Study Material

STUDY MATERIAL
INDIAN ECONOMY
UNIT 2
BY PROF. SHIRSENDU ROYCHOWDHURY
SHIRSENDU ROYCHOWDHURY
ST.XAVIER’S COLLEGE ,KOLKATA
UNIT II
Indian Economy under different Policy Regimes
• Indian economy on the eve of Independence - low level of economic development

under the colonial rule in terms of agriculture, industry, and foreign trade )
• Composition of national income and occupational structure
• Growth and Structural Change Since 1950
• Coordination failure
• Evolution of Economic Planning and State-dominated import substitution
development strategy
• The post 1991 globalization strategies based on stabilization and structural adjustment
packages to stimulate growth through competition and trade
• Shift in policy direction from prescriptive to indicative planning
• Redefined role of the State
• Macroeconomic Policies and their Impact on the Indian economy - Fiscal Policy and
monetary policies.
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PROF. SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST. XAVIER’S COLLEGE (AUTONOMOUS), KOLKATA
Indian economy on the eve of Independence
• Low level of economic development under the colonial rule in terms of agriculture,
industry, and foreign trade
INTRODUCTION
At the time of Independence, Indian Economy was overwhelmingly rural and agricultural in
character with 85% of the population living in villages and deriving their livelihood from
agriculture and related pursuits using traditional, low productivity techniques. The backwardness
of the economy was reflected in unbalanced occupational structure where 70% of working
population was engaged in agriculture but still the country was not self-sufficient in food and raw
materials for industry. Average availability of food was not only deficient in quantity and quality
but also precarious (could collapse any time) which was exhibited in recurrent famines. 84%
(High) of population was illiterate with majority of children (60%) in the age group of 6-11 years
not attending school. Mass Communicable diseases were wide spread. In absence of good public
health service, mortality rate were very high (27 deaths per thousand population per year). An
average India born between 1940 and 1951 could expect to live for barely 32 years. Epidemics
and diseases like Small Pox, Plague, Cholera, Malaria and other fevers carried away millions every
year. So, in one line we can say that the Indian economy was a backward economy with mass
poverty, ignorance and diseases all–aggravated by unequal distribution of resources between
social, economic, religious groups and across different regions.
AGRICULTURE
Colonisation acted as a constraining factor in India’s agricultural and industrial development.
Agriculture stagnated and deteriorated over the years (1st half of 20th century), where full
impact of colonialism had began to be felt. Per capita agricultural production declined at the rate
of 0.72% per year during 1911 to 1941. For per capita food grain production the condition was
even worse. It declined by 29% between 1911 to 1941 at the rate of 1.14% per year. Per capita
non food grain output grew by 14% but it failed to make up for the decline in food grain
production. The increase in yield of non food grains was basically at the cost of food grain yields,
as cultivators shifted better and irrigated land and capital resources towards commercial crop
farming to earn cash.
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Causes of stagnation in Agriculture
1. Regressive agrarian structure:
In order to understand the regressive structure of agriculture, we need to first understand the
land revenue system under various land settlement systems under the British. The various land
settlement systems that were operating during the British are :
• Sub-infeudation tenancy
• Share cropping
• Zamindari System
• Ryotwari system
Sub-infeudation tenancy
The granting of a portion of an estate by a feudal tenant to a subtenant, held from the tenant on
terms similar to those of the grant to the tenant.
Sharecropping
Sharecropping is a form of agriculture in which a landowner allows a tenant to use the land in
return for a share of the crops produced on their portion of land. Sharecropping has a long history
and there are a wide range of different situations and types of agreements that have used a form
of the system.
Zamindari System
Zamindari System was introduced by Cornwallis in 1793 through Permanent Settlement Act. It
was introduced in provinces of Bengal, Bihar, Orissa and Varanasi. This was also known
as Permanent Settlement System. Zamindars were recognized as owner of the lands. Zamindars
were given the rights to collect the rent from the peasants. The realized amount would be divided
into 11 parts. 1/11 of the share belongs to Zamindars and 10/11 of the share belongs to East India
Company.
3
Ryotwari System
Ryotwari System was introduced by Thomas Munro in 1820. Major areas of introduction include
Madras, Bombay, parts of Assam and Coorgh provinces of British India. In Ryotwari System the
ownership rights were handed over to the peasants. British Government collected taxes directly
from the peasants. The revenue rates of Ryotwari System were 50% where the lands were dry
and 60% in irrigated land.
In all these systems the peasant class suffered the most. They had barely anything for their
subsistence, and so they relied on money lenders who used to charge very high rates of interest.
So the peasant proprietors fell into the clutches of moneylenders and lost control over their land.
The owners of the land usually used the surpluses for rack renting (usuary) and they did not invest
on land. As the investment was not taking place, so the farmers had to rely on traditional
techniques and could not use modern equipments. Hence agricultural sector remained regressive
(usage of traditional agricultural methods/ technologies), which was one of the reasons for
stagnating agricultural sector.
2. Internal Drain of Capital :
Agricultural surpluses were siphoned from this sector without any return to the agricultural
sector itself, subjecting it to an internal drain of capital. In the 18th & 19th Century, high land
revenue demand ate into peasant’s surplus and even his subsistence. Govt. spent very little on
improving agriculture. Landlords took no interest in agriculture beyond collecting rent. Rack-rent,
usuary (the action or practice of lending money at unreasonably high rates of interest) appeared
to be more profitable than making production in land. The moneylenders and merchants used
their increasing share of agricultural surplus to intensify usuary or to take possession of land and
become landlords.
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3. Poor Technology
The type of equipments changed very little till 1941. Modern machinery were absent.
All these reasons lead to the stagnation of the agricultural sector at the time of independence.
INDUSTRY
India’s Industrial situation in 1948 was the result of a long period of change. Modern Industry
replaced the traditional crafts. The ruining of the traditional arts and crafts was the result of
British commercial policy. Restrictions were imposed upon Indian exporting to the West, whereas
favours were granted to the British Exporters, who flooded the Indian market. Till the end of the
19th century, the only major large scale industry which had taken root in the country were
TEXTILES. So the Industrial development was confined to only Cotton and Jute Textile. Modern
Industries began to develop during the second half of the 19th century. The Iron and Steel
industry developed after 1907. Sugar, Cement, Paper Industry and Engineering Industry came up
in the 1930s. It has been noted by the Census of Manufacturing in 1951 that, Cotton and Jute
textiles contributed to nearly 60% of the total value added in Manufacturing and 30% of Total
Employment in Manufacturing Sector. A very important feature of Indian industrial structure was
the virtual absence of the capital or producers goods industry. Indian Industry had to rely wholly
on imported machineries and machine tools. Modern Banking and Insurance was grossly
underdeveloped. British controlled banks starved the Indian Industry or firms and favoured
British owned and controlled enterprises. This led to the Indian entrepreneurs not being able to
mobilize the available capital.
TRADE
Till the end of the 19th century, the only major large scale industries which had taken root in the
country were TEXTILES. Little attention was paid to improvement of agriculture or to the needs
of rural areas. Surplus (whatever available) were directed to the purchase of imports -partly of
better finished products from abroad and partly of equipments for the new transportation
system designed primarily in the interests of foreign commerce. Responsibility for promoting
modern commerce and industry came to be concentrated in the hands of certain classes in the
urban areas. The growth of foreign trade and rapid construction of railways, which could have
been the positive factor, unfortunately became the instrument for the underdevelopment of the
Indian economy. Under conditions of free trade, imports displaced indigenous handicrafts and
artisanal industries and prevented the rise of new industries. In the absence of a simultaneous
industrial revolution, similar to that of England, railways had only introduced commercial
revolution and further colonized the Indian Economy. The layout of railway lines and the railway
freight policy promoted the export of raw materials and distributed imported goods as they
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encourage traffic between ports as against traffic between inland centres. The railway did not
have any forward or backward linkages. They had served as a social overhead not for Indian but
for British Industry.
Note : A Social Overhead Capital (SOC) is the social capital mainly owned by the government that
is the basic facilities and services needed for the functioning of a community or society, such as
transportation (roads), education and health (schools, public libraries, and hospitals),
communications and utilities (telephones, water, electricity), etc. The SOC term can be used as
the economic overhead facilities and economic infrastructure.
Backward linkages of a product suggest what other products have contributed to make or
produce one particular product. And forward linkage refers to what other products can be built,
produced, or made using that particular product. The backward linkage for railways can be iron
and steel and all other necessary inputs and forward linkage can be all those industries which
benefitted from railways like capital goods industries, transport sector etc.
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REVIEW QUESTIONS :
1) Explain the condition of the Indian economy at the eve of Independence.
2) Explain the condition of industry, agriculture and trade at the eve of independence.
3) What is backward linkage and forward linkage?
4) What is social overhead capital ?
5) Explain the causes of stagnation of Indian agriculture at the time of independence.
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Composition of national income and occupational structure
Low degree of Economic Development can be judged from relative importance of various
economic activities in terms of their contribution to National Income and the workforce engaged
in those sectors.
Sector National Income Workforce

(1948-49) (1950-51)
Agriculture, Animal Husbandry, Forestry, Fisheries

49.1 72.3
Mines, Manufacturing, Industries, Small Enterprise

17.1 10.7
Trade, Transport and Communication

18.5 7.7
Other Services, Professionals, Administration, Domestic

Services
15.7 9.3
th
Ref: Bettlehem Charles, India Independent (p2) cross ref Uma Kapila (p35, 29 Edn)
Composition of NI: Statistics speaks for low level of Industrialization
• Agricultural Activities contributed to nearly 50% to India’s National Income

th
• Mines, Factories and small craftsmen’s work contributed only 1/6 in the National
Income
th
• Trade, Transport and Communication contributed a little more than 1/6
• Other Services (Professionals, Administration, Domestic Services) shows least
contribution in National Income
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Occupational Distribution: Summary
• Agricultural sector absorbed 72% of total workforce

• Less than 11% of workforce employed in all forms of Industries
• Organized Industries employed only 2% of workforce which is even lower than the
number of people engaged in administrative services (2.7%)
• Less than 8% employed in Trade and Transport
• Less than 10% employed in other services
9
REVIEW QUESTIONS :
1) Explain the composition of national income and the occupational structure at the time
of Independence.
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Growth and Structural Change Since 1950
Let us look at the following table :
Year Agriculture & allied Industry Services
1950-51 53.1% 16.6% 30.3%
1960-61 48.7% 20.5% 30.8%
1970-71 42.3% 24% 33.7%
1980-81 36.1% 25.9% 38%
1990-91 29.6% 27.7% 42.7%
1999-2000 23.2% 26.8% 50%
2012-13 13.9% 27.3% 58.8%
2013-14 13.9% 26.2% 59.9%
2015-16 15.4% 31.3% 53.3%
2017 15.5% 23% 61.5%
2019-2020 14.65% 30.29% 55.17%
2020-2021 16.38% 29.34% 54.27%
In the above table we considered the primary sector (agriculture and allied) , the secondary
sector (industry) and tertiary sector (industries). We considered the period from 1950 – 1951 to
2020-2021. The table shows the shares of the primary sector, secondary sector and the tertiary
sector as percentages of GDP.
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In 1950 – 51, agriculture had the highest share in GDP (53.1%), followed by the service sector
( 30.3%) and then the industrial sector (16.6%).
For the agricultural sector we found that the share steadily declined from 53.1% to 16.38%
(36.72%) in 70 years (1950-51 to 2020-21).
For the industrial sector we found that the share in GDP increased from by around 11% from
1950-51 to 1990-91, i.e till economic reforms but thereafter from 1991 to 2020-21 , it increased
by around 2 % to 3 %. So we see that from 1950 till economic reforms, industrial sector performed
well (11.1% increase in share) and thereafter the performance declined (only 2% - 3% rise in
share).
For the service sector, the rise in share was by 12.4% in the 40 years before economic reforms (
1950-51 to 1990-91) but then it increased by around 20% in the next 27 years.
So to summarise, the share of agriculture declined steadily from 1950-51 to 2020-21. The share
of industries initially increased before the reforms but then the increase was much less. But for
the service sector, it was just the reverse, that is, initially the service sector’s share increased by
only around 12% before reforms but thereafter the rise in share was by around 20%.
Analysis :
During 1950s and 1960s, research by Kuznets and Chenery suggested that, development would
be associated with a sharp decline in proportion of GDP generated by primary sector, counter
balanced by a significant increase in Industry and by a more robust rise in service sector.
Sectoral shares in employment were also expected to follow a similar pattern. However, a
sample of 123 countries were studied from 1970-1980. It was found that, the sectoral share
given up or sacrificed by agriculture as the economy matures goes more to the service sector
and less to the Industry than the Kuznets Chenery work had suggested. The modern view is
that as an economy matures, the share of services in output, employment and even in
consumption grows along with the decline in agriculture. By contrast, the share of industry first
increases modestly and then stabilizes or declines.
So India’s Growth experience can be characterized by the following:
A decline in the share of agriculture in GDP and an increase in the share of Industry and then
by relatively more rise in services. This reflects a significant change in the structure of Indian
Economy.
Two questions that we need to address here are :
1) Is service led growth sustainable ?
2) What about employment generation ?
Is Service led growth sustainable ?
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India was witnessing a service sector led growth and the question of un-sustainability of this
service led growth was being asked. The entire decline in the share of agricultural sector has been
balanced by an increase in the share of service sector. Thus the resilience of the economy to
shocks owes to the service sector which has the largest share and the most consistent growth
performance.
In the absence of sufficiently high growth in agriculture and industry, services would be seriously
constrained to sustain growth acceleration auto-pilot mode since many of these services are
dependent buoyancy in the commodity producing sector especially the industry. The
unemployment growth of India’s service sector, with no corresponding growth in the share of
manufacturing sector, has caused many cynics to raise doubts about its sustainability in the long
run.
What about employment generation ?
The biggest drivers of the service sector expansion since 2004-05 was communication and
banking & insurance sector. Robust growth in these sectors primarily drove the expansion of the
service sector even after 2010-11. Real estate and business services also gained a fair amount of
share. However some segments of the service sector also registered a decline after 2010-11 and
these included domestic trade, hotels and storage. The inability of some of these employment
intensive sectors to attain sustained momentum is one of the reasons for the less than
commensurate growth in employment in services.
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REVIEW QUESTIONS :
1) Explain the growth and structural change that took place in the Indian economy since
Independence.
2) Is service – led growth sustainable ?
3) Why service sector has not been able to generate adequate employnment ?
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Coordination failure
Coordination Failure is a State of affairs in which the inability of economic agents to coordinate
their behaviour (choices) leads to a state of bad equilibrium, where all economic agents are worse
off. This situation arises due to difference in expectation by different agents leading to lack of
coordination among them. Here each agent waits for the other agent to take their first move and
the bad state could have been avoided by ensuring perfect coordination between economic
agents. The country could have been and the economic agents would also be better off by
coordinating with each other. Even when the information was given to the economic agents,
there was an alternative preferred equilibrium state (good equilibrium) , their failure to
coordinate have led to the trap of bad equilibrium.
Example :
In a village there are farmers, whose children are not educated and work in fields. Then there is
a firm who wishes to open an unit in that village, but for the firm to open an unit there, they need
educated skilled labours which is only possible if farmers educate their children. Again the
farmers children work in fields and do not receive education. To educate their children, the
farmers have to bear a cost and the farmers cannot afford to do that unless they are sure that
their children will get job in a firm.
So, the firms can open an unit only if farmers educate their children so that they get skilled
labours nearby. And farmers will educate their children only if the farms open an unit and they
are sure that their children will get the jobs.
So, the farmers will expect the firms to invest and open an unit first and then they would educate
their children and the firms will expect the farmers to educate their children first and then they
will open an unit so that they get skilled labours there otherwise they will incur losses.
Now let us think of two situations :
Situation 1 : Firms invest and farmers educate their children.
Situation 2 : Firms expect that children should be educated first and so they do not invest and
farmers expect that firms should invest first and then they would educate their
children.
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In the first situation, both the farmers and firms are better off, and the economy is also in a better
position. So we call it good equilibrium.
In the second situation, the farmers will not educate their children and the firms will not invest.
So the economy will be stuck in a bad equilibrium. And this happens due to mismatch of
expectations. The farmers expect the firms to invest first and the firms expect the farmers to
educate their children first.
The second situation is called co-ordination failure. This happens because each agent expects the
other to make the first move. This leads to a good equilibrium.
The first situation happens when there is perfect coordination and it leads to good equilibrium.
COORDINATION FAILURE AND THE TRAP OF UNDERDEVELOPMENT
Indian economy during the time of independence was in a period of stagnation. The reason for
this was that it was stuck in a vicious circle of poverty. This vicious circle of poverty is also called
poverty trap or low level equilibrium trap. One of the reasons for the economy to be stuck in the
vicious circle of poverty is Co-ordination failure.
What is vicious circle of poverty ?
Vicious circle of poverty refers to a state where the economy remains stuck in a poverty situation
because some situations occur in a cyclical manner in such a way that the conditions that are
required for poverty to continue remains.
One of the main reasons for poverty to remain is low per capita income. Now, it can be shown
both from the demand side and supply side that due to certain cyclical conditions, the per capita
income will remain low.
VICIOUS CIRCLE OF POVERTY FROM SUPPLY SIDE
Let us start from the point of low per capita income. If per capita income is low, then per capita
savings and per capita consumption will be low. If per capita savings is low, then per capita
investment will be low. If per capita investment is low, then per capita capital formation will be
low and if per capita capital formation is low, then per capita output will be low, if per capita
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output is low then per capita income will be low. So we see that we come to the same starting
point. So, it is referred to as a circle as the starting point and ending point is same. This circle will
go on and on ultimately perpetuating mass poverty.
low per low per

capita capita
income savings
low per low per

capita capita
output investment
low per
capita
capital
formation
VICIOUS CIRCLE OF POVERTY FROM DEMAND SIDE
Let us start again from the point of low per capita income. If per capita income is low, then per
capita savings and per capita consumption will be low. If per capita consumption is low, then the
demand will be low in the economy. If the demand is low, then it means that the market size will
be narrow. If market size is narrow then investment will be low because no one will like to invest
if the size of the market is narrow. If investment is low, then output and income will be low and
again per capita income will be low.
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low low
income demand
narrow
low output
market size
low
investment
So, the economy was caught under the vicious circle of poverty. Thus the economy was at a state
of bad equilibrium.
How to break this trap?
In order to break this trap, one needs to increase Investment per capita so as to increase capital
formation leading to increase in output. However, as the income rises from a very low level,
population (also rises and if rate of change in population is higher that the rate of change in
Income then ultimately per capita income decreases. Therefore, a small increase in income is
not going to solve the problem. There has to be a substantial increase in income. Small
incremental change will not be able to solve the problem. This requires substantial increase in
Investment.
Immediately after Independence, any big Increase in Investment was constrained by two factors:
• On the supply side, increase in Investment was constrained by low level of savings
• On the demand side, there was little incentive to invest as the market size was very
narrow and the industries did not take initiative to take up investment due to small size
of the market. So establishment of modern industry did not happen.
Thus at the supply side problem of low per capita savings cannot increase investment and
therefore income cannot grow substantially. If per capita savings increases substantially then
income will increase but income cannot increase as per capita savings is low. The demand side
problem is due to narrow market size. Low per capita savings cannot be solved unless there is
substantial rise in income. Income cannot rise unless there is substantial rise in investment. And
investment cannot rise when the market size is narrow. Thus the economy was caught in a state
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of bad equilibrium (Low level equilibrium trap). The increase in income permitted by low level of
investment per capita was virtually neutralised by the rise in population.
The growth of India between 1850 and 1947 was 0.5% which was quite low. Whatever saving
was done by the rich was in non-reproducible assets ( A tangible asset with unique physical
properties, like land, mine or a work of art ). According to Rosenstein Rodan and Hirschman many
of the investments that did not happen due to the lack of initiatives by the investors reflects the
problem of coordination failure. Many investments did not happen because other
complementary investments did not take place, that is former investments were missing.
Sources of coordination failure:
• INTER INDUSTRY LINKAGE:-
The expansion for transportation network will reduce the cost of inputs used by the other sectors
and thereby encourage investment and expansion of that sector. This is called Supply Link.
Similarly, an expansion of the transportation network will increase the demand for the inputs
used by that sector such as actual steels, cement etc. and thereby help in the expansion of that
sector. This is called Demand Link.
Although the positive external benefit of investment is very large, the benefit for private
investment is low. Therefore investors do not come with their investment plans.
• DEMAND COMPLEMENTARITIES:-
It arises when an expansion of any industry increases the income and the demand for the
products of the other industries. For example, car and petrol are complementary. For investment
in the car industry, it is needed that someone should invest in petrol pumps. So these two
investments are complementary.
Each investor would invest if it were to believe that, the demand would be high. All investors
would invest if they expected high demand in the market.
India was in a bad state of equilibrium and investment pessimism was quite likely and this state
of things would keep India in a state of bad equilibrium.
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REVIEW QUESTIONS :-
1) Explain co-ordination failure with an example.

2) Explain vicious circle of poverty from demand side and supply side.
3) Explain the sources of coordination failure.
4) Explain how co-ordination failure acted as a reason for India being stuck in a low
level equilibrium at the time of Independence.
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EVOLUTION OF PLANNING
• Evolution of Economic Planning and State-dominated import substitution development

strategy
• The post 1991 globalization strategies based on stabilization and structural adjustment
packages to stimulate growth through competition and trade
• Shift in policy direction from prescriptive to indicative planning
• Redefined role of the State
INTRODUCTION :-
From the above discussion it is clear that coordination failure was one of the main reasons for
the economy to be stuck in a bad equilibrium. So, in order to move to a good equilibrium, perfect
coordination among economic agents was needed. So, there was the need of a co-ordinating
agency. In case of India, the Government played the role of a coordinating agency through the
formation of the Planning Commission in 1950. Once the Government takes the economy to a
higher or a good state, it can reduce its intervention as the higher state of equilibrium or a good
equilibrium would be maintained automatically. Once the economy reaches a preferred state of
equilibrium, there is no more change in the behaviour of agents which bring back the economy
to a bad state.
What are the structural constraints faced by the Indian economy during the time of
Independence that led to the formation of Planning Commission in 1950 ?
Just after the attainment of Independence , the Government of India set up the planning
commission in 1950 with two objectives :
i) Make an assessment of the material, capital and human resources of the country and
ii) ii) to formulate a plan for the most effective and balanced utilization of the country’s
resources.
Resources in the underdeveloped country being scarce, it was essential to identify the leading
sectors and use the scarce resources there rather than diffusing the resources all over. An
economy like India which has stagnated for a long time cannot grow unless a “Big Push” was
given to it. The Indian economy needed this kind of push when the country got independence in
1947. The factors perpetuating structural backwardness are described below :
1) The basic constraint on development was the acute shortage of material capital which
prevented the introduction of more productive technologies.
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2) The capacity to save was low which acted as a limitation to the speed of capital accumulation.
3) The structural limitation prevented conversion of savings into productive investment.
Therefore, even if domestic capacity to save was increased by suitable fiscal and monetary
policies, it could not be transformed into productive investment.
4) It was assumed that agriculture operated according to diminishing returns to scale whereas
industrial sector operated according to increasing returns to scale. So the surplus labour which
remained underemployed in agriculture could be employed more productively in Industrial
sector.
5) It was assumed that introduction of free market mechanism would result in excessive
consumption by the upper-middle class along with relative underinvestment in sectors essential
to the development of the economy.
6) Unequal distribution of income was considered to be a “bad thing” but redistribution was not
the right option because redistribution means transfer of income from the rich, who have a high
marginal propensity to save, to people who are relatively poor , with very low marginal
propensity to save, which means redistribution of income would lead to the fall in aggregate
savings of the economy. So there was a tolerance towards income inequality provided it was not
excessive and could be seen to result in a higher rate of growth.
Given all these perceptions it was felt that the basic questions relating to how much to save,
where to invest and in what forms to invest could be best handled with the help of a plan. This
led to the formation of planning commission in 1950.
Phase Wise Economic Planning
The entire plan period can be divided into the following four phases:
• Phase I (1950-65): Sustained growth Phase with Heavy Industrialization and Import
Substitution Strategy
• Phase II: Redistributive development strategy (1966-80)
• Phase III: Period of recovery (1980-91)
• Phase IV: Period of Economic reform (1991 onwards)
Phase I (1950-65): Sustained growth Phase with Heavy Industrialization and Import
Substitution Strategy
Immediately after independence, Govt’s main concern in Economic policy was

• to control persistent and severe inflationary pressure
• to alleviate shortage of essential food items (aggravated by partition of country at time
of independence)
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First Five Year Plan (1951-56) :
• India embarked upon the programme of planned economic development of the

country.
• Agriculture - price stability- Power – transport
Second FYP (1956-61) :
• Rapid industrialization- heavy & basic Industries ( Mahalanobis plan )
Third FYP (1961-66) :
• Based on the experience of first two plans agriculture was given top priority to support
the exports and industry
• Its aim was to make India a 'self-reliant' and 'self-generating' economy.
• Import Substitution Industry
• Failure Due to: Chinese aggression 1962, Indo-Pak war 1965, Severe drought 1965-66.
Summary :
The first phase spanning over three five years plan emphasized on the nature of country’s
development problem and on various options for mobilizing resources and achieving
development with more equal distribution. But on balance the plan rejected radical solutions
especially in respect of redistribution of wealth and incomes. According to Jawaharlal Nehru
without increasing the size of national cake a redistribution program can only redistribute
poverty. Therefore the first plan targeted towards long run growth of national income. The first
plan projected that saving and investment as proportion of national income would rise from an
estimated 5-6 %in early 50s to 20 % by 1968-69. Aggregate national income expected to double
in approximately 20 years and per capita income in 27 years.
The completion of first plan was followed by a very ambitious second five year plan. The
plans author P C Mahalanobis provided an analytical foundation for it with two sector closed
economy growth model.
Mahalanobis Growth Model
Sector I: This sector will produce investment goods with sector specific capital.
(Concentration of scarce investment in expanding capital goods producing heavy industry)
Sector II: This sector will produce consumer goods.

(Employment of abundant labour resources to manufacture consumer goods)
The fundamental insight of this model was that the greater proportion of investment devoted
to increasing the capacity of the investment goods sector to foster the long run growth in
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consumption and investment. Current consumption demand was to be met by employing
surplus labor resources to manufacture consumer goods using labor intensive technique of
production. The encouragement of labor intensive forms of producing mass consumption
goods was seen to be an important way of reconciling the conflict between emphasis on
heavy industry which would generate growth of income and employment in long run and
need to generates adequate jobs for currently unemployed and underemployed people.
Therefore the 1956 industrial policy resolution emphasized that, state must play a progressive
role in the development of industries.
Mahalanobis Planning model had a deep disbelief about the role of trade as an engine of
growth. The Mahalanobis strategy of second five year plan continued into the third plan in a
different way. The policy model that went along with Mahalanobis planning model was that
of Import Substituting Industrialization.
Import Substitution Strategy (ISI)
ISI is a trade and economic policy which advocates replacing foreign imports with domestic
production so as to reduce foreign dependency through local production of industrialized goods.
It is basically a state lead development through nationalization, subsidization of vital industries
(agriculture, power generation etc) and highly protectionist trade policies .It is a state directed
centrally planned form of economic development in promoting state induced industrialization
through government spending.
ISI involves the following strategies:
- An active industrial policy to subside the production of strategic substitutes.
- Barriers to trade (such a tariff, quota etc.)
- An overvalued currency .
- Discouragement of FDI
How did State Dominated Import Substitution Development Strategy help to overcome the
problem of Coordination Failure ?
In the presence of massive coordination failure and acute deficiency of organizational capital, the
state was not expected to produce entrepreneurs who are capable of making several investments
that would push the economy to a higher growth trajectory but the state played an important
role in overcoming the problem of coordination failure by making investment planning one of
the core areas of state action. Investment planning is essentially the task of making a choice
between the investment projects. A good investment is one that increases growth and decreases
poverty. The investment package of India in the 1950s was inspired by the ‘Soviet’ model of
achieving self sufficiency in a world dominated by giant MNCs of the capitalist countries. Thus,
the investment planning was expected to push the economy on the higher growth path. In order
to build or develop a modern industrialized economy by refusing the dependence on external
sources the state was given the task of developing the machine building or capital goods
industries. The private sector would not invest in these industries as it requires huge amount of
initial capital that can generate increasing returns to scale but at the same time involves risk. This
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was the backdrop of the state emerging as supreme entrepreneurs in the development of
machine building industries. The availability of capital goods was expected to ease out the
physical capital shortage faced by potential investors and increase private investment. Importing
Capital goods will not solve the problem due to Foreign Exchange constraint. In order to make
domestic production of mass consumer goods highly profitable, the Import Substitution industry
was expected to overcome coordination problem through Inter-industry Linkage and Demand
Complementarities.
1) Inter-industry links:
The expansion of machine-building industries will encourage the expansion of many other sectors
by providing them the necessary capital goods at reasonable cost. This is an example of supply
link. On the other hand the expansion of capital goods sector will raise the demand for input need
by the capital goods sector, such as steel.
2) Demand Complementarities:
The planned expansion of capital goods sector and mass consumption goods industry will help to
raise income and generate demand for the product ofother sectors.
In a state-dominated ISI strategy, it was believed that, the entry of State as entrepreneur and
that too in the field of high risk capital goods sector will help to remove/reduce the primary
uncertainty faced by private investors and open up investment opportunities.
Trickle Down Theory
The first three five year plans had two objectives:

1)The growth objective
2)The employment objective.
The plan performance shows that the plans had to some extent succeeded in initiating some
growth in per capita income. But the objectives of poverty eradication, reduction in inequality of
income and rapid expansion of employment opportunities were been fulfilled. The first three five
years plan relied on what is known as Trickle Down strategy for poverty eradication. According
to P C Mahalanobis the poverty problem can be reduced by growth oriented measures. The
growth oriented measure would benefit the well of section of the population. It was expected
that the income rise of the affluent section would percolate down to the lowest strata of the
society. But the trickle down theory failed to show its impact for the following reasons:
1. Growth rate was not very high for percolation theory to work. It was below 4 per cent
where as at least 5 per cent growth rate is required for this theory to bring some
changes.
2. High population growth rate.
3. The maximization of rate of growth may need a capital intensive technology but in
that case rise in employment does not take place. The adoption of labor intensive technology
may rise employment potential but growth potential will suffer. In Indian circumstances there
was some inconsistency between growth and employment objective. The second five year plan
25
emphasized on capital intensive technology and it raises employment opportunities for skilled
labor.
Performance of Indian Economy in Phase I:
• 8 to 10 per cent compound growth rate of industrial output.

• 3-3.5 per cent growth rate in food grains output.
• Around 1.75 per cent growth rate in per capita output.
Characteristics:
• Fairly sustained growth in per capita income.
• Distinct acceleration in public sector investment.
• Growth of industrial output.
Therefore the first phase was dominated by growth oriented development strategy.
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Phase II: Redistributive development strategy (1966-80)
Three Annual Plans (1966-69) : Plan holidays

Economy absorbed the shocks generated during the Third Plan.
Major events:
• Devaluation of rupee
• Inflationary recession
• Postponement of Fourth FYP
• New agricultural strategy (Green Revolution)
Fourth FYP (1969-74)
• Growth with stability
• Progressive achievement of self reliance
• Big Failure due to Influx of Bangladeshi refugees before and after 1971 Indo-Pak war
Fifth FYP (1974-79) : (till 78)
• Removal of poverty (Garibi Hatao)
• Attainment of self reliance
Janta Party came to power in 1978, the Plan was terminated.
Rolling Plan (1978-80)
• Janta Govt. put forward a plan for 1978-1983 emphasizing on employment.
• Lasted for only 2 years.
• Congress Govt. returned to power in 1980 with a different plan directly attacking on
poverty
Summary
The 50’s and 60’s were marked by relatively strong and stable Government under the control of
both central and State Government. As stated by Tendulkar, whatever success had been claimed
for the growth oriented development strategy of the first phase could be attributed to the
credibility of the planning process. The atmosphere changed dramatically after severe drought
and foreign exchange crisis in mid 60’s. The sudden increase in defence expenditure consequent
to the armed conflict with China and Pakistan and the decrease in foreign aid all in the short span
of three years (1962-65) put the economy under severe strain. A crisis occurred when two
consecutive droughts occurred in 1966 & 1967 and real GDP declined in absolute terms. This
sharp deterioration of the economic situation highlighted two main weaknesses of the existing
strategies. They are
1. Relative neglect of agriculture
2. A critical dependence on foreign aid
The two year period (1966-67) witnessed the worst drought during that phase and consequent
famines in the large parts of North India. At the same time, all aid was cut off to India by donor
countries on account of Indo-Pak war in 1965, including food aid. The consequence was a virtual
27
collapse of the economy and recourse had to be taken to extraordinary financing from IMF and
the World Bank which were accompanied by stiff conditionalities. This traumatic experience
brought food security concern into the forefront. It was again observed that sustained
industrialization was not possible without adequate provision of wage goods. The fourth plan
conceived after three years of plan holiday had to have food security as it’s centrepiece. The fifth
plan (1974-79) recognized that, growth and industrialization could not necessarily improve the
living conditions of the people, particularly the poor. The concept of ‘minimum needs’ (i.e.
primary education, medical care, road communication, supply of pure drinking water and so on),
implementation of special programmes, greater equalization of consumption level and anti
poverty programmes were the innovations of this plan. Therefore during 4th and 5th FYP, there
was a clear diversion of resources from development and investment oriented activities to
populist programmes. Due to increase in Govt. expenditure there was a sharp increase in budget
deficit, which created the demand for loanable funds in the country. It caused an increase in the
rate of interest which in turn led to crowing out of investment. [ Budget deficit increases if
Government expenditure is more than taxes, and in order to finance the deficit, the Government
demands loans from the loanable funds market. Now, increase in demand for loans increases the
rate of interest. If rate of interest rises, then investment demand falls. This fall in investment due
to rise in investment is called crowding out of investment]. It was responsible for almost stagnant
growth rate (3.5%) of the country over the period 1965-80. Due to scarcity of investment,
industrial sector also showed a stagnation during mid 60’s. As a result during the second phase
of planning, India’s share became marginal in the world market.
Hindu Rate of Growth

Hindu rate of Growth refers to the low annual growth rate of National Income and Per Capita
Income that India experienced before1991 i.e. between the period from 1950’s to 1980’s. The
Growth rate of NI stagnated around 3.5% while per capita income averaged around 1.3%. The
low per capita income led to sharp rise in poverty.
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• Phase III: Period of recovery (1980-91)
Sixth FYP (1980-85)

• Increase in national income,
• Modernization of technology,
• Poverty & Unemployment Reduction:
Schemes for transferring skills – Training of Rural Youth for Self Employment (TRYSEM)
Integrated Rural Development Programme (IRDP)
Providing slack season employment – National Rural Employment Programme (NREP)
Seventh FYP (1985-90)
• Major focus: food, work & productivity
• Very Successful (Hindu Rate of Growth - 5%)
• The first signs of India's balance of payments crisis became evident in late 1990, when
foreign exchange reserves began to fall.
Summary
The third phase planning spanned roughly over the 6th and 7th Five year plan period. Observing
the industrial stagnation during mid 60’s to 70’s, the 6th plan (1980-85) for the first time
recognized that the success of Mahalanobis Heavy Industrial Strategy in raising the savings rate
of the country had to create a situation where excess capacities were becoming evident in certain
industries. A shift in the pattern of industrialization with lower emphasis on heavy industries and
more on infrastructure begins here.The basic objective stressed in the 6th plan was described as
modernization which was mainly about innovation that is introduction of modern science and
technologies. The other objectives were social justice and self reliance.
The 7th Five Year Plan (1985-90) represented the culmination of this shift. In perspective, it may
justifiably be termed as the infrastructure plan. It was during this period, the a reappraisal of the
import substitution policy began and a gradual liberalisation of the Indian economy was initiated.
The fiscal expansion of 1980’s, accompanied by some liberalization of economic activity
generated real GDP growth of more than 58% per year. During this period, growth in GDP per
capita was 36% per year. The sharp step up in growth rates not only in aggregate, but also sector-
wise suggest that, 1980-81 was the turning point. Therefore this period was known as ‘period of
recovery’. The period of recovery led to the emergence of deficits. Because, to meet huge fiscal
expenditure, Govt. took loans from IMF and World Bank under stiff conditionalities. Since, India
is marginalized in the world market, it’s demand for loans failed to influence the international
rate of interest. As a result, it led to huge fiscal deficit along with trade deficit, which is known as
Twin Deficit. This deficit driven growth was not sustainable and therefore it led to the
macroeconomic crisis of 1991.
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Phase IV: Period of Economic reforms (1991 onwards)
Economic Reform (1991)

• Severe balance of payments crisis
• foreign exchange reserves began to fall.
• Liberalisation, Privatization, Globalization policy was introduced
Eighth FYP (1992-97)
• Worsening Balance of Payment position,
• rising debt burden & widening budget deficits
• recession in industry
• Inflation
• share of public sector in total investment declined to 34 %
• The eighth plan was postponed by two years because of political uncertainty at the
Centre
Ninth FYP (1997- 2002)
• Growth With Social Justice & Equality
• priority to agriculture & rural development
• Depend predominantly on the private sector Indian as well as foreign (FDI)
• State as of facilitator in social sectors like education, health etc. and infrastructure
Tenth FYP (2002-2007)
• Reduction in gender gaps in literacy and wage rate,
• Reduction in infant & maternal mortality rates,
• Access to potable drinking water
• Cleaning of major polluted rivers, etc.
• Greater involvement of panchayati raj institutions. (decentralization of power)
• Achieve balanced development of all states.
Eleventh FYP (2007-12)
• 7.6% GDP growth rate
• Objective was ‘Towards Faster & More Inclusive Growth’
Twelfth FYP (2012-17)
• Objective: Faster, Sustainable & More Inclusive Growth
• Dropped in 2017. NITI Aayog replaced planning commission on 1st January, 2017
The 8th Five year plan was undertaken during the crisis of 1991. The dramatic events and policy
initiatives of the two year plan holiday (1990-92) demanded a full appraisal of planning
methodology and the 8th plan represented the first efforts at planning for a market oriented
economy.
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Post Reform Development Strategy to Stimulate Growth through Competition and Trade
Backdrop:
In sharp contrast to the period of the 1960s & the 1970s, GDP growth rate picked up in the 1980s
to 5.81%. However, higher growth was financed by massive internal and external borrowing.
What is important is not the quantum of growth but the quanlity of growth. Resources were
diverted from capital investment programs in infrastructure, health and education to promote
populist relief type spending. Infrastructural bottlenecks in power, roads, railways,
telecommunication put a break on private investment. While the slowing down of public and
private investment contributed to the slow growth of the supply of output, reckless rise in the
Govt. spending overheated the demand side of the economy by the late 1980s. This pushed the
economy to a medium-term path of stagflation. The years of financing budget deficit through
monetisation had already led to liquification of the economy. The superimposition of monetary
factors on overheated real sector further fuelled inflation. The mounting fiscal and trade deficit
finally brought the expansionary programme to a halt, however by that time the economy got
entangled in the debt trap. Although the faulty macroeconomic policies brought the macro crisis
to the forefront, fundamental causes of the crisis was traced to growing inefficiencies of the
system of production and non-competitiveness of the country’s exportable due to Import
Substituting Industrialisation Strategie (ISI), to subversion of market faced through a plethora of
controls & restrictions and to the public sector’s dominance over the core sector.
The economic reforms consisted of the macroeconomic stabilization programme and the
structural adjustment programme (SAP)
The macroeconomic stabilization programme consisted of
1) 18% devaluation of rupee in two successive stages;
2) Reduction in fiscal deficits through expenditure compression and tax reforms;
3) Partial privatization
4) Autonomy of RBI in the conduct of monetary policies was adopted to tide over the fiscal
and Balance of Payment crisis.
These measures were supplemented by
a. Transition to a system of market driven exchange rate with current account
convertibility of rupee.
b. Permitting selected Indian corporates to raise funds from international capital
market.
c. Encouragement of capital inflows by way of foreign institutional investments (FII ),
Foreign Direct Investment (FDI ) and NRI deposits.
But to address the fundamental problem behind the crisis, structural reform measures were
undertaken in the sphere of industries, financial sector and trade.
1. The ISI strategy was gradually given up through phased liberalization of exports and
Imports.
2. Policies aimed at raising productivity in domestic industries were undertaken like
a) Dismantling of investment licensing
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b) Entry of private sector into industries that were reserved for the public sector.
The basic aim of the reforms in the real sector has been towards creating a more competitive
environment in the economy as a means to improving the productivity and efficiency of
production units.
The real sector reform was complemented by thorough overhaul (renovation) of the financial
sector during the 1990s. Major features of the reform were:
1) Partial privatization of a number of public sector banks and financial institutions.
2) Entry of private banks, mutual funds and other financial intermediaries.
3) A cutback in the Statutory liquidity ratio (SLR ) from 38% to 25% and Cash reserve
ratio(CRR ) from 15% to 5% respectively.
4) Adoption of international (Basel ) norms for financial institutions relating to capital
adequacy, income recognition, asset classification and provisioning.
5) Empowering banks to fix their lending and deposit rates.
6) Abolition of control of capital issues, dematerialisation of shares, institution of screen
based trading in the securities market and setting up SEBI for making private equity and
bond issues easier and rule based, and functioning of stock exchanges transparent.
A fiscal deficit occurs when a government's total expenditures exceed the revenue that it
generates, excluding money from borrowings. Deficit differs from debt, which is an accumulation
of yearly deficits.
Current account convertibility refers to freedom in respect of payments and transfers for current
international transactions. In other words, if Indians are allowed to buy only foreign goods and
services but restrictions remain on the purchase of assets abroad.
Foreign Institutional Investor (FII) means an institution established or incorporated outside India
which proposes to make investment in securities in India.
Foreign direct investment (FDI) is an investment in a business by an investor from another
country for which the foreign investor has control over the company purchased.
Statutory liquidity ratio (SLR) is the Indian government term for the reserve requirement that
the commercial banks in India are required to maintain in the form of cash, gold, government
approved securities before providing credit to the customers.
Cash Reserve Ratio (CRR) is a certain minimum amount of deposit that the commercial banks
have to hold as reserves with the central bank. CRR is set according to the guidelines of the central
bank of a country.
Basel I is a set of international banking regulations put forth by the Basel Committee on Bank
Supervision (BCBS) that sets out the minimum capital requirements of financial institutions with
the goal of minimizing credit risk.
Dematerialisation is the process of converting physical shares into electronic format. An investor
who wants to dematerialise his shares needs to open a demat account with Depository
Participant. Investor surrenders his physical shares and in turn gets electronic shares in his demat
account.
Screen-based trading system (SBTS): where a member can punch into the computer the
quantities of shares and the prices at which he wants to transact. The transaction is executed as
soon as the quote punched by a trading member finds a matching sale or buys quote from
counterparty.
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SHIFT IN POLICY DIRECTION FROM PRESCRIPTIVE TO INDICATIVE PLANNING
India followed prescriptive type of planning till economic reforms. After economic reforms India
followed Indicative planning. In this sense, planning was redefined with economic reforms. Let
us try to understand the difference between prescriptive planning and indicative planning.
Prescriptive planning
The conventional centralized type of planning as practiced in former Soviet Union is known as
prescriptive planning. In orthodox prescriptive planning the following steps are involved:
1. Plan goals are identified.
2. Physical and financial targets are specified to attain the goal.
3. Production units of the economy are either motivated or directed to follow the pattern of
investment desire by the planners so that targets can be full filled. The job of the planners is to
ensure that the production units get the financial resources to full fill their production target.
4. In the extreme form of such planning consumption is rationed to ensure that pattern of
consumption coincides with the pattern of production.
Indian variant of prescriptive planning had a similar objective expect for any detailed rationing
system imposed on consumers. Indian economy was a mixed economy with a very large private
sector engaged in production of mass consumption goods. The Government had control over
investment and production only in capital good sector. Investment licensing was introduced to
regulate volume and pattern of investment in the private sector. It was observed that Indian
planners subsided to a basically supply side view of planning problem because the domestic
demand could possibly be a constraint on the growth process. Through an active state policy on
investment all possible slack in the economic system would be utilized.
Indicative Planning
In the background of Economic liberalization in 1990s, it was widely recognized that, markets
were better institutions to coordinate the economic activities of a large number of economic
entities than centralised planning. Accordingly the prescriptive component of economic planning
diminished. Henceforth indicative planning became more important. In this planning the primary
function of theGovt. is to pool information about the future of the economy. Investment plans,
very often constrained by imperfect information about future, are non existent. However
investments are essentially regarded as forward looking activities. Indicative planning can be
used to provide a SWOT analysis of the future so that uncertainty of the investors about the
future can be reduced. This is expected to increase investments. So, in essence indicative
planning involves a complementary role of Govt. and market.
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Redefined role of planning in a liberalised economy
Thus process of economic liberalisation was initiated in 1991 the domestic industry is now free
to decide its product, process and plant size. Most imports did not require import licences and
tariffs had been reduced. While the markets were expected to bring about an equilibrium
between demand (backed by purchasing power) and supply, but it will not be able to ensure a
balance between need and supply. Nearly 1/3rd of the population was so poor that it did not
have enough resources to meet their ‘need’ and Govt. intervention was necessary as before. Also
during the 8th plan period, a transition to the liberalized economy had to be managed and
therefore the poor would have to be protected with special programmes and care. Here lies the
redefined role of planning in a liberalized economy.
Redefined role of State
In an economy like India where there the 26% of the population is below poverty line and
untouched by the market mechanism the state has therefore to play a positive role in
employment generation for the poor and to promote their social welfare. It was often said that
markets bypass the poor and the under privileged and that they cannot participate in the market-
driven development. This is not an accurate statement. The poor and the under privileged are
very much driven into the market. The child labour and bonded labour were participating in the
market but at very unequal and unfavourable terms. Therefore, it has rightly been said that the
market can be good servant when it is intelligently utilized but a bad master when it is allowed
to have a free day. The promotional role of the state in providing rural infrastructure and extend
credit to the poor at low interest rates can become an effective instrument in poverty removal.
The second role of the state is to provide infrastructure – economic as well as social
infrastructure.
The third area which needs state intervention is macroeconomic management of the economy.
In this the govt. can intervene in a variety of ways, more especially for such sections of the
population which are not covered by the market mechanism. World Bank study ‘The East Asian
Miracle’ (1993) about eight highly performing economies of Asia states: ‘In most of these
economies in one form or another, govt. intervene – systematically and through multiple
channels to faster development, and in some cases the development of specific industries.’
Another area which needs state intervention is the reform of public sector. The govt. has
intervened by signing MOUs (Memorandum of understandings) but has not intervened honestly
and effectively. The state has to act decisively in this regard and innovate measures to link wages
with productivity. Because market believes in the survival of the fittest, state intervention should
therefore be in the favour of weaker sections of the society. In this context, the role of the state
must change in the favour of un-fittest. World Development Report (1999-2000) stated that,
‘Govt. play a vital role in development but there is no simple set of rules that tells them, what to
do’. The question that is relevant is not to use the state on the market but to use state and the
market and strike a balance, which fulfils the three objectives outlined by Keynes, ‘The political
problem of mankind is to combine three things: economic efficiency, social justice and
34
individual liberty.’ Both the market and the state have to be harnessed in the fulfilment of
these objectives.
35
REVIEW QUESTIONS :
1) What are the structural constraints faced by the Indian economy during the time of
Independence that led to the formation of Planning Commission in 1950 ?
2) Explain the Mahalanobis growth model.
3) How did the Mahalanobis model aim to reconcile the conflict between emphasis on
heavy industries and generation of jobs for the currently unemployed ?
4) With what objectives did the Planning Commission come into existence ?
5) What is Import substituting industrialization strategy ?
6) How did State Dominated Import Substitution Development Strategy help to overcome
the problem of Coordination Failure ?
7) What is Trickle down theory ? Why did it fail to give the desired result ?
8) Why was the planning strategy during 1966 – 80 called the redistributive development
strategy ?
9) During the second phase of planning, India’s share became marginal in the world
market. Why ?
10) What is Hindu rate of growth ?
11) How did the phase of recovery lead to the emergence of deficits that ultimately led to
the macroeconomic crisis of 1990s ?
12) Explain the situation that led to economic reforms of 1991.
13) Discuss in detail the macroeconomic stabilization programme and the structural
adjustment programme that were undertaken as a part of the post reform development
strategy to stimulate economic growth through competition and trade.
14) What is prescriptive planning ?
15) How is the Indian variant of prescriptive planning different from the conventional
prescriptive planning followed in Soviet Union ?
16) What is Indicative planning ?
17) Explain the redefined role of planning in a liberalized economy ?
18) What should be the redefined role of state in a country like India ?
36
Macroeconomic Policies and their Impact on the Indian economy - Fiscal Policy and monetary
policies.
MACROECONOMIC POLICIES AND THEIR IMPACT ON THE ECONOMY
Introduction
The macroeconomic policies primarily comprise of fiscal and monetary policies in Indian
context. Fiscal policy and monetary policy are essentially two arms of overall economic
management.
Fiscal policy refers to the use of government spending and tax policies to influence economic
conditions, especially macroeconomic conditions such as aggregate demand for goods and
services, employment, inflation, and economic growth.
During a recession, the government may lower tax rates or increase spending to encourage
demand and spur economic activity. Conversely, to combat inflation, it may raise tax rates or cut
spending to cool down the economy.
Monetary policy is a set of tools used by a nation's central bank to control the overall money
supply and promote economic growth and employ strategies such as revising interest rates and
changing bank reserve requirements.
Both fiscal policy and monetary policy have common objectives i.e., the stabilization of output
and prices. Both fiscal policy and monetary policy belong in the genre of policy instruments that
mainly operate on aggregate demand, adjusting or smoothing it so as to ensure an economy wide
correspondence with the evolution of aggregate supply. So it is very important for the
formulation and implementation of monetary and fiscal policies that they need to be
complementary so as to maximize public policy’s contribution to enhancing social welfare.
FISCAL POLICIES IN INDIA
General objectives of Fiscal Policy are :

1. To maintain and achieve full employment.
2. To stabilize the price level.
3. To stabilize the growth rate of the economy.
4. To maintain equilibrium in the Balance of Payments.
5. To promote the economic development of underdeveloped countries.
The objective of fiscal policy during the 1950s and 1960s was mainly to increase the growth rate
of the economy through increasing public investment and overall economic planning. Taxation
was used as an instrument for reducing private consumption and investment and for transferring
resources to the Government to enable it to undertake large-scale public investment in an effort
to spur economic growth. Furthermore, taxation policy was geared towards achieving the
economic objectives of promoting employment through grant of tax incentives to new
investment; reducing inequality through progressive taxes on income and wealth; reducing
37
pressure on balance of payments through increase of import duties; and stabilizing prices
through tax rebate in excise duties on consumption goods.
Fiscal policy during the 1970s consciously focused on achieving greater equity and social justice
and both taxation and expenditure policies were employed towards this end.
During the 1980s, Indian public finances were in a state of disarray with the fiscal pattern
destabilizing the relationship between the economy and the budget. This resulted in persistently
large deficits which were seemingly intractable.
During post 1991, the reforms aimed at augmenting revenues and removing anomalies in the tax
structure through restructuring, simplification and rationalization of both direct and indirect
taxes.
The reduction in fiscal deficits has also helped in turning around savings and investments in
recent years. The long-term upward trends in savings and investments have been interspersed
with phases of stagnation. In particular, during the 1980s, the inability of the Government
revenues to keep pace with growing expenditure resulted in widening of the overall resource
gap. The period 1997-98 to 2002-03 witnessed rising public debt with its adverse impact on public
investment and growth.
To achieve these objectives, it was necessary to raise more resources through taxation and
restrain the growth of unproductive and non-plan expenditure.
Since 2001-02, the Central Government has continued to follow prudent fiscal policy comprising:
(i) Balanced tax structure of direct and indirect taxation based on moderate tax rates with
minimum exemptions covering a wider class of tax payers and
(ii) An expenditure policy that aims to restrain the growth in non-developmental expenditure and
adequately provide for pressing social and infrastructure needs of a developing economy.
(iii)To raise more revenue for achieving growth with macroeconomic stability, tax-GDP ratio has
been sought to be raised.
With this end in view the tax reforms undertaken since the beginning of nineties have sought to
bring about a compositional shift in the structure of the tax system away from the excessive
dependence on regressive indirect taxes to progressive direct taxes for raising resources for
accelerating economic growth with stability. Besides, to ensure competitiveness of the products
of Indian industry excise duties and custom duties have been reduced so that rapid growth of
Indian exports is possible.
MONETARY POLICIES IN INDIA
Monetary policy is the process by which the monetary authority of a country, generally central
bank, controls the supply of money in the economy by its control over interest rates in order to
maintain price stability and achieve high economic growth. In India, the central monetary
authority is the Reserve Bank of India (RBI).It is designed to maintain the price stability in the
economy along with other objectives. The objectives of the monetary policy of India, as stated
by RBI, are:
• Price stability
• Controlled expansion of bank credit
• Promotion of fixed investment
• Restriction of inventories and stocks
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• Promoting efficiency
• Reducing rigidity
INSTRUMENTS OF MONETARY POLICY IN INDIA
Generally, there are two sub-divisions among the monetary policy techniques, such as
quantitative and qualitative methods and they are popularly known as general and selective
credit controlling measures.
QUANTITATIVE METHODS
• BANK RATE
The dictionary meaning of Bank Rate is the discount rate of a central bank. Now it is known as
the base rate and it is also called as the Minimum Lending Rate (MLR). It is the rate at which the
central bank lent to the other banks. The bank rate is the minimum rate charged by the central
bank for discounting approved bills of exchange. Hence, being the lender of last resort‘, the
central bank helps the commercial banks by rediscounting the first class bills, i.e. by advancing
loans against approved securities. The Reserve Bank of India Act defines Bank Rate as ―the
standard rate on which it is prepared to buy or rediscounts bills of exchange or other commercial
papers eligible for purchase under this Act. That is why Bank Rate is known as the Rediscount
Rate‘.
As a part of financial sector reforms of 1990s, the Reserve Bank of India has decided to consider
the Bank Rate as a policy instrument for transmitting signals of monetary and credit policy. Bank
Rate now serves as a reference rate for other rates in the financial markets.
• CASH RESERVE RATIO (CRR)
Cash reserve ratio is the ratio which banks maintain between their holdings of cash and their
deposit liabilities, and sometimes referred to as the Cash Ratio. Banks have to keep a certain
proportion of their total assets in the form of cash, partly to meet the statutory reserve
requirement and partly to meet their own day-to-day needs for making cash payments. Cash is
held partly in the form of cash on hand and partly in the form of balances with the RBI. Cash
Reserves are to be kept as balances with the RBI.
• STATUTORY LIQUIDITY RATIO (SLR)
Every bank is required to maintain a minimum percentage of their net demand and time liabilities
as liquid assets in the form of cash, gold and unencumbered approved securities. This ratio of
liquid assets to demand and time liabilities is known as statutory Liquidity Ratio (SLR). RBI is
empowered to increase this ratio up to 40 per cent. The difference between CRR and SLR is that
cash Reserves are to be kept with the Central Bank whereas statutory ratio is maintained by the
commercial banks concerned.
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• OPEN MARKET OPERATIONS
Open market operations involve the sale or purchase of Government securities by the Central
Bank. When the Central Bank sells Government securities in the market it withdraws a part of
the deposit resources of the banking sector thereby reducing resources available with the bank
for lending. Open market sale of Government securities reduces the surplus cash resources of
banks, contracting the base for credit creation. The Open Market Operations (OMOs) have been
effectively used by the Reserve Bank since the mid-1990s for sterilizing the monetary impact of
capital flows by offloading the stock of government securities to the market.
Sterilization is the process by which monetary authorities ensure that foreign exchange
interventions do not affect the domestic monetary base, which is one component of the overall
money supply.
• REPO RATE
Repo is a money market instrument, which enables collateralized short-term borrowing and
lending through sale or purchase operations in debt instruments. Under a repo transaction, a
holder of securities sells them to an investor with an agreement to repurchase at a pre-
determined date and rate. In short, Repo rate is the rate at which the RBI lends short term money
to banks. When the repo rate increases, borrowing from RBI becomes more expensive.
A repo is equivalent to a cash transaction which results in transfer of money to the borrower in
exchange for the legal transfer of the security to the lender; while the forward contract ensures
repayment of the loan to the lender and return of the collateral of the borrower.
• REVERSE REPO RATE
Reverse repo rate is the rate at which banks park their short-term excess liquidity with the RBI.
The RBI uses this tool when it feels that there is too much money floating in the banking system.
An increase in the reverse repo rate means that the RBI will borrow money from the banks at a
higher rate of interest. As a result, banks would prefer to keep their money with the RBI. Thus,
we can say that repo rate signifies the rate at which liquidity is injected into the banking system
by the RBI, whereas reverse repo rate signifies the rate at which the central bank absorbs liquidity
from the banks.
Thus Reverse repo rate is the rate at which RBI borrows money from banks. Banks are always
happy to lend money to RBI, since their money is in safe hands with a good interest. An increase
in reverse repo rate can cause the banks to transfer more funds to RBI due to these attractive
interest rates. It can cause money to be drawn out of the banking system.
SELECTIVE CREDIT CONTROL METHODS
Apart from the general or quantitative methods of credit control, there are selective or
qualitative methods of credit control for specific purposes. While the general credit controls
relate to the total volume of credit (changing High-powered money) and the cost of credit,
selective credit controls operate on the distribution of total credit. Selective credit control
40
measures have positive and negative aspects. Measures can be used to encourage greater
channelling of credit into particular sectors, as is being done in India in favour of designated
priority sectors, is the positive aspect. On the negative side, measures are taken to restrict the
flow of credit to particular sectors or activities. Most of the time, the term is used in this aspect.
Quantitative credit control measures do not control the quality of credit and do not influence
the purpose for which loans and advances are used. On the other hand, selective credit control
methods control the uses of bank credit. The quantitative credit control methods operate
primarily by affecting the cost, volume and availability of bank reserves, and thereby, tend to
regulate the total supply of credit. The selective measures on the other hand, are meant to
regulate the terms on which credit is granted in specific sectors. They seek to control the
demand for credit for different uses by determining minimum down payments and regulating
the period of time over which the loan is to be repaid.
The different selective credit controls are given below:
• VARYING MARGIN REQUIREMENT
It is an important qualitative method of credit control. Banks do not advance money to the full
value of the security pledged for the loan. Margin requirement = Value of security - Amount
advanced. According to Ritter, Marginal requirement is the difference between the value of the
security and the amount of the loan sanctioned against that security‖. This method of credit
control is very simple and easy to operate. It controls the credit in the speculative area and in this
way demand for speculative credit is controlled. So it helps to diversify the credit and directs its
flow into the desired channels. This technique of credit control is contributed to stabilize the
economy and minimize cyclical disturbances.
• REGULATION OF CONSUMER CREDIT
It helps to regulate the terms and conditions under which the credit repayable in instalments
could be extended to the consumers for purchasing the durable goods. Under the consumer
credit system, a certain percentage of the price of the durable goods is paid by the consumer in
cash. The balance is financed through the bank credit which is repayable by the consumer in
instalments. The central bank can control the consumer credit
(a) by changing the amount that can be borrowed for the purchase of the consumer durables
and
(b) by changing the maximum period over which the instalments can be extended.
This method seeks to check the excessive demand for durable consumer goods and thereby to
control the prices of these goods. The method is helpful in controlling inflationary trends in
developed countries where the consumer credit system is widespread. In countries like India,
however, this method has little significance.
41
• RATIONING OF CREDIT
The central bank can also adopt the rationing of credit as a selective measure. Under this method,
the central bank can fix a limit for the credit facilities available to commercial bank. This is to
control and regulate the purpose for which the credit is granted by the banks. It can be
implemented in four ways:-
(1) It can deny giving loans to a particular bank.
(2) It can scale down the amount of loans to be given to different banks.
(3) It can fix quota of the credit to be given to different banks. and
(4) It can fix the limits of loans to be given to different industries and traders.
Thus, Credit can also be controlled by the mechanism of rationing. This helps to credit
contraction. With the introduction of this method, banks are cautious in matter of advancing
loans even though they dislike such restrictions.
• DIRECT ACTION
Direct action refers to direct dealings with the individual bank which adopt policies against the
policies of the central bank. Under this method, the central bank may be obliged to take action
against the defaulting banks, if they do not follow the policy laid down by the central bank. So
direct action includes all types of restrictions imposed upon the commercial banks by central
bank concerning lending and investment. This is the most extensively used method and is not
used in isolation; it is often used to supplement other methods of credit control. Under this
system,
(1) the central bank may refuse to rediscount the bills of exchange of the commercial banks
(2) it may charge a penal rate of interest over and above the bank rate and
(3) the central bank may refuse to grant more credit to the particular banks.
• MORAL PERSUASION
Moral suasion means advising, requesting and persuading the commercial banks to co-operate
with the central bank in implementing its general monetary policy. This method is a psychological
method and its effectiveness depends upon the immediate and favourable response from the
commercial banks.
• PUBLICITY OR PROPAGANDA
It is another technique of credit control that is used by the central bank. It gives wide publicity to
its credit policy through the media, periodicals and journals. Through publicity the central bank
seeks.
(1) To influence the credit policies of the commercial banks.
(2) To educate people regarding the economic and monetary condition of the country and
(3) To influence the public opinion in favor of its monetary policy.
42
• CREDIT AUTHORIZATION SCHEME
Credit Authorization Scheme (CAS) is a type of selective credit control introduced by the Reserve
Bank of India in November 1965. Under this scheme, the commercial bank had to obtain Reserve
Bank‘s authorization before granting any fresh credit of Rs.1 crore or more to any single party.
The limit was later raised gradually to Rs.4 crore in November 1983, in respect of borrowers in
private as well as public sector. The limit was further raised to Rs.6 crore with effect from April
1986. Under this scheme, the Reserve Bank requires the commercial banks to collect, examine
and supply detailed information regarding the borrowing concerns. The main purpose of this
scheme is to keep a close watch on the flow of credit to the borrowers. It requires that the bank
should lend to the large borrowing concerns on the basis of credit appraisal and actual
requirement of the borrowers. Since July 1987, the CAS has been liberalized to allow for greater
access to credit to meet genuine demands in production sectors without the prior sanction of the
RBI.
RECENT MONETARY POLICY REVIEW
On the basis of an assessment of the current and evolving macroeconomic situation, the
Monetary Policy Committee (MPC) at its meeting (August 5, 2022) decided to:
• Increase the policy repo rate under the liquidity adjustment facility (LAF) by 50 basis
points to 5.40 per cent with immediate effect. Consequently, the standing deposit facility (SDF)
rate stands adjusted to 5.15 per cent and the marginal standing facility (MSF) rate and the Bank
Rate to 5.65 per cent.
• The MPC also decided to remain focused on withdrawal of accommodation to ensure that
inflation remains within the target going forward, while supporting growth. These decisions are
in consonance with the objective of achieving the medium-term target for consumer price index
(CPI) inflation of 4 per cent within a band of +/- 2 per cent, while supporting growth.
A liquidity adjustment facility (LAF) is a tool used in monetary policy, primarily by the Reserve
Bank of India (RBI) that allows banks to borrow money through repurchase agreements (repos)
or to make loans to the RBI through reverse repo agreements.
The standing deposit facility (SDF) allows the RBI to absorb excess cash from the economy by
sucking liquidity from commercial banks without giving government securities in return to the
lenders.
Marginal Standing Facility (MSF) is a provision made by the Reserve Bank of India through which
scheduled commercial banks can obtain liquidity overnight ,if inter-bank liquidity completely
dries up.
43
GLOBAL ECONOMY
• Since the MPC’s meeting in June 2022, the global economic and financial environment
has deteriorated with the combined impact of monetary policy tightening across the
world and the persisting war in Europe heightening risks of recession.
• Gripped by risk aversion, global financial markets have experienced surges of volatility
and large sell-offs. The US dollar index soared to a two-decade high in July. Both advanced
economies (AEs) and emerging market economies (EMEs) witnessed weakening of their
currencies against the US dollar.
• EMERGING MARKET ECONOMIES are experiencing capital outflows and reserve losses
which are exacerbating risks to their growth and financial stability.
DOMESTIC ECONOMY
• Domestic economic activity remains resilient.

• High frequency indicators of activity in the industrial and services sectors are holding up.
Urban demand is strengthening while rural demand is gradually catching up.
• Merchandise exports recorded a growth of 24.5 per cent during April-June 2022, with
some moderation in July.
• Non-oil non-gold imports were robust, indicating strengthening domestic demand.
• CPI inflation eased to 7.0 per cent (year-on-year, y-o-y) during May-June 2022 from 7.8
per cent in April, although it persists above the upper tolerance band.
• Food inflation has registered some moderation, especially with the softening of edible oil
prices, and deepening deflation in pulses and eggs.
• Fuel inflation moved back to double digits in June primarily due to the rise in LPG and
kerosene prices
• India’s foreign exchange reserves were placed at US$ 573.9 billion as on July 29, 2022.
On the outlook for growth, rural consumption is expected to benefit from the brightening
agricultural prospects. The demand for contact-intensive services and the improvement in
business and consumer sentiment should bolster discretionary spending and urban consumption.
Investment activity is expected to get support from the government’s capex push, improving
bank credit and rising capacity utilisation.
• Given the elevated level of inflation and resilience in domestic economic activity, the MPC
took the view that further calibrated monetary policy action is needed to contain
inflationary pressures, pull back headline inflation within the tolerance band closer to the
target, and keep inflation expectations anchored so as to ensure that growth is sustained.
44
• Accordingly, the MPC decided to increase the policy repo rate by 50 basis points to 5.40
per cent. The MPC also decided to remain focused on withdrawal of accommodation to
ensure that inflation remains within the target going forward, while supporting growth.
45
REVIEW QUESTIONS :
1) What are the general objectives of fiscal policy ?

2) What are the objectives of monetary policy ?
3) Discuss the impact of the fiscal policies on the Indian economy.
4) Discuss the qualitative and quantitative credit control measures of RBI.
5) What is the difference between the repo rate and the bank rate ?
6) Discuss the recent monetary policies taken by the RBI.
7) Can you relate the recent monetary policy changes with the current situation of the
domestic and the global economy.
46
THANK YOU
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• Indian economy on the eve of Independence - low level of economic development

Sector National Income Workforce

Agriculture, Animal Husbandry, Forestry, Fisheries

Mines, Manufacturing, Industries, Small Enterprise

Trade, Transport and Communication

Other Services, Professionals, Administration, Domestic

Composition of NI: Statistics speaks for low level of Industrialization

• Agricultural Activities contributed to nearly 50% to India’s National Income

• Agricultural sector absorbed 72% of total workforce

Let us look at the following table :

Year Agriculture & allied Industry Services

1950-51 53.1% 16.6% 30.3%

1960-61 48.7% 20.5% 30.8%

1970-71 42.3% 24% 33.7%

1980-81 36.1% 25.9% 38%

1990-91 29.6% 27.7% 42.7%

1999-2000 23.2% 26.8% 50%

2012-13 13.9% 27.3% 58.8%

2013-14 13.9% 26.2% 59.9%

2015-16 15.4% 31.3% 53.3%

2017 15.5% 23% 61.5%

2019-2020 14.65% 30.29% 55.17%

2020-2021 16.38% 29.34% 54.27%

Is Service led growth sustainable ?

COORDINATION FAILURE AND THE TRAP OF UNDERDEVELOPMENT

VICIOUS CIRCLE OF POVERTY FROM SUPPLY SIDE

low per low per

low per low per

VICIOUS CIRCLE OF POVERTY FROM DEMAND SIDE

• INTER INDUSTRY LINKAGE:-

1) Explain co-ordination failure with an example.

• Evolution of Economic Planning and State-dominated import substitution development

Phase Wise Economic Planning

Immediately after independence, Govt’s main concern in Economic policy was

• India embarked upon the programme of planned economic development of the

Second FYP (1956-61) :

• Rapid industrialization- heavy & basic Industries ( Mahalanobis plan )

Third FYP (1961-66) :

Mahalanobis Growth Model

Sector II: This sector will produce consumer goods.

Import Substitution Strategy (ISI)

Trickle Down Theory

The first three five year plans had two objectives:

Performance of Indian Economy in Phase I:

• 8 to 10 per cent compound growth rate of industrial output.

Three Annual Plans (1966-69) : Plan holidays

Hindu Rate of Growth

Sixth FYP (1980-85)

Economic Reform (1991)

Redefined role of State

MACROECONOMIC POLICIES AND THEIR IMPACT ON THE ECONOMY

FISCAL POLICIES IN INDIA

General objectives of Fiscal Policy are :

MONETARY POLICIES IN INDIA

INSTRUMENTS OF MONETARY POLICY IN INDIA

• CASH RESERVE RATIO (CRR)

• STATUTORY LIQUIDITY RATIO (SLR)

• REVERSE REPO RATE

SELECTIVE CREDIT CONTROL METHODS

The different selective credit controls are given below:

• VARYING MARGIN REQUIREMENT