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Economics For Finance
Economics For Finance
Economics For Finance
Net Value of all economic goods and services produced within the • For analyzing and evaluating the performance of an economy,
domestic territory of a country in an accounting year plus net factor • Knowing the composition and structure of the national income,
income abroad. • Income distribution, economic forecasting and for choosing
economic policies and evaluating them.
Disposable Income
Factor Cost = Market Price - Gross Domestic Product at Net Domestic Product at Factor Net National Product at Factor
Factor Cost (GDPFC) Cost (NDPFC) is defined as the
Cost (NNPFC) or National Income
Net Indirect Taxes = Market • GDP MP – Indirect Taxes + total factor incomes earned by
Subsidies the factors of production. • NNPFC = National Income
Price - Indirect Taxes +
• Compensation of employees • NDPFC = NDPMP - Net Indirect • FID (factor income earned in
Subsidies + Operating Surplus (rent Taxes
domestic territory) + NFIA.
+ interest + profit) + Mixed = Compensation of employees
Income of Self - employed + + Operating Surplus ( rent
Depreciation + interest + profit) + Mixed
Income of Self - employed
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Measurement of National
(Rent , Wages, Method or and entails the consolidation of the
Interest ,Profit) Production production of each industry less
Method intermediate purchases from all other
industries.
Income
income is calculated by summation
Income of factor incomes paid out by all
production units within the domestic
Method territory of a country as wages and
salaries, rent, interest, and profit.
Circular flow of Transfer incomes are excluded.
income
Two -Sector Model Three Sector Model Four Sector Model The Investment Multiplier
• John Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest and Money’ published in 1936 put forth a comprehensive
theory to explain the determination of equilibrium aggregate income and output in an economy.
• The equilibrium analysis is best understood with a hypothetical simple a two-sector economy which has only households and firms with all
prices (including factor prices), supply of capital and technology constant; the total income produced Y, accrues to the households and equals
their disposable personal income.
• The equilibrium output occur when the desired amount of output demanded by all the agents in the economy exactly equals the amount
produced in a given time period.
• In the two-sector economy, Aggregate Demand (AD) or aggregate expenditure consists of only two components: aggregate demand for
consumer goods and aggregate demand for investment goods / being determined exogenously and constant in the short run.
Circular Flow in a Two Sector Economy The Keynesian assumption is that consumption increases
with an increase in disposable income (b > 0), but that the
Wages,Rent,Interest,Profit increase in consumption will be less than the increase in
Factor Payment disposable income (b < 1).
(Y) The propensity to consume refers to the proportion of the
Factor input total and the marginal incomes which people spend on
consumer goods and services.
The proportion or fraction of the total income consumed
Households Firms is called ‘average propensity to consume’ (APC)= Total
Consumption /Total Income
Goods and Since Y = C + S, consumption and saving functions are
Services (O) counterparts of each other. The condition for national
Consumption income equilibrium can thus be expressed as C + I = C + S
expenditure Changes in income are primarily from changes in the
(C) autonomous components of aggregate demand, especially
from changes in the unstable investment component.
The investment multiplier k is defined as the ratio of change
Consumption function expresses the functional relationship in national i ncome (∆Y) due to change in investment (∆I)
between aggregate consumption expenditure and aggregate The marginal propensity to consume (MPC) is the
disposable income, expressed as C = f (Y). The specific form determinant of the value of the multiplier. The higher the
consumption function, proposed by Keynes C = a + bY marginal propensity to consume (MPC) the greater is the
The value of the increment to consumer expenditure per unit value of the multiplier.
of increment to income (b) is termed as Marginal Propensity The more powerful the leakages are, the smaller will be the
to Consume (MPC). value of multiplier.
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Keynesian Consumption Function Effects of Changes in Autonomous Income
Aggregate Demand
C =f(Y)
E
Consumption
Slope = b
I
450
a O Y0 Y1 Y2 X
(B)
S
Saving/Investment
Income Y E
I+ I
I S=I E
I
O
Y0 Y1 Y2 X
Consumption and Saving Function
Income Output
Y=C+S
Y
Three Sector Model
Saving
Consumption
C+S Payments
C+I < C+S House
B Business Taxes Government Taxes hold
C+I
C+I=C+S
C+I > C+S A E C
Government
Borrowings
45O
O Y1 Financial
Y0 Y2 X Market
(B) Investment Savings
Saving/Investment
S
Factor Payments Personal Income
S=I Factor
I I Market
E Factor Services Factor Services
O Y1 Y0 Y2 X
Income Output
Y1
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Government
Borrowings
Y
45O Financial
O Market
S,I,G Y Yi Investment Saving
Income (Output)
S+T
Determination of Equilibrium Income:
E1 Four Sector Model
I+G
G E
I C+S+T
(A) C+I+G+(K-M)
Aggregate expenditure
O Y Y1
E
Income (Output)
I+G+X
injection and national income increases. Conversely, if X<M,
there is net withdrawal and national income decreases.
The autonomous expenditure multiplier in a four sector O
model includes the effects of foreign transactions and is stated Y
as 1 against 1 in a closed economy.
1-(b+v) (1-b) Income(Output)
The greater the value of v, the lower will be the autonomous
expenditure multiplier.
An increase in the demand for exports of a country is an
increase in aggregate demand for domestically produced
output and will increase equilibrium income just as would an
increase in government spending or an autonomous increase
in investment.
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Government
Public Finance Redistribution Function
intervention
Market Failures
Stabilization Function
♦ The allocation responsibility of the government involves ♦ One of the key functions of fiscal policy and aims at
appropriate corrective action when private markets fail to eliminating macroeconomic fluctuations arising from
provide the right and desirable combination of goods and suboptimal allocation.
services. ♦ Concerned with the performance of the aggregate economy
♦ A variety of allocation instruments are available by which in terms of labour employment and capital utilization,
governments can influence resource allocation in the overall output and income, general price levels, economic
growth and balance of international payments.
economy such as, direct production, provision of incentives
♦ Government’s stabilization intervention may be through
and disincentives, regulatory and discretionary policies etc.
monetary policy as well as fiscal policy. Monetary policy
has a singular objective of controlling the size of money
supply and interest rate in the economy, while fiscal policy
aims at changing aggregate demand by suitable changes in
government spending and taxes.
Distribution Function
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Asymmetric Information
♦ Asymmetric information occurs when there is an imbalance
Spillover in information between buyer and seller i.e. when the buyer
effects knows more than the seller or the seller knows more than the
buyer. This can distort choices. With asymmetric information,
low-quality goods can drive high-quality goods out of the
market.
Either
consumers ♦ Asymmetric information, adverse selection and moral hazard
or producers affect the ability of markets to efficiently allocate resources and
result in costs Neighbourhood therefore lead to market failure because the party with better
or benefits that effects information has a competitive advantage.
do not reflect Externalities
as part of the
market price.
Consumtion
is collective in
nature
Third-party
effects or side-
effects Inadequate
Property Non-rival –
rights and consumption of
free rider the good
problems Pure Public
goods
Externalities cause market inefficiencies because they hinder characteristics
the ability of market prices to convey accurate information
about how much to produce and how much to buy. Since
externalities are not reflected in market prices, they can be a
source of economic inefficiency.
Non-
Indivisibility Excludable
Examples of Externalities
Negative Production Externalities
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P1
P A
Government interventions to correct Externalities
♦ One method of ensuring internalization of negative
Marginal Social Benefit
externalities is imposing pollution taxes. Pigouvian taxes
by ‘making the polluter pay’, seek to internalize external
costs into the price of a product or activity.
Q1 Q Quantity
♦ Pollution taxes are difficult to determine and administer
due to difficulty to discover the right level of taxation,
problems associated with inelastic nature of demand for Effect of Subsidy on Output
the good and the problem of possible capital flight.
♦ Tradable emissions permits are marketable licenses to
emit limited quantities of pollutants and can be bought
and sold by polluters. The high polluters have to buy more P
S=MPC=MSC
permits and the low polluters receive extra revenue from
selling their surplus permits.
S=E
MSB
Q Q1 Quantity
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Government Intervention in the case of Merit Goods: Government Intervention in the case of Demerit Goods
♦ Merit goods such as education, health care etc are socially ♦ Demerit goods are goods which impose significant
desirable and have substantial positive externalities. negative externalities on the society as a whole and are
They are rival, excludable, limited in supply, rejectable believed to be socially undesirable.
by those unwilling to pay, and involve positive marginal ♦ The production and consumption of demerit goods
cost for supplying to extra users. are likely to be more than optimal under free markets.
♦ Left to the market, merit goods are likely to be under- The government should therefore intervene in the
produced and under-consumed so that social welfare marketplace to discourage their production and
will not be maximized. consumption.
♦ The possible government responses to under-provision
of merit goods are regulation, legislation, subsidies,
direct government provision and a combination of Outcomes of Minimum Price for a Demerit Good
government provision and market provision.
♦ When governments provide merit goods, it may give
rise to large economies of scale and productive efficiency MSC=MPC
and there will be substantial demand for the same. Minimum price
P1
B
P MPB
Market Outcome for Merit Goods A
C
Cost/
benefit Marginal Social Benefit
Marginal Private Cost
Q1 Q Quantity of
B Marginal Social Cost
alcohol consumed
A Welfare loss from
P underproduction/
underprovision
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Price floor
150 150
Price ceiling
75 75
Q Quantity Quantity
Q1 Q2
Q1 Q2
Government Intervention for correction Information Failure Government Intervention for Equitable Distribution
♦ Government makes it mandatory to have accurate labeling ♦ One of the most important activities of the government is
and content disclosures by producers. For example: to redistribute incomes so that there is equity and fairness
SEBI requires that accurate information be provided to in the society.
♦ Some common policy interventions include:
prospective buyers of new stocks.
progressive income tax, targeted budgetary allocations,
♦ Public dissemination of information to improve unemployment compensation, transfer payments,
knowledge and subsidizing of initiatives in that direction. subsidies, social security schemes, job reservations, land
♦ Regulation of advertising and setting of advertising reforms, gender sensitive budgeting etc.
standards to make advertising more responsible, ♦ Government also intervenes to combat black economy
informative and less persuasive. and market distortions associated with a parallel black
economy
Through the use of budgetary instruments such as public revenue, public expenditure, public debt and deficit financing,
governments intend to favourably influence the level of economic activity of a country.
Fiscal Policy
Expansionary Fiscal Policy
Automatic
An expansionary fiscal policy is used to address recession and the
Objectives of Stabilizers
problem of general unemployment on account of business cycles.
Fiscal Policy Versus Instruments of Types of Fiscal
Discretionary Fiscal Policy Policy Expansionary Fiscal policy for Combating Recession
Fiscal Policy
Price LAS SAS1
Level
The objectives of Fiscal Policy SAS2
♦ Achievement and maintenance of full employment.
♦ Maintenance of price stability.
♦ Acceleration of the rate of economic development and P2
equitable distribution of income and wealth. P1
P3 AD2
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Instruments of Fiscal Policy Fiscal Policy for long term Economic Growth
♦ Government Expenditure : Generates income and also effect ♦ A well designed tax policy that rewards innovation and
of multiplier. entrepreneurship, without discouraging incentives will
♦ Taxes : Determine the size of the disposable income of public. promote private businesses who wish to invest and thereby
♦ Budget : A widely used tool to stimulate or contract aggregate help the economy grow.
demand.
♦ Public Debt: Public Borrowing and Debt Repayment system.
AD1
Y
Real GDP ( Y)
A Medium of
Exchange
Functions of
Money
Money
Characteristics Classical
of Money Approach(QTM) A Standard
A Store of Value
Neo Classical of Postponed
Theories of Approach Payment
Demand for
Money Keynesian Theory Inventory Approach Functions of
of Demand to Transaction Money
Balances (Baumol)
Post-Keynesian
Development in
the Theory of Friedman’s
Demand for Money Restatement of the
Quantity Theory
The Basis of
A Unit of Credit
The demand for Account
Money as Behavior
towards Risk
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♦ Generally acceptable
♦ Durable or long-lasting The Keynesian Theory of Demand for Money
♦ Difficult to counterfeit i.e. not easily
reproducible by people ♦ Keynes’ theory of demand for money is known as ‘Liquidity
♦ Relatively scarce, but has elasticity of Preference Theory’. ‘Liquidity preference’, a term that
Characterstics supply was coined by John Maynard Keynes in his masterpiece
of Money ‘The General Theory of Employment, Interest and Money’
♦ Portable or easily transported
♦ Possessing uniformity (1936), denotes people’s desire to hold money rather than
♦ Divisible into smaller parts in usable securities or long-term interest-bearing investments.
quantities or fractions without losing value
♦ Effortlessly recognizable
People hold money (M) in cash for three motives
Demand for Money
The demand for money is derived demand and is a decision Transactions motive
about how much of one’s given stock of wealth should be held ♦ The transactions motive for holding cash relates to ‘the
in the form of money rather than as other assets such as bonds
need for cash for current transactions for personal and
business exchange’.
Classical Approach : The Quantity Theory of Money ♦ Lr = kY, Where, Lr is the transactions demand for money,
♦ One of the oldest theories of Economics, was first propounded by k is the ratio of earnings which is kept for transactions
Irving Fisher of Yale University in his book ‘The Purchasing Power purposes and Y is the earnings.
of Money’ published in 1911. ♦ The aggregate transaction demand for money is a function
♦ There is strong relationship between money and price level and of national income.
the quantity of money is the main determinant of the price level
or the value of money. Precautionary motive
Fishers version of Equation : Equation of Exchange of ♦ Precautionary motive is to meet unforeseen and un
predictable contingencies involving money payments and
Transaction approach : MV = PT
depends on the size of the income, prevailing economic
♦ Where, M= the total amount of money in circulation (on an as well as political conditions and personal characteristics of
average) in an economy. the individual such as optimism/ pessimism, farsightedness
♦ V = transactions velocity of circulation i.e. the average number of etc.
times across all transactions a unit of money (say Rupee) is spent
in purchasing goods and services.
♦ P = average price level (P= MV/T). Speculative motive
♦ T = the total number of transactions. ♦ The speculative motive reflects people’s desire to hold cash
Fishers Extended version : Equation of Exachange to include in order to be equipped to exploit any attractive investment
opportunity requiring cash expenditure.
demand ( bank) depostits( M’) and Velocity in the total
♦ The speculative demand for money and interest are inversely
supply of Money : MV + M’V’ = PT
related.
♦ In the early 1900s, Cambridge Economists Alfred Individual’s Speculative Demand for Money
Marshall, A.C. Pigou, D.H. Robertson and John Maynard
Keynes (then associated with Cambridge) put forward
a fundamentally different approach to quantity theory,
known neo classical theory or cash balance approach. m
Cambridge equation = Md = k PY
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Aggregate Speculative Demand for Money ♦ The Demand for Money as Behavior
toward as ‘aversion to risk’ propounded
by Tobin states that money is a safe asset
but an investor will be willing to exercise a
trade-off and sacrifice to some extent the
r* The Demand higher return from bonds for a reduction
for Money
in risk.
Interest rate as Behavior
toward Risk ♦ According to Tobin, rational behaviour
induces individuals to hold an optimally
r1 structured wealth portfolio which is
r2 Liquidity Trap comprised of both bonds and money and
Region the demand for money as a store of wealth
r0
depends negatively on the interest rate.
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M1 = Currency and coins with the people + demand Current Practice : Money Multiplier Approach to
deposits of banks (Current and Saving accounts) + Supply of Money
other deposits with the RBI. ♦ The money multiplier is a function of the currency ratio which
M2 = M1 + savings deposits with post office savings banks.
depends on the behaviour of the public, excess reserves ratio of
M3 = M1 + net time deposits with the banking system.
M4 = M3 + total deposits with the Post Office Savings the banks and the required reserve ratio set by the central bank.
Organization (excluding National Savings The money multiplier approach to money supply propounded
Certificates). by Milton Friedman and Anna Schwartz, (1963) considers three
factors as immediate determinants of money supply
a) the stock of high-powered money (H)
New Monetary Aggregates b) the ratio of deposit to reserve, e = {ER/D} and
c) the ratio of deposit to currency, c ={C/D}
♦ Based on the recommendations of the Working Group on
Money (1998), the RBI has started publishing a set of four The additional units of high powered money that goes into
new monetary aggregates on the basis of the balance sheet ‘excess reserves’ of the commercial banks do not lead to any
of the banking sector in conformity with the norms of additional loans and therefore, these excess reserve do not lead
progressive liquidity. The new monetary aggregates are : to the creation of deposits.
Determinants of Money Supply : Two Theories Monetary policy refers to the use of monetary policy instruments
which are at the disposal of the central bank to regulate the
♦ Determined exogenously by central bank. availability, cost and use of money and credit to promote economic
♦ Determined endogenously by changes in the economic growth, price stability, optimum levels of output and employment,
balance of payments equilibrium, stable currency or any other goal
activities which affect peoples desire to hold currency of government’s economic policy.
relative to deposites, rate of interest etc.
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Interest Rate
Channel
Indirect
Instruments
Monetary Policy
Instruments A reduction in has the opposite effect. The SLR
the SLR during requirement also facilitates a
periods of economic captive market for government
Direct Indirect downturn securities.
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Repo on
Repo on Corporate Other Repos ♦ The Monetary Policy Committee
sovereign debt securities
securities (MPC) consisting of six members shall
determine the policy rate to achieve
the inflation target through debate and
♦ The Liquidity Adjustment Facility(LAF) majority vote by a panel of experts.
is a facility extended by the Reserve ♦ The Monetary Policy Framework
Bank of India to the scheduled Agreement is an agreement reached
commercial banks (excluding RRBs) between the Government of India and
The Liquidity and primary dealers to avail of liquidity the Reserve Bank of India (RBI) on the
Adjustment in case of requirement (or park excess Monetary maximum tolerable inflation rate as 4
(LAF) funds with the RBI in case of excess Policy per cent Consumer Price Index (CPI)
liquidity) on an overnight basis against Committee inflation with a deviation of 2 percent.
the collateral of government securities ♦ Choice of a monetary policy action
including state government securities. is rather complicated in view of the
surrounding uncertainties and the
♦ In India, the fixed repo rate quoted for need for exercising complex judgment
sovereign securities in the overnight to balance growth and inflation
segment of Liquidity Adjustment concerns. Additional complexities
Policy Rate
Facility (LAF) is considered as the arise in the case of an emerging market
‘policy rate’. like India.
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Export-Related
Important Theories of International Trade Measures
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Countervailing Duties
♦ Government Procurement Policies : Govt.
♦ Countervailing duties are tariffs to offset the artificially low may lay down policies w.r.t procurements.
prices charged by exporters who enjoy export subsidies ♦ Trade-Related Investment Measures : May
and tax concessions offered by the governments in their include rules on local content requirements
home country. of production.
Non- ♦ Distribution Restrictions.
Technical ♦ Restriction on Post-sales Services.
Measures ♦ Administrative Procedures.
♦ Rules of Origin : To determine the national
Create source of a product.
obstacles to ♦ Safeguard Measures : Initiated by countries
trade to restrict imports of a product temporarily
Increase Reduce the if its domestic industry is injured.
government prospect ♦ Embargos : Total ban on import or export
revenues of market of some commodition to a particular
access country or region for some or indefinits
period.
Effects of
Tariff
Technical Measures
Unit-III Trade Negotiations
♦ Sanitary and Phytosanitary (SPS) measures : applied to International trade negotiations, especially the ones aimed at
protect human, animal or plant life from risks arising form formulation of international trade rules, are complex interactive
addition, pests, contaninants, toxins or disease causing processes engaged in by countries having competing objectives.
organisms.
♦ Technical Barriers to Trade specifying details such as size,
shape, design, labelling/marking etc. Trade
Negotiations
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The major guiding principles of the WTO Unit-IV Exchange Rate and its Economic Effects
♦ Trade without discrimination, most-favoured-nation Exchange rate is the rate at which the currency of one country
treatment(MFN) exchanges for the currency of another country.
♦ The National Treatment Principle (NTP)
♦ Freer trade
♦ Predictability The Exchange Rate
♦ General prohibition of quantitative restrictions Regimes
♦ Greater competitiveness Exchange
International Rate and its Changes in
♦ Tariffs as legitimate measures for protection
Economic Exchange Rates
♦ Transparency in decision making Trade
Effects
♦ Progressive liberalization Devaluation Vs
♦ Market access Depreciation
♦ A transparent, effective and verifiable dispute settlement
mechanism.
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Qe Q1 $ (Billions)
International Trade
Home-Currency Appreciation under Floating
Exchange Rates
International Capital
e Movements
S$
S1 $
FDI FPI
Exchange Rate Rs/$
E
e eq Foreign direct investment is defined as a process whereby the
resident of one country (i.e. home country) acquires ownership
of an asset in another country (i.e. the host country) and such
e1 E1 movement of capital involves ownership, control as well as
management of the asset in the host country.
♦ Profits
Being an over-the-counter market, it is not a physical place;
♦ Higher rate of return
rather, it is an electronically linked network bringing buyers and
♦ Possible economies of large-scale operation
sellers together and has only very narrow spreads. ♦ Risk diversification
♦ Retention of trade patents
♦ Capture of emerging markets
On account of arbitrage, regardless of physical location, at any
♦ Lower host country environmental and labour standards,
given moment, all markets tend to have the same exchange rate ♦ Bypassing of non tariff and tariff barriers
for a given currency. Arbitrage refers to the practice of making ♦ Cost–effective availability of needed inputs and tax and
risk-less profits by intelligently exploiting price differences of an investment incentives.
asset at different dealing places.
Foreign direct investment takes place through
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