older method, private corporate sector series was covered on the basis of
financial results of around 2500 companies. In the new series, a comprehensive coverage of
corporate sector has been ensured by analyzing 5 lakh companies.
• Earlier, estimates for local bodies and autonomous institutions were prepared on the basis
of information received for seven autonomous institutions and local bodies of four states. In
the new series, there has been an improved coverage of local bodies and autonomous
institutions, covering around 60% of the grants/transfers provided to these institutions.
• The GDP data revision will also incorporate the new CPI (CPI- Combined) instead of the
previous practice of using CPI for various groups such as agricultural laborers and industrial
workers.
Reasons for change in GDP estimates as per new method:
• Composition of various activities between the two Series- The weighting pattern of various
activities in the GVA in the old and new series for the year 2011-12 also influences to some
extent the overall growth rate in GVA. Marked changes have been observed in the shares of
two major industries, namely, ‘manufacturing’ and ‘trade’. In the case of manufacturing,
with the availability of the MCA21 database (5 lakh enterprises), coverage of the activities
other than manufacturing in the companies has improved significantly. . Estimates of ‘trade
and repair services’ has become lower than in the old series because Trade carried out by
manufacturing companies, which has now become part of ‘manufacturing’, was earlier
covered in ‘trade’.
Weights of various sectors at current prices in the new and old series:
Industry 2004-05 2011-12

series series
Agriculture, forestry and fishing 17.9 18.4

Manufacturing 14.7 18.1

Trade, repair, hotels and restaurants 17.4 10.8
Transport, storage, communication & services related to 7.3 6.5
broadcasting
Mining and quarrying 2.7 3.2

Electricity, gas, water supply & other utility services 1.6 2.4

Construction 8.2 9.4

Criticism of the new method:
• The new numbers seem completely out of sync with other economic indicators such as the
revenue growth of listed firms and bank credit growth. The reason for this difference lies in
method of calculating estimates of private corporate sector. Under the older method, a
sample of 2500 companies was taken and estimates were bloated up to represent all
registered companies. However, many companies out of these registered ones were shell
companies. Thus, the older method resulted in higher private corporate estimates. The new
method was supposed to solve this problem by taking all companies registered under MCA
21 (5 lakh). However, in reality, the new method bloated up the data again to cover all
“Active” registered companies (more than 9 lakh). This has resulted in a bloated data, which
fails to represent true economic picture.

GDP DEFLATOR:
The ratio of nominal to real GDP gives us an idea of how prices have moved from the base
year to the current year. The volume of production is fixed (current year) in calculation of
real and nominal GDP.
This ratio of nominal to real GDP at current year’s volume is known as GDP Deflator.
Therefore, GDP Deflator = Nominal GDP/ Real GDP
Other than GDP deflator, there are other ways also to measure change in prices in an
economy. These are known as consumer price index and wholesale price index.

CONSUMER PRICE INDEX (CPI):
In India, the Consumer Price Index or CPI measures changes in the prices paid by consumers
(retail price) for a basket of goods and services. To measure CPI, we take two years- base
year and current year. We calculate the cost of purchase of a given basket in the current
year as well as base year. Comparison of costs of these two years gives us consumer price
index.
Consumer price index is measured by Central Statistical Office (CSO) with base year as 2012.

Retail price is not the only price belonging to a product. The other is the wholesale price, the
price at which goods are traded in bulk in the market. Rise in price of a product at wholesale
level is called as WHOLESALE PRICE INDEX. WPI is measured by Economic Advisor,
Department of Industrial Policy and Promotion with base year as 2004.

The difference between GDP Deflator and CPI/ WPI is to be noted:
a) GDP takes into account all goods and services produced in an economy. CPI and WPI
are based on a basket of goods.
b) CPI includes prices of imported goods as well (imported and consumed by the
consumer). GDP deflator does not include any such imported price


GOVERNMENT BUDGETING

There are 3 major functions of the government in economic sector:
a) Allocation function
b) Distribution function
c) Stabilization function

ALLOCATION FUNCTION:
There are many public goods and services, which cannot be provided by the private sector
due to lack of possibility of making any kind of profit from them. These are goods like
national defence, government administration, supply of basic services like cheap housing,
water supply, free education et cetera.
The government takes on the responsibility of providing them. This function of the
government is called allocation function.

DISTRIBUTION FUNCTION:
In any society, there are rich and poor people. Rich are taxed more on their income
compared to the poor. This process of taxation is called progressive taxation. The reason for
taxing rich and poor differently is DISTRIBUTION function of the government. In a welfare
state like India with huge poverty, it is the responsibility of the government to try and
reduce inequality of income in the economy. This objective is achieved through distribution
function, wherein money is transferred from rich to the poor through progressive taxation
and transfer payments to the poor. Basic services like free education, free healthcare, free
housing et cetera are provided to the poor to enable them to earn more in the future by
educating themselves and growing as healthy living beings.

STABILIZATION FUNCTION:
Stabilization function means pushing up an economy suppressed by lack of aggregate
demand. An economy may face long periods of unemployment and depression due to lack
of aggregate demand and vice versa. It is the responsibility of the government to stabilize
such an economy by creating or controlling aggregate demand.


These 3 functions are carried out through Government Budget.
Government
Budget
Revenue budget Capital Budget
Revenue Capital
Revenue Receipts Expenditure Capital Receipts Expenditure
Plan revenue Plan capital

Tax revenue expenditure expenditure
Non-plan capital
Non-plan revenue expenditure
Non tax revenue expenditure

Revenue Budget-
Revenue budget consists of revenue receipts and revenue expenditure. These are
transactions of recurring nature, which do not add any capital/ asset to the nation. They are
day to day/ administrative expenses made to run the country and recurring receipts to be
received every year.
Revenue receipts-
Revenue receipts can be sub classified into tax receipts and non-tax receipts. Direct Tax
receipts are of 2 kinds (income tax and corporate tax) and there are multiple Indirect tax
receipts of both central and state government.
Non-tax receipts are receipts from fines, interest receipts on loans made by the
government, charges etc.
There is no role of plan-non plan classification in revenue receipts.

Revenue Expenditure-
Revenue expenditure can be sub-classified into plan revenue expenditure and non-plan
revenue expenditure. Revenue expenditures do not result in creation of any additional
physical or financial assets.
Plan revenue expenditure relates to central plans and central assistance to states and UTs,
which do not create any kind of asset.
Non plan expenditures are interest payments on debt taken by the government, defence
services, subsidies, salaries and pensions etc.
Out of all non-plan revenue expenditures, interest payments constitute the largest
component.
Though defence expenditure is considered a revenue non plan expenditure, it is also a

committed expenditure as it is a national security expenditure.
Similarly, grants for creation of capital assets are considered under revenue expenditure.
Numbers relating to these expenditures should be taken from union budget and analyzed
well to understand the importance of every expenditure in our economy.
Capital Budget-
The capital budget outlines assets and liabilities of the government. Capital budget shows
capital requirements of the government (capital expenditure) and how they finance these
requirements through capital receipts.
Capital receipts-
Capital can be collected by the government through various sources- market borrowings by
issuing bonds etc; borrowing from RBI and commercial banks; loans received from foreign
governments and agencies like IMF, World Bank, NDB etc; recovery of loans forwarded
earlier; disinvestment proceeds; savings of the people in areas like small savings, provident
fund etc.

Capital expenditure-
Capital expenditure can be sub-divided into Plan and Non-Plan expenditure. Plan
expenditure relates to central plan and central assistance for states and UTs, which results
in creation of physical or financial assets.
Non-Plan capital expenditure relates to expenditure on social services provided by the

government.
Any imbalance between government receipts and expenditures will result in either a deficit
or a surplus. Indian government experiences an overall deficit due to higher expenditures on
developmental and welfare activities.
There are various terms connected to government deficit:
Revenue deficit-
Revenue deficit is incurred when government’s revenue expenditure is more than its
revenue receipts.
Revenue deficit = revenue expenditure – revenue receipts
Revenue deficit means that the government is spending more on its day-to-day
administrative activities than its revenue earnings (recurring). This implies that the
government will have to finance not only expenditures for asset creation but also for
consumption and administrative expenditures. In case of a heavy revenue deficit, the
government starts reducing expenditure on capital creation and focuses on meeting
revenue expenditures. This harms a country as finances are used up for consumption rather
than asset creation.
Fiscal Deficit-
Fiscal deficit can be defined in two ways-

1. Fiscal deficit is the total borrowings taken by the government in a year to finance its
overall deficits
2. Fiscal deficit is the difference between the government’s total expenditure and total
receipts excluding borrowing
Interestingly, when you analyze both, you will realize that they mean the same thing.
Gross fiscal deficit = total expenditure – (revenue receipts + non-debt creating capital
receipts)
Or,
Gross fiscal deficit = total borrowings (domestic borrowings, international borrowings,

borrowings from RBI)
Primary deficit-
The present government is also required to pay for debts of past governments in the form
of interest payments. Since, this debt and accumulated interest is not created by the
present government, it wants to remove this liability to arrive at the figure of deficit created
in the present. This figure is called as primary deficit.
Numerically, primary deficit = gross fiscal deficit – (interest payments – interest receipts)
IMPACTS OF GOVERNMENT DEFICIT:
Government deficit impacts an economy both positively and negatively. We will understand
how government deficit is financed and how it impacts the country.
Financing government deficit-

Government/
budgetary deOicit
borrowing from
domestic and printing money-
higher taxation
international money creation
sources
Higher taxation results in a fall in Disposable Income of the people and negatively affects
Aggregate Demand in the economy. Disposable Income refers to net income of households
after taxation, which they can spend according to their needs. Lesser disposable income
means less demand for goods and services in the market.
Higher taxation is also bound to increase tax evasion as people take it as an unnecessary
burden.
Since we are talking about taxation and tax evasion, let us also understand the inverted U
curve/ Laffer curve related to taxation.

As can be seen in the graph, as tax rate increases (X- axis), government revenue increases
up-to a point (Y- axis). Beyond a certain point, government revenue starts reducing with a
rise in tax rate due to tax evasion and less tax compliance by the people. This relationship
between taxation and government revenue is called as laffer curve.
Printing of money used to be a widely used method of financing government deficit in India.
Whenever the government fell short of cash, it passed an order to RBI to print more money
for its financing. This resulted in misapplication of money by the government and heavy
money supply in the economy. Since, RBI is the institution responsible for maintaining
money supply in Indian economy, money creation by the government defeated the purpose
of RBI. Heavy money supply in the economy also reduced value of money and spiked
inflation because when people have a lot of money in their hands, they demand more,
resulting in higher inflation.
This act of the government (called as issue of ad-hoc treasury bills) was closed in 1997 and
replaced by WAYS AND MEANS ADVANCES.
WMAs are given by RBI to government and do not require any collateral. Its amount is
limited and arrived at the beginning of every fiscal year through consultation between GOI
and RBI. If the government violates the agreed amount by demanding more money, penalty
rates are charged upon it by RBI. WMAs are made at the prevailing Repo rate by RBI.
WMAs have brought in fiscal discipline in the Government, as it has to pay higher rates for
borrowing above pre-agreed limit.
Borrowing from domestic and international sources.
By borrowing, the government transfers the burden of debt on future generations, who
have to reduce their consumption to pay back the debt. For example, if the government
raises money by issuing 30-year bonds to the people, it gets money today but has to pay
back the entire sum after 30 years.
Out of these 3 methods, borrowings are most widely used by the government today
because the impacts of borrowing are felt in the future.

Impact of Deficits-
DeOicits- Impact
Burden on Crowding out of

Future InOlationary Private
Generations Investment
Crowding out of Private Investments- when the government borrows heavily from the
market, it takes away financing options of private companies, as there is limited capital
available in the system. Private companies find it difficult to raise the same amount of
capital at the same cost (interest). This either delays investment or makes it more costly.
Inflationary- By increasing supply of money in the economy, deficit financing results in more
inflation. This was considered at the time of 2008 financial crisis, when Indian government
decided to launch MGNREGA at a larger scale to provide wages to people and tackle the
financial crisis by maintaining domestic demand. As money supply increased, the economy
faced high inflation.
FISCAL RESPONSIBILITY AND BUDGET MANAGEMENT ACT:
• The Fiscal Responsibility and Budget Management Act, 2003 (FRBMA) is an Act of
the Parliament of India to improve fiscal discipline, reduce India's fiscal deficit,
improve macroeconomic management and the overall management of the public
funds by moving towards a balanced budget.
• Though the Act aims to achieve deficit reductions prima facie, an important

objective is to achieve inter-generational equity in fiscal management. This is

because when there are high borrowings today, it should be repaid by the future
generation. But the benefit from high expenditure and debt today goes to the
present generation. Achieving FRBM targets thus ensures inter-generation equity by
reducing the debt burden of the future generation.
• Other objectives include: long run macroeconomic stability, better coordination
between fiscal and monetary policy, and transparency in fiscal operation of the
Government.
• Prohibits borrowing by Government from RBI - Making Monetary Policy independent
of Fiscal Policy.
• Prevent monetization of Government deficit - Ban on purchase of primary issues of
Central government by RBI from 2006
The Act mandates 4 Documents to be laid before Parliament:
• Medium Term Fiscal Policy Statement: o 3 year rolling targets for 5 fiscal indicators
with respect to GDP at market price and the strategy to attain them. o Five fiscal
targets are: Revenue Deficit, Fiscal deficit, Tax to GDP Ratio and Total Outstanding
Debt as percentage of GDP.
• Fiscal Policy Strategy Statement
• Macro-economic Framework Statement
• Medium Term Expenditure Framework Statement: This has been added in 2012 and
presented in Monsoon Session.
The main purpose of FRBMA was to eliminate revenue deficit of the country (building
revenue surplus thereafter) and bring down the fiscal deficit to a manageable 3% of the GDP
by March 2008.

Due to the 2008 international financial crisis, the deadlines for the implementation of the
targets in the act was initially postponed and subsequently suspended in 2009.
The FRBM rule had set a target reduction of fiscal deficit to 3% of the GDP by 2008-09. This
was to be realized with an annual reduction target of 0.3% of GDP per year by the Central
government. Similarly, revenue deficit had to be reduced by 0.5% of the GDP per year with
complete elimination by 2008-09. The targets were revised following global financial crisis
and presently a committee by N K SINGH is reviewing the structure of FRBM Act.

Committee to review FRBM targets
• As per the Union Budget 2016-17, the government constituted a Committee to
review the implementation of the FRBM Act. This was done after a widely held view
among experts that instead of fixed fiscal deficit targets, it may be better to have a
fiscal deficit range as the target. This will help the government to meet specific
situations like recessions which demand high government expenditure.
• There is also a suggestion that fiscal expansion or contraction should be aligned with
credit contraction or expansion respectively, in the economy.
• While remaining committed to fiscal prudence and consolidation, Budget stated that
a review of the FRBM Act is necessary in the context of the uncertainty and volatility
in the global economy.

BALANCE OF PAYMENTS
So far, we had assumed that we are operating in a closed economy. Now we are going to
remove this assumption and talk about trade in an open economy.
Indian economy was largely closed between 1947 and 1991. Foreign trade was limited to
necessary articles; current and capital account convertibility was highly controlled by the
government; laws were not in favor of international trade as it was considered that trade
with the world might put India back into colonial suppression. We will be talking about
features of trade in India before and after 1991 when we read about History of Indian
Economy.
Here, the focus is on Balance of Payments i.e. only monetary side of trade with the world.
Balance of Payments record transactions in goods, services and assets between residents of
a country with the rest of the world.
BoP
OfOicial reserve
Current account Capital account account
Trade in goods and Purchase and sale of

services capital assets Gold
Unilateral transfers- FDI (domestic and

remittance, foreign overseas) Foreign exchange
aid, grants
Factor income- Foreign Portfolio Special drawing

interest, dividend Investment rights
Reserve position in
IMF

Current account-
Current account records 3 things- trade in goods and services, transfer payments/ unilateral
transfers and factor income earned from investments.
Current account records transactions of recurring nature or transactions which do not result
in capital/ asset creation.
Trade in goods and services- trade in goods and services includes both merchandise trade
and invisible trade. Trade here refers to both import and export of goods and services.
Trade balance is determined by comparing exports and imports of goods and services. Trade
deficit refers to a situation when imports (money to be paid) are higher than exports and
vice-versa.
Unilateral Transfers- these are uni-directional flows with no counter/ offsetting flows. These
are receipts made by residents without having to make any present or future payments in
return. Foe example, remittances received from abroad, foreign aid received by the
government etc. grants (foreign aid) might look like a capital account receipt but it is
considered as a current account receipt because of its nature as a unilateral transfer.
Factor Income- factor income refers to income from investments and loans made abroad by
Indian residents in the form of interest, dividends and profits. Current account considers
both factor income and factor payments in an economy in a financial year.
Any deficit in current account is financed either by net capital inflows or by using reserves of
foreign exchange.
NOTE: J-CURVE EFFECT
When we talk about trade balance, it is important to understand the J-Curve effect, which
brings out the impact of currency depreciation on a country’s trade balance.

According to J-Curve, following currency depreciation, current account deficit increases

further in the short term due to a sudden rise in cost of imports. However, after a short
period current account deficit starts to reduce due to advantages experienced by
depreciation. Depreciation of currency results in cheaper exports and costlier imports, thus
increase outbound trade of goods and services.
Capital Account-
All inflow and outflow of money for long-term investment purposes comes under capital
account. Capital account receipts and payments can be sub-divided into 3 heads- purchase
and sale of capital assets, FDI and FPI
Purchase and sale of capital assets- sale of capital assets by India is recorded as credit as it
results in inflow of money. Purchase of capital assets is recorded as debit as it results in
outflow of money from India. It is important to note that purchase and sale of capital assets
has an impact on future factor income (current account) as purchase of capital assets might
result in present outflow of money but may also result in inflow of interests, dividends or
profits in the future.

FDI and FPI- Foreign investment in Indian companies/ assets or in Indian economy by setting
up new companies/ units is called as foreign direct investment. Similarly, Indian investment
overseas is called ‘Overseas Indian Investment’.
Foreign portfolio investment refers to investment in Indian financial markets by purchase of

equity stake in companies. It differs from FDI as FPI is considerably for a shorter period and
does not amount to control in management of an invested company. On the other hand, FDI
results in purchase of substantial stake in a company to enable the investor to have a say in
management of the company. Both FDI and FPI are considered as capital flows as they result
in purchase of stake in an Indian company.
Technically, any investment in Indian financial markets above 10% stake in a company is
considered as FDI and investment equal to or less than 10% stake is termed as FPI.
Official Reserve Account-
There are 4 kinds of accounts under official reserve account:
• Gold
• Special drawing rights
• Foreign Exchange
• Reserve position in IMF
ORA refers to transactions undertaken by authorities to finance the overall balance and
intervene in foreign exchange markets.
Authorities can use ORA to either artificially change/ support value of Indian currency or to
balance the deficit in current or capital account. For example, If RBI wants to support value
of rupee, it would buy more rupee in the market using foreign exchange to increase demand
for rupee. On the other hand, if RBI wants to weaken rupee, it would exchange/ sell rupee
for foreign currency in the market to increase its supply.

Quality of Deficit-
Most developing countries experience BoP deficit due to demands of development and
growth, which need active government intervention to provide for everyone’s needs. It is
important to note that it is not necessary to achieve BoP equilibrium every year. The more
important thing to understand is quality of deficit in a country.
If a country is experiencing BoP deficit in the present due to heavy import of capital goods
that are necessary for economic development, the deficit can be self correcting in long run
because capital investments in the present would start generating competitive exports in
the future.
However, if a country is experiencing BoP deficit due to import of consumption goods like
FUEL or FOOD, the situation will not correct itself. Therefore, what matters is nature and
causes of di-equilibrium in an economy.
India experienced heavy BoP deficit in 1980s. However, that deficit was made for
consumption purposes, contributing to Indian bankruptcy in 1991.
Similarly, the present deficit in current account is due to heavy imports of FUEL/OIL from
west Asian countries. These imports are not contributing to future capital creation and thus,
its consumption/ import is not going to correct itself. The quality of a debt can be easily
identified with what a country is importing regularly.

TERMS IN FOREIGN EXCHANGE MARKET
A total of 4 important terms are to be discussed:
1. Nominal exchange rate
2. Real exchange rate and purchasing power parity
3. Nominal effective exchange rate (NEER)
4. Real effective exchange rate (REER)
Nominal and real exchange rate:
The price of one currency in terms of the other is known as exchange rate. For example, if 1
US Dollar costs Rs 50, this means that it costs Rs 50 to buy 1 US Dollar. This is the exchange
rate between USA and INDIA. This is also known as “Bilateral Nominal Exchange Rate”.
On the other hand, real exchange rate measures the ratio of foreign to domestic prices. This
means that real exchange rate compares foreign and domestic goods to find out parity in
prices of a basket of products.
Numerically, Real Exchange Rate = ePf/ P
Where e is the nominal exchange rate, Pf is the price of a particular good abroad and P is the
price of that same good in India/ domestic market.
For example, if a pen costs Rs 200 in India and $ 4 is USA with nominal exhcnage rate of Rs
50 per dollar,
Real exchange rate = 50 *4/ 200 = 1
A real exchange rate of 1 means that there is parity between price levels of products in two
countries real exchange rate > 1 means that foreign products are costlier/ expensive than
domestic products.
Real exchange rate helps to determine “International Competitiveness” of a country’s

products.
NEER and REER:

The above explanation of nominal and real exchange rate considers bilateral comparison.
The focus of NEER and REER is to look at multilateral comparison. NEER and REER enable us
to see the movement of domestic currency relative to all other currencies through a single
number.
NEER calculates price of a domestic currency in terms of a representative basket of foreign

currencies. It is measured by taking into consideration weights of international trade of each
foreign currency with respect to domestic currency.
REER is calculated as the weighted average of real exchange rates of all trading partners, the
weights being the shares of the respective countries in foreign trade. It is similar to real
exchange rate in concept, the only difference being “weights” of multiple foreign currencies.

History of exchange rate management systems in the world
The era of stable exchange rates/ Gold Standard-
The Gold Standard was followed between 1870 and 1914. Under this system, exchange
rates were fixed based on availability of gold in a country. Every currency was valued with
respect to gold and each currency was freely convertible to gold.
In order to maintain official parity between currencies, each country was required to have
an adequate stock of gold reserves. All countries in the gold standard experienced stable
exchange rates.
Before the gold standard, an approach called “mercantilist approach” was accepted,
according to which, unless a country intervened in foreign trade through tariffs and quotas,
it would lose out its gold reserves due to imports from other countries.
This approach was rejected by “David Hume” in 1752 when he stated that when a country
experiences heavy imports, the value of its currency falls, making its imports costlier and
exports cheaper. As a result, the exports of this country would rise, bringing its currency
back to equilibrium automatically.
The gold standard broke down with breakup of first world war due to many problems with
the standard.
Between 1914 and 1945, there was no global/ universal standard for currency valuation.
Many methods were tried and rejected by different countries on their own.
Fixed Exchange rate system-
In 1944, the Bretton Woods system was adopted after Bretton Woods Conference, which
set up the IMF and WB and a system of FIXED EXCHANGE RATE.

Unlike the gold standard, where every currency could be exchanged for Gold, under the
fixed exchange rate system, a 2-tier system of convertibility was established wherein every
currency could be exchanged for US DOLLAR and Dollar could be exchanged for Gold at a
pre-determined rate of $ 35 per ounce of gold.
This system was followed because distribution of gold in the world was uneven with USA
holding 70% of gold reserves. Direct convertibility of currencies into gold would require re-
distribution of gold, which was an impossible task.
However, acceptance of Dollar as a global reserve currency resulted in TRIFFIN DILEMMA
TRIFFIN DILEMMA-
• Triffin Dilemma relates to a country providing the world its currency as reserve
currency.
• According to the theory, the more popular the reserve currency is relative to other
currencies, the higher its exchange rate and the less competitive domestic exporting
industries become. This causes a trade deficit for the currency issuing country, but
makes the world happy.
• If the reserve currency country instead decides to focus on domestic monetary policy
by not issuing more currency then the world is unhappy.
• After WW-2, United states pumped dollars into the world economy through post war
programs like the Marshall Plan. This heavy pumping made it increasingly difficult to
stick to the gold standard. In order to maintain the standard, it had to both instill
international confidence by having a current account surplus while also having a
current account deficit by providing immediate access to gold.
• US Dollar experienced high current account deficit due to heavy imports and high
inflation due to oversupply of money in global as well as domestic economy.

The Bretton Woods System failed in 1967 due to the dual linkage between gold and US
Dollar wherein there was heavy flight from dollar to gold and countries like UK started
demanding the gold value of its dollar holdings.
The Smithsonian agreement was entered in 1971, which widened the band of movements
of exchange rates to 2.5% above and below the central rate. However, this agreement was
short lived and was replaced by “Floating system” or floating exchange rates. The floating
exchange rate system is followed by countries around the world in different formats.

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MICRO

versus MACRO Economics

© Anuj Jindal successrbigradeb@gmail.com 1

of production (land, labor, problems of the economy

© Anuj Jindal successrbigradeb@gmail.com 2

Macroeconomics as a separate branch:

© Anuj Jindal successrbigradeb@gmail.com 3

© Anuj Jindal successrbigradeb@gmail.com 4

© Anuj Jindal successrbigradeb@gmail.com 5

3. Fundamental reasons- there was no guarantee on bank deposits. In tough times,

© Anuj Jindal successrbigradeb@gmail.com 6

Basics of national income accounting

© Anuj Jindal successrbigradeb@gmail.com 7

Net Investment = Gross Investment – Depreciation

© Anuj Jindal successrbigradeb@gmail.com 8

Circular flow of income

• Land- remuneration received in terms of rent

• Labor- remuneration received in terms of wage

• Capital- remuneration received in terms of Interest

• Entrepreneurship- remuneration received in terms of profit

In a simple economy, after a good or service is produced, it is assumed that it is consumed

Similarly, the amount of remuneration paid to 4 factors of production by businesses is equal

© Anuj Jindal successrbigradeb@gmail.com 9

1. Aggregate value of expenditure by households (CALLED EXPENDITURE METHOD)

2. Aggregate value of goods and services provided by businesses and (CALLED

3. Aggregate value of factor payments/ income to households (CALLED INCOME

1. Value Added Method/ Product Method:

Total production 100 200

© Anuj Jindal successrbigradeb@gmail.com 10

Intermediate goods used 0 50

Value added 100 150

Total value added will be 100 + 150 = Rs. 250

Therefore, we can write-

So, GDP = GVA1 + GVA2 + GVA3.... + GVAn

In expenditure method, we calculate the final expenditure made by households to purchase

© Anuj Jindal successrbigradeb@gmail.com 11

a) Consumption expenditure for final consumption

b) Investment expenditure on capital goods for producing further goods or services

c) Expenditure made by government on final goods and services

d) Export revenues by selling goods abroad

Therefore, total value of revenues of a firm according to expenditure method (RV) = C + I +

Therefore, RV = C – Cimport + I – Iimport + G – Gimport + X

Considering expenditure and income method together, we get

© Anuj Jindal successrbigradeb@gmail.com 12

Since total spending is supposed to be equal to total income,

Rewriting it, we get

The above equation means that

I – S is excess of investment over saving in an economy,

This means that savings will be equal to investments in a simple economy.

© Anuj Jindal successrbigradeb@gmail.com 13

MACROECONOMIC IDENTITIES OR TERMS

The following macroeconomic terms will be covered under this heading:

1. Gross domestic product

2. Gross national product

3. Net national product

4. Net national product @ factor cost

6. Personal disposable income

7. National disposable income

9. Gross value added @ basic prices

10. Gross value added @ market prices

11. GDP @ constant market prices

12. GDP Deflator

13. Consumer price index (CPI)