NEXT IAS GS PRE CUM MAIN FOUNDATION COURSE for CSE - 2022 MODULE-1: Introduction to GS Economy by Vibhas Jha SirNEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Economics It is a subject matter, which deals with alteration of scarce resources in such a way so that consumer can get maximum satisfaction, producer can get maximum profit and society can get maximum welfare. OR It is a social science which studies the way a society chooses to use its limited resources which have alternate uses, to produce goods and services and to distribute them among different groups of people. Economy A system which provides people the means to work and earn living is called economy. Process of an Economy a. Production b. Consumption c. Investment or Capital Formation Scarcity It refers to the limitation of supply in relation to its demand (DD>SS) Economic Problem It is a problem of choice involving satisfaction of unlimited wants out of limited resources having alternative uses. (f LIMITED: \ RESOURCES Pate UNLIMITED . | | wants w= ALTERNATIVE | [uses |NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Reasons for Economic Problem a. Scarcity of Resources Resources like land, labour, capital are limited in relation to its demand and economy does not produce all what people wants. There would be no problem if resources were not scarce. b. Unlimited Human Wants Human wants are never ending. As soon as one want is satisfied another want emerges. Every human want are differentin priorities. Some are more important than other. Due to this reason people allocate their resources in order to preference to satisfy their wants. c. Alternate uses Resources are not only scarce but also put to many uses. It means choice among the resources is very important. For e.g. Milk. Economizing of resources It refers to making optimum use of the available resources POSITIVE eg. There is price discrimination in economy, prices are conctantly Studies the facts what was, what not give of life is, what will value NORMATIVE Studies what ; eg. income are desirable what ought to —_gives value inequalities and undesirable should beNEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 bby Vibhas Jha Sir MICRO ECONOMICS MACRO ECONOMICS determines price of a . . a - Studies economy as a Studies individual unit whole ’ 3 determines income and employment level commodity ‘of the economy . . assumes all macro assumes all micro variables are constant variables are constant . . eg. individual demand, eg. aggregate demand, WHAT-TO™ hb PRODUCE-ANDAN HO} Roe ae PRODUCE meets individual supply aggregate supply LABOUR: INTENSIVE: TECHNIQUE’ CAPITAL: INTENSIVE FUNCTIONAL: DISTRIBUTION’ PERSONAL: DISTRIBUTION Central Problems of an Economy 1. What to Produce The problem involves selection of goods and services to be produced and the quantity of each selected good to be produced. There is problem of allocation of resources among different good. The problem of what to produce has two different aspects: a. What possible commodities to be produced An economy has to decide which consumer goods like rice, wheat etc. to 5NEXT IAS | GS Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir be produced or capital goods like machine, equipment’s etc. whether to produce war time good like gun, gun powder or civil goods like bread, butter. b. How much to be produced After deciding the goods to be produced economy has to decide the quantity of each commodity. Guiding principle Allocate the resources in a manner which gives maximum aggregate satisfaction. 2. How to Produce This problem refers to selection of technique of production of goods and services. Techniques are classified as: a. Labour intensive technique In which more of labour and less of capital is used. E.g. India. b. Capital intensive technique In which more of capital and less of labour is used. E.g. U.S.A. Guiding Principle Combine factors of production in such a manner so that maximum output is produced at minimum cost using least possible scare resources. 3. For Whom to Produce This problem relates to the distribution of goods and services among the individuals within the economy i.e selection of the category of people who will ultimately consume the goods i.e whether to produce goods for more poor and less rich or more rich and less poor. Thus a problem of choice arises. The problem is concerned with distribution of income among factors of production (land, labour, capital & enterprise). The problem can be catergorised under two main heads: a. Personal Distribution It means how national income of an economy is distributed among different groups of people. b. Functional Distribution It involves deciding the share of different factors of production in the total national product of the country. Guiding Principle Ensure that urgent wants of each productive factors are fulfilled to the maximum possible extend.NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Opportunity Cost The value of next best alternate use of a commodity OR The value of the benefit is sacrificed by choosing an alternative. For example, suppose you have Rs. 20,000 and you want to purchase LED T.V. and laptop with only Rs. 20,000 in hand. You cannot purchase both. If you desire to purchase laptop the opportunity cost of choosing the laptop is the cost of the forgone satisfaction from LED T.V. OR Suppose you are working in an office for Rs. 20,000. You receive new job offer for work as executive at 17,000 per month and work as journalist as Rs. 15,000 per month. The opportunity cost of working in an office is the cost of next best alternative forgone. Marginal Opportunity Cost It is the loss of one commodity when shifting resources from one good to another produces one more unit of another commodity. MOC= Unit of one good sacrificed/Unit of other good gained Production Possibility Curve (PPC) Graphical presentation of various combinations of two goods that can be produced with available technology and resources assuming effective and efficient utilization of resources is called PPC. Characteristics of PPC The two basic characteristics or features of PPC are: 1. PPF slopes downwards PPF shows all the maximum possible combination of two goods, which can be produced with the available resources and technology. In such a case, more of ‘one good can be produced only by taking resources away from the production of another good. As there exists an inverse relationship between changes in quantity of one commodity and change in quantity of the other commodity, PPF slopes downwards from left to right. PF of Guns and Suter 2. PPF is Concave Shaped PPF is concave shaped because of increasing marginal opportunity costs, i.e. more and more units of one 3 commodity are sacrificed to gain an additional unit of 7NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 bby Vibhas Jha Sir another commodity. In the given example, units of guns sacrificed keep on increasing each time to increase production of one unit of butter. Due to increasing marginal opportunity cost, PPF becomes more and more steep as we move from points A to G. Technically, a curve with an outward bend is described as ‘Concave to the Origin’. od Attainable and Unattainable Proton * All points on or 000 fener inside the frontier 7 are attainable cS = Point A is attainable, Quantity of so is point B. In fact computers B is better! = Point Cis unattainable © Guantiy oF 4,000 Care Produced Assumptions 1. No change in technology 2. No change in resources 3. Resources are fully and efficiently utilized The production possibility curve represents graphically alternative production possibilities open to an economy. There are scarce, a choice has to be made between the alternative goods that can be produced. In other words, the economy has to choose which goods to produce and in what quantities. If it is decided to produce more of certain goods, the production of certain other goods has to be curtailed. Let us suppose that the economy can produce two commodities, cotton and wheat. We suppose that the productive resources are being fully utilized and there is no change in technology. The following table gives the various production possibilities.NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 bby Vibhas Jha Sir Alternative Production Possibilities Prodiction cowton Wheat Possibiites (i000 quintals) (in 000 quinals x 0 5 8 1 4 ¢ 2 2 Dd 3 9 E 4 5 F 5 0 12 < aie S 2 = TEL Pg 2 fou It all available resources are employed for the production of wheat, 15,000 quintals of it can be produced. If, on the other hand, all available resources are utilized for the production of cotton, 5000 quintals are produced. In this diagram AF jis the production possibility curve, also called or the production possibility frontier these are the two extremes represented by A and F and in between them do B, C, D and E represent the situations. At B, the economy can produce 14,000 quintals of wheat and 1000 quintals of cotton. At C the production possibilities are 12,000 quintals of wheat and 200 quintals of cotton, as we move from A to F. For instance, moving from A to B, 1000 quintals of wheat are sacrificed to produce 1000 quintals of cotton, and so on. Moving from A to F, increasing amounts of cotton is sacrificed. This means that, in a full- employment economy, more and more of one good can be obtained only by reducing the production of another good. This is due to the basic fact that the economy’s resources are limited. Reasons for Rightward Shift in PPC More training of employees, enabling them to be more productive Greater investment in in capital goods such as machines and equipment An increase in the population size, for example, through immigration Improvements in technology, providing better ways of doing things Discovery of new resources. FaeNEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 bby Vibhas Jha Sir Sometimes improvements could happen only in the production of one product, while the other product could remain the same. For example, if technological improvement is specific to one sector, but not the other, then the effect will be biased. This will rotate the PPC outward, but only in that specified area. Steel output will remain the same. Leather Yoourt For example, if the improvement in technology only in the cheese production sector, the PPC will shift outward only from the cheese production output. Production possibility curve can be straight line:NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir * Constant Cost PPF Graph (straight line PPF) Qy Food Auy point above line @.100) is Unobtainable in ° CL Short Run with existing resources Any point on line is Efficient production of goods, Country is at full potential © Lowest unemployment rate | roa + Job = Human Capital Any point below line is Inefficient Shelter |[* Companies ail efficient Production possibility curve can be convex to the origin: "NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 bby Vibhas Jha Sir Decreasing Opportunity Cost (PPF is convex): Food -As we move along the production possibility curve with increasing computer, less and less food must be forgone 2 10 30 Computer DECREASING OPPORTUNITY. o cost: Shift in production possibility curve: =» « Overview of ppf:NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir =. Unattainable P Point > BP; 5 8 = = < 8 *, Outward ar, shift = . cc. Underutilisation *, . of resources Bag ol Fe Commodity - X + PPF slopes downwards as increase in production of one good requires decrease in production of the other. * PPF is concave due to increasing Marginal rate of transformation. * PPF shows transformation of one good into another not physically but by diverting resources from one use to another use. * — PPF shows maximum available possibility. «If an economy be operates on PPF (Point A, B, C) it means resources are fully and efficiently utilized. * Economy cannot operate at any point outside the PPF (Point E) as it is unattainable with the available productive capacity. «An outward shift in PPF from PP to P1P1 means the economy can produce more of both the commodities which was not possible earlier. « — An inward shift in PPF from PP to P2P2 means that the economy’s capacity to produce both the commodities has reduced. Concepts of Demand and Supply Relationship between price and quantity levels of goods and services. Demand Quantity of the good that buyers are willing and able to purchase at different prices is called Demand. Factors Affecting Demand . Price of the Own CommodityNEXT IAS | GS Pre Cum Main Foundation Course for CSE-2022 ty Vibhas Jha Sir Price and quantity demanded of a commodity are inversely related. If price of a commodity rises, its quantity demanded falls and vice versa. The logic behind this inverse relation is that rise in the price of the commodity lowers the purchasing power of the consumer and this therefore discourages him to increase his consumption. Price of Related Goods Goods can be related to each other as substitutes or complementaries. Substitute goods: These are the goods that can be used alternatively. For example: tea and coffee, Pepsi and coke, etc. Imagine a rise in the price of tea. What will be its impact on the quantity demanded for coffee? A rise in the price of tea means consuming tea becomes expensive to the consumer and thus he may want to shift to some other cheaper alternative, that is, tea. Therefore, higher price for tea lowers its quantity demanded but increases the quantity demanded for coffee. Hence, we observe a direct relation between price and quantity demanded for substitute goods. Complementary goods: These are the goods that are used simultaneously to satisfy a common purpose. For example: car and petrol. Imagine a rise in the price of petrol. What will be its impact on the quantity demanded of car? A rise in the price of petrol means driving cars now become costlier to the consumer. The consumer might prefer travelling by public means of transport or any other means. This therefore lowers the quantity demanded for cars. Hence, we observe an inverse relation between price and quantity demanded for complementary goods. Income of the Consumer The relation between income and quantity demanded of a good depends upon the nature of the good. Before that, let us understand what is substitution effect and income effect. Substitution Effect: Substitution effect refers to substituting one commodity in place of other when it becomes relatively cheaper. When price of given commodity falls, it becomes relatively cheaper as compared to its substitute. As a result, demand for given commodity rises. Income Effect: Income effect refers to effect on demand when real income consumer changes due to change in price of the given commodity. When price of the given commodity falls, it increases the purchasing (real income) of the consumer. As a result, he can purchase more of the commodity with the same money income. 14NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Always remember, Price effect = Income effect + Substitution effect On the basis of nature, a good can be either a normal good or an inferior good Normal goods: Those goods whose quantity demanded rises with rise in income are called normal goods. Example: wheat Both substitution effect and income effect are positive. So price effect will be positive, that is, consumer will consume more of a normal good when its price is reduced. Inferior goods: Those goods whose quantity demanded falls with rise in income are called inferior goods. Example: bajra Substitution effect is positive, but income effect is negative. The total effect of price reduction is rise in demand. It happens because increased demand due to Positive substitution effect is more than reduced demand due to negative income effect. As a result, demand for inferior good rises. Hence, there is a direct relation between income and quantity demanded for normal goods, but an inverse relation exists between the two in case of inferior goods. The logic behind this relation is that with rise in income the consumer is able to save some money and consume more of a better quality good than (normal good) than inferior good. Tastes and Preferences Developing favourable tastes and preferences towards a commodity increases its quantity demanded. For example: people have developed favourable tastes and preferences towards colour television relative to black and white televisions. So the quantity demanded for colour television rises relative to black and white televisions. Role of Expectations Expecting a rise in the prices in future motivates the consumer to increase his consumption in present and vice versa. Law of Demand It is a statement which says that quantity demanded of any good is inversely proportional to the prices, keeping all other things/factors constant.NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir A Pa price pj ps. demand curve > au 2 @ cuantity demanded Properties of Law of Demand One sided Law of demand explains the effect of change in quantity demanded due to change in price but it does not tell us the change in price caused due to change in quantity demanded. Hence it operates one sidedly only. Qualitative but not quantitative Law of demand is a qualitative statement. It tells us only the direction of change in quantity demanded due to change in price but not the magnitude of change in demand due to change in price. Exceptions to Law of Demand Necessary goods: These are the goods essential for survival to a person. These can be medicines or drugs. Even when prices of such commodities rise, the consumer still buys it rather than reducing his demand. Law of demand does not operate in this case. Highly luxurious goods: These are some goods demanded by the super wealthy people. It could be a private chopper or any other luxurious good. If they experience a price rise, the consumer would still want it. Hence, law of demand does not operate in this case. Giffen goods These are highly inferior goods where the negative income effect is stronger than the positive substitution effect. Price effect is therefore negative. As a result, its demand falls with fall in its price. All giffen goods are inferior goods but all inferior goods are not giffen goods. This is because all giffen goods have negative income effect. All inferior goods are not giffen goods because all inferior goods do not have dominating income effect that is negative income effect is not stronger than positive substitution effect in case of all inferior goods. So, it is rightly said that all giffen goods are inferior goods but not vice versa. 16NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir « Fashion related goods Goods related to fashion do not follow law of demand and their demand increases even with a rise in their prices. For example: If any particular type of dress is in fashion, then demand for such dress will increase even if its price is rising. Supply Quantity of a good that the seller/producer is willing to sell at different prices in the market is called Supply. Factors affecting supply + Price of the Commodity The price and quantity supplied for a commodity are directly related. It means, as price rises, the quantity supplied of the given commodity also rises and vice versa. It happens because at higher prices, there are greater chances of making profit. This induces the firm to offer more for sale in the market. * Prices of other goods Increase in the prices of other goods, makes them more profitable in comparison to the given commodity. As a result, firm shifts its limited resources from production of given commodity to production of other goods. For example: increase in the price of other good (say, wheat) will induce the farmer to use land for cultivation of wheat in place of the given commodity (say, rice). + Prices of factors of production (inputs) When amount payable to factors of production and cost of inputs increases, the cost of production also increases. This decreases the profitability. As a result, seller reduces the supply of the commodity. On the other hand, decrease in prices of factors of production, increases the supply due to fall in the cost of production and subsequent rise in profit margin. * State of Technology Technological changes influence the supply of a commodity. Advanced and improved technology reduces the cost of production, which raises the profit margin. It induces the seller to increase the supply. * Government Policy (Taxes and subsidy) Increase in taxes raises the cost of production and thus reduces the supply, due to lower profit margin. On the other hand, subsidies increase the supply as they make it more profitable for the firms to supply goods. Law of SupplyNEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir It is a statement which says that quantity supplied of any good is directly related to the price of the own good, keeping other factors constant Supply curve 8 —> = ‘uot Spplied Changes in Demand and Supply When changes in demand and supply occur due to price alone, it is called expansion and contraction of demand and supply. When changes in demand and supply happen due to factors other than price, it is called increase and decrease in demand and supply. Expansion of demand: When quantity demanded of a commodity rises due to fall in the price of the commodity alone, it is called expansion of demand. It is shown by a downward movement along the demand curve. Contraction of demand: When quantity demanded of a commodity falls due to rise in the price of the commodity alone, it is called contraction of demand. Price rN Quantity Diagram 1 Diagram 2 demanded Increase in demand: When demand for a commodity rises due to factors other than price, it is called increase in demand. 18NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Decrease in demand: When demand for a commodity falls due to factors other than price, it is called decrease in demand. ° ‘qunntiy Expansion of supply: When quantity supplied of a commodity rises due to rise in the price of the commodity alone, it is called expansion of supply. Contraction of supply: When quantity supplied of a commodity falls due to fall in the price of the commodity alone, it is called contraction of supply. Quantity Increase in supply: When supply for a commodity rises due to factors other than price, it is called increase in supply. Decrease in supply: When supply for a commodity falls due to factors other than price, it is called decrease in supply.NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir > fan for/, fff Increase Market Equilibrium Equilibrium means a state of balance or a state of rest. A market is said to be in equilibrium when demand of a good equals its supply, that is, there should be neither excess demand nor excess supply of any good in the market. Pe <— Equilibrium Point In case price rises above the equilibrium price then it leads to excess supply in the market. With excess supply competition among producers rises and this causes the price to fall till it reaches the equilibrium level. 20NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Excess Supply P excess ‘supply Quantity Quentity demanced®s Q* Supplied s In case price falls below the equilibrium level then it leads to excess demand in the market. With excess demand, competition among buyers rises and this causes the price to rise till it reaches the equilibrium level. Excess Demand ‘Supply Demand 4 \ excess : demand} t Quantity o* Quantity suoplied 2 @ cerandes 20 Changes in Market Equilibrium due to Changes in Demand 1. Increase in demand: Increase in demand results in rightward shift of the demand curve. At the original equilibrium level (Pe), situation of excess demand prevails and this creates a competition between the buyers, leading to rise in prices till equilibrium is achieved (P2). Hence, equilibrium price rises with rise in demand due to factors other than price. 2NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 bby Vibhas Jha Sir Changes in Equilibrium Prices — Increasing Demand Price Of | | An outward shift of market demand (ceteris paribus) leads toa offee rise in equilibrium price and an expansion of market supply Market ‘Supply “” eeeee oe Market Market Demand (2) | Demand (1) Qe a2 Quantity supplied Increase in Supply: Increase in supply results in rightward shift of the supply curve. At the original equilibrium level (Pe), situation of excess supply prevails and this creates a competition between the sellers, leading to fall in prices till equilibrium is achieved (P2). Hence, equilibrium price falls with rise ‘in supply due to factors other than price. Price of ‘An outward shift of market supply will lead to a fall in Coffee equilibrium price and an expansion of market demand Market Supply (1) Market Supply (2) | Pe P2 Market Demand (1) Qe a2 Quantity supplied Equilibrium Market Prices: An increase in Supply 2MEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 Production by Vibhas Jha Sir Production Function It is an expression of the technological relation between physical inputs and output of a good. Ox = f (X1, X2, Xa... Here, Ox =Output of the commodity X F = Functional relationship. X1,X2,X 3...Xn = Inputs needed for Ox Xn Short Run and Long Run Short Run Refers to a period in which output can be changed by changing only variable factors. In the short run, fixed inputs like plant, machinery, building etc. cannot be changed. It means, production can be raised by increasing variable factors, but till the extent of capacity of fixed factors. Long Run Long Run refers to a period in which output can be changed by changing all factors of production. Long period is a period, that is long enough for the firm to adjust all its inputs according to change in the conditions. In the long run, firm can change its factory size, switch to new techniques of production, purchase new machinery etc. Difference between Short Run and Long Run Basis Short Run Long Run Meaning Short Run refers to a period in which output can be changed by changing only variable factors Long Run refers to a period in which output can be changed by changing all factors of production Classification Factors are classified as variable and fixed factor in the short Run All Factors are Variable in the long run. 23NEXT IPS | Gs Pre Cum Main Foundation Course for CSE-2022 Variable Factor and Fixed Factor by Vibhas Jha Sir Basis Variable Factors Fixed Factors Meaning | Variable Factors refers to those Fixed Factors refers to those factors, which can be changed in | factors, which cannot be the short Run changed in the short run. Relation with | They vary directly with the level | They do not vary directly with Output. of output. the level of output. Example | Raw material, casual labour, Plant and machinery, building, power, fuel, etc. land, etc. Types of Production Function a. Short Run Production Function: This relationship explained by “Law of Variable Proportions. b. Long Run Production Function: This relationship is explained by the Law of Return to Scale”. Concept of Product 1. Total Physical Product (TPP) Refers to total quantity of goods produced by a firm during a given period of time with given number of inputs. 2. Average Physical Product (APP) Refers to output per unit of variable input. APP = Total Physical Product (TPP) / Units of Variable Factor (n) 3. Marginal Physical Product (MPP) Refers to addition to total product, when one more of variable factor is employed. MPP,= TPPn - TPPa-t For eg, If 10 labours make 60 kg of rice and 11 labours make 67 kg of rice, then MPP of 11¢? labour will be : TPP1; - TPP 10 24NEXT IPS | Gs Pre Cum Main Foundation Course for CSE-2022 Relationship between TPP and MPP PYnNP When MPP rises, TPP increases at increasing rate (Convex) When MPP falls, TPP increases at diminishing rate (Concave) When MPP=0, TPP is Maximum When MPP is negative, TPP declines ¥ stace TP OUTPUT AMOUNT OF VARIABLE FACTOR “Mr Relationship between APP and MPP 1. 2. 3. When MPP > APP, APP increases When MPP = APP, APP is Maximum When MPP < APP, APP decreases. Tabular Presentation Fixed inputs, Variable Inputs TPP | APP | MPP 1 0 0 1 1 2 2 2 1 2 6 3 4 1 3 12 4 6 1 4 16 4 4 1 5 18 3.5 | 2 1 6 18 3 0 1 7 14 2 4 1 8 8 1 “6 25 by Vibhas Jha SirNEXT IAS | GS Pre Cum Main Foundation Course for CSE-2022 ty Vibhas Jha Sir Law of Variable Proportion The law states that as we increase the quantity of only one input, keeping other inputs fixed, the total product increases at an increasing rate in the beginning, then increases at decreasing rate after a level of output and ultimately falls. Assumptions 1. It operates in short run, as factors are classified as variable and fixed factor. 2. The law applies to all fixed factors including land 3. This law applies to the field of production only 4. The state of technology is assumed to be constant Diagrammatic and Tabular Presentation Fixed inputs Variable Inputs TPP MPP 0 0 16 18 18 14 4 2 4 12 6 4 2 0 @lrfoa}ulafulr)a Total Product Increasing {Diminishing! retums~ {returns © Marginal Product Unit of the variable factor (labour) 26NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Explanation of the Law PHASE I: INCREASING RETURNS TO A FACTOR In the first phase, every additional variable factor adds more and more to the total output. It means, TPP increases at an increasing rate and MPP of each variable factor rises. Reasons As variable input increases specialisation or division of labour takes place, we observe - Increase in efficiency of the variable input - Better utilisation of fixed factor. PHASE II: DIMINISHING RETURNS TO A FACTOR In the second phase, every additional variable factors adds lesser and lesser amount of output. It means, TPP increases at a diminishing rate and MPP falls with increase in variable factor. The second phase ends when MPP= 0, TPP is maximum. Reasons With the increase in the quantity of variable input, a pressure on fixed inputs increases, as a result Efficiency of the variable input declines Imperfect substitutes of fixed and variable factors. PHASE Ill: NEGATIVE RETURNS TO A FACTOR In the third phase, the employment of additional variable factor causes TPP to decline. MPP now becomes negative. Reasons Fixed input is too small in relation to variable input. This reduces the efficiency of the variable input so much that MPP becomes negative and TPP starts falling. Reason for Increasing Returns to a Factor Better Utilization of the Fixed Factor: In the first phase, the supply of the fixed factor (say, Land) is too large, whereas variable factors are too few. So, the fixed factor is not fully utilised. When variable factors are increased and combined with fixed factor, then fixed factor is better utilised and output increases at an increasing rate. Increased Efficiency of Variable Factor: When variable factors are increased and combined with the fixed factor, then variable factors are utilised in a more efficient manner. At the same time, there is greater cooperation and high degree of specialisation between different units of the variable factor. Fy]NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Reasons for Diminishing Returns to a Factor Optimum Combination of Factors: Among the different combinations between variable and fixed factor, there is one optimum combination, at which total product (TPP) is maximum. After making the optimum use of fixed factor, the marginal return of variable factor begins to diminish. Reasons for Negative Returns to a Factor Limitation of Fixed Factor: The negative returns to a factor apply because some factors of production are of fixed nature, which cannot be increased with increased with increase in variable factor in the short run. Decrease in Efficiency of variable Factor: With continuous increase in variable factor, the advantages of specialization and division of labour start diminishing. It results in inefficiencies of variable factor, which is another reason for the negative returns to eventually set in. Returns to Scale In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale of production can be changed by changing the quantity of all factors of production. The term “returns to scale” refers to the changes in output as all factors change by the same proportion. Returns to scale are of three types Increasing returns to scale Increasing returns to scale or diminishing cost refers to a situation when all factors of production are increased, output increases at a higher rate. It means if all inputs are doubled, output will also increase at the faster rate than double. Hence, it is said to be increasing returns to scale. This increase is due to many reasons like division external economies of scale. 28NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir nf A P, ° aa UNITS OF LABOUR & CAPITAL OX axis represents increase in labour and capital while OY axis shows increase in output. When labour and capital increases from Q to Qi, output also increases from P to Ps which is higher than the factors of production i.e. labour and capital. Diminishing Returns to Scale Diminishing returns or increasing costs refer to that production situation, where if all the factors of production are increased in a given proportion, output increases in a smaller proportion, It means, if inputs are doubled, output will be less than doubled. If 20 percent increase in labour and capital is followed by 10 percent increase in output, then it is an instance of diminishing returns to scale. The main cause of the operation of diminishing returns to scale is that internal and external economies are less than internal and external diseconomies. Yi ° aa, * UNITS OF LABOUR & CAPITAL 29NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir On OX axis, labour and capital are given while on OY axis, output. When factors of production increase from Q to Q: (more quantity) but as a result increase in output, i.e. P to P; is less. We see that increase in factors of production is more and increase in production is comparatively less, thus diminishing returns to scale apply. Constant Returns to Scale Constant returns to scale or constant cost refers to the production situation in which output increases exactly in the same proportion in which factors of production are increased. In simple terms, if factors of production are doubled output will also be doubled. In this case internal and external economies are exactly equal to internal and external diseconomies. This situation arises when after reaching a certain level of production, economies of scale are balanced by diseconomies of scale. This is known as homogeneous production function. Cobb-Douglas linear homogenous production function is a good example of this kind. * R Py ® 2 = eS / « 0 aa, fe UNITS OF LABOUR & CAPITAL Introduction to Economic Structure Economy An economy is any region with well-defined set of rules and defined set of institutions to implement those rules. All activities of production, consumption, exchange and distribution are regarded as economic activities. These activities work in a networked environment. 30NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir All illegal activities and all production of services for self-consumption are not regarded as economic activities and are said to be non-economic activities. Similarly distribution of goods by the government will be considered an economic activity because of the resources involved. Circular flow of income —_—————eeee FACTOR INPUTS FACTOR PAYMENTS Land Rent Labour Wages/salary Capital Interest Entrepreneur Profit 2 sector model - firms and households 3 sector model - firms, HH’s and financial markets 4 sector model - firms, HH’s, financial markets and government Financial markets and government are also well connected. Now till yet we were considering only a closed economy, that is, we are neither exporting nor importing. In open economy, we include in the external sector, also called ROW (Rest of the world) 5 sector model - firms, HH’s, financial markets, government and external sector Firms earn earnings through their exports while they make payments for their import, Whereas, HH’s receive remittances from abroad and also send money to their contacts abroad. Net factor income from abroad = factor income coming to India - factor payments to the rest of the world. GNP = GDP + NFYA GDP - The total value of all the final goods and services produced within the 4NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir domestic territory of an economy in a given financial year is called the Gross Domestic Product. All GDP data is calculated on a quarterly basis. The Central Statistics Office (CSO), a governmental agency in India under the Ministry of Statistics and Programme Implementation gives the GDP estimates in India. Types of goods (“‘use” based classification) + Consumer goods + Capital goods + Intermediate goods and services Consumer goods - All those goods and services used for the ultimate satisfaction of the households are called consumer goods. Example: car used by households. Capital goods - All those goods used for further production of goods are called capital goods. Example: car used as taxi. Intermediate goods and services - All those goods and services used for further production of goods and services and which get completely exhausted during production process are intermediate goods and services. We do value addition to the intermediate goods to make them a final/processed good. Whether a good is a final good or an intermediate good depends upon the interpretation for its use. Example: bread used by household is a final good but not necessarily for a restaurant. Final goods and services = consumer G&S + capital G&S. Domestic territory - production done in domestic territory is a part of domestic product. Domestic territory includes: + Land and sea boundary + Allaircrafts and ships operated by residents of a country abroad + All oil platforms and natural gas rigs operated by Indian resident/company abroad + Embassies and consulates of a country abroad. GNP - total value of final goods and services produced in an economy by all normal residents in a given financial year. All those individuals who live in a country for more than one year and whose center of economic interest lies in that country are called normal residents. Example: Indian government employee abroad for more 32NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir than one year will still have center of interest in India. Similarly, for students and people gone for medication for more than a year will have center of interest in India. People who cross borders have their center of interest in area where they live. Difference between domestic product and national product Domestic product is a geographical concept, whereas national product is a personal/ residency related concept. GNP is best described as the measure of national output than GDP. GNP = GDP + NFYA NFYA = all factor income earned by normal residents of a country abroad - income of non-residents earned in domestic territory If depreciation is included as part of domestic product = GDP. Depreciation is the expected fall in the value of a capital asset due to wear and tear over a number of years Capital loss is the UNEXPECTED fall in the capital asset’s value due to a uncertain event. If depreciation is not included in GDP, then we get NDP. NDP = GDP - depreciation Real GDP is GDP calculated at basic prices GVA at basic price = GVA at factor cost + production tax. Market Price and Factor Cost Factor Cost: refers to all factor payments made by the producing unit (firm) to the factors of production for their contribution in the production of goods and services. Whatever income is generated, is distributed among factors in the form of factor income, that is, rent, wages, interest and profit. Factor income is called factor cost because factor incomes is cost incurred by the producer who pays to the factors. Market Price: Market price is the price at which a commodity is sold and purchased in the market. It is the price what buyers pay actually, not what the producers actually get. The point is that when a product goes to the market for sale, government levies indirect taxes (like GST) which is added to the factor cost of the commodity (MP= FC + indirect tax). Consequently, market price becomes higher than the factor 33NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir cost. Similarly, government sometimes gives subsidies on sale of certain goods (like sugar, LPG cylinder etc.) to lower the price which is subtracted from the factor cost. As a result, MP becomes lower than FC (MP= FC - subsidy). The difference between Indirect tax and subsidy is known as Net Indirect Tax (NIT= indirect tax- subsidy). Indirect taxes: Taxes which are levied by the government on the production and sale of commodities are called indirect taxes. Subsidies: These are cash grants given by the government to the enterprises to encourage production of certain commodities or to sell goods at prices lower than the free market prices. Subsidies are opposite of indirect tax because they lower the market price. National income Estimation There are three methods for calculating national income. 1 Income method 2. Expenditure method 3 Value added method Income method: Measures the national income from the side of payments made to the primary factors of production in the form of rent, wages, interest and profit for their productive services in an accounting year. Thus, income is calculated by adding up factor incomes generated by all the producing units located within the domestic economy during a period of account. The resulting total is called Net Domestic Product at FC. Components under income method are: a. Compensation of employees: This includes co Wages and salaries paid both in cash and kind, and co Employer’s contribution to social security schemes. This consists of contribution to life insurance, provident fund, pension schemes, etc. b. Rent and royalty: rent is earned from lending the services of land, building whereas royalty is income earned by the landlord from granting leasing rights of sub- soil assets (deposits of coal, iron, natural gas, etc.) and for use of patents, copyrights, etc. c. Interest: It is the price for the funds borrowed. It is a factor income to the lender of funds. 34NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir d. Profit: Profit is the residual factor payment to owners of production units, Thus, profit is the income of factor input called, entrepreneurship for organising production and undertaking attendant risks. The net profit of a corporate enterprise is used mainly for three purposes o Corporate tax: Corporate tax is the direct tax levied by the government on the profit of a company. The company pays it out of its total profits. The company pays it out of its total profit. Corporate tax is thus part of domestic income since it is actually earned by the company. o Dividend: It is that part of profit of a corporate enterprise which it pays to its shareholders in accordance with the number of shares held by the latter. Undistributed profit (reserve fund) e. Mixed income of self-employed: income of self-employed persons and unincorporated enterprises who use their own labour, capital, etc. is known as mixed income. They do not generally hire factor services from the market; rather they use their own resources like land, labour, funds, etc. As a result, it becomes difficult to classify their income distinctively among rent, wages, interest and profit. Adding the above components gives us NDP at Factor cost. 2. Expenditure method: Under expenditure method, national income is calculated first by adding up all the items of final consumption expenditure and final investment expenditure within the domestic economy. The resulting total is called GDP at MP. Components in expenditure method a. Private final consumption expenditure: In this category, we include consumption expenditure by consumer households and private non-profit institutions serving households on all types of consumer goods and services. b. Government final consumption expenditure: Consists of value of following items © Compensation of employees paid by the government. o Direct purchases from abroad by the government less value of sales. o Net purchases of currently produced goods and services in the domestic market which is obtained by multiplying the volume of sales to government by the enterprises with the retail prices c. Gross fixed capital formation: Refers to increase in stock of fixed capital during a year which includes depreciation. It includes o Business fixed investment, that is, addition to machinery, factory building and equipment. 35NEXT IAS | GS Pre Cum Main Foundation Course for CSE-2022 ty Vibhas Jha Sir o Residential construction investment, that is, addition to housing facilities. © Public investment, that is, capital formation by government in the form of schools, roads, hospitals, canals, etc. d. Change in stocks: Refers to the physical change in the stock of inventories like raw material, semi-finished goods and finished goods lying with the producers for smooth working of production process. It is measured by subtracting opening stock (stock in beginning of the year) from closing stock (stock at the end of year). e. Net exports: It is the difference between exports and imports of a country during a particular time period. Since export implies expenditure by foreigners on purchase of domestically produced goods, therefore, exports are a part of domestic product. Similarly, as import implies expenditure by domestic residents on purchase of foreign goods produced abroad, therefore, they are not part of domestic product. Hence, value of exports is added and that of imports is subtracted. ‘Adding all the above components gives us GDP at MP. 3. Value added method: In value added method, national income is calculated at the stage of production (or addition of value). Clearly, value added method measures the contribution of each producing unit in the domestic economy avoiding any possibility of double counting. Under this method, domestic income is first calculated by totalling “net value added at FC” by all the producing units during an accounting year within the domestic territory. This total is called “net domestic product at FC” or domestic income. Then by adding net factor income from abroad to domestic income (NDP at FC), we get National income (NNP at FC). Steps under value added a. Value of output = sales + change in stock (output is always at MP. Output implies gross output) b. Value added = value of output - value of intermediate consumption = Gross product = Gross value added at MP NVA at MP = GVA at MP- depreciation. d. NVA at FC = NVA at MP - net indirect taxes = sum of factor incomes. ° Net value added at FC= Gross output - intermediate consumption - depreciation - net indirect taxes. 36NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Critical Analysis of New Measure of Growth in India The Central Statistical Office (CSO), in January 2015, released the new and revised data of National Accounts, effecting a few changes: 1. The new measure of growth has been changed from calculation at FC to MP Old method; GDP at FC = GDP at MP - IT + Subsidy New method; GDP at MP = GDP at FC + IT - Subsidy. In new method, there is less incentive to charge less indirect tax and give higher subsidy to inflate GDP, which was present when GDP was calculated at FC. Most of the market economies calculate their GDP at MP. 2. Base year has been shifted from 2004-05 to 2011-12. This is done to capture the dynamism in the economy. (Base year should be a normal trend year). This was done in accordance with the recommendations of the National Statistical Commission (NSC). 3. Better coverage has been provided by including several new services like tuitions, beauty salons and new industries like recycling. This helps in better understanding the link between production and consumption in a better manner. 4. Larger coverage has become possible of financial sector by inclusion of information from the accounts of stock brokers, asset management companies, mutual funds and pension funds and regulatory bodies like SEBI, IRDA, etc. Better coverage of local bodies and autonomous institutions. Comprehensive coverage of corporate sector, both in manufacturing and services by incorporation of annual accounts of companies as filed with the Ministry of Corporate Affairs (MCA) under their e-governance initiative, MCA- 21, Use of MCA-21 database for manufacturing companies has helped in accounting for activities other than manufacturing undertaken by these companies. ae Criticisms 1. New method would give higher GDP growth due to increase in indirect taxes. If found, it should be reported because indirect tax being regressive in nature increases inequality in the economy. 7NEXT IAS | GS Pre Cum Main Foundation Course for CSE-2022 ty Vibhas Jha Sir 2. New method gives GDP at MP and the series of data is from 2011- current year. Old method used FC and there is no record of data at MP in it. This means that it is not possible to construct a complete time series covering data from 1950-21 to current year. This results in making macroeconomic forecasting difficult. 3. New measure calculates GDP with consumption base while old method calculated it with production base. In case of consumption base, it becomes difficult to collect proper data and it is possible that some part of data is exaggerated. 4. Lack of clarity on measurement of GVA, which has been developed using MCA data which do not represent the entire economy. The new method is a good beginning to begin towards modern transactions (more formalisation) and more transparent data reporting. Larger coverage under the new method will also help in better policy design. But, there are several discrepancies in projection of growth and activities on the ground. CSO should assure that activities are covered properly with respect to consumption base and indirect tax regime should be made more stable by making the GST more comprehensive. More research is needed to understand the large share of “discrepancy” in evaluating GDP by different methods. Therefore, given CSO rectifies the above problems, new measure of GDP growth will become a useful technique to measure growth. The trends in National Income (NNP) will be studied along the topic ‘Planning’. Government Budget and the Economy Government budget is an annual statement, showing item wise estimates of receipts and expenditures during a fiscal year. Fiscal year is taken from 1 April- 31 March. Objectives of Government Budget 1, Reallocation of Resources * Allocation of resources can be done by government through budget in many ways. * Those production activities which government wants to encourage, on those areas government can provide tax concessions and subsidies. * On the other hand, Government discourages the production of harmful consumption goods (like liquor, cigarettes etc.) through heavy taxes. * By doing this, indirectly it will lead to reallocation of resources. The areas in which private sector does not take any initiative to enter the government enters directly into such economic activities. 38NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir 2. Reducing Inequalities of Income and Wealth Government can raise welfare of people through reduction in income inequalities in the following way: «Higher rate of taxes can be imposed on higher income group by the government and lower income group can be taxed at a lower rate. « — It will reduce income of the rich and raise standard of living of the poor. * Lower income group people can be provided tax exemptions. * Also, lower income groups can be provided facilities like education, medical, housing etc. at a subsidized rate or free of cost through the amount collected by government through taxes. 3. Economic Stability Government can exercise control over these fluctuations through taxes and expenditure. « Inflationary tendencies emerge when aggregate demand is higher than the aggregate supply. Government can bring down aggregate demand by reducing its own expenditure. * During deflation, government can increase its expenditure and give tax concessions and subsidies. In short, policies of surplus budget during inflation and deficit budget during deflation help to maintain stability of prices in the economy. 4, Reducing Regional Disparities The government budget aims to reduce regional disparities through its taxation and expenditure policy for encouraging setting up of production units ‘in economically backward regions. 5. Economic Growth Budget can be effective tool to ensure the economic growth in a country. * If the government provides tax rebates and other incentives for productive ventures and projects, it can stimulate savings and investments in an economy. * Spending on infrastructure of an economy enhances the production activity in different sectors of an economy. However, before planning such expenditure, rebates and subsidies, Government. should check the rate of inflation and tax rates. Also there may be the risk of debt trap if loans are too high to finance the expenditure. Components of Budget 1, Revenue Budget 2. Capital Budget 39NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 bby Vibhas Jha Sir Budget Receipts Revenue Receipts: Refer to those receipts which neither create any liability nor cause any reduction in the assets of the government. Nether ereates a abilty (Satisfies both the conditions) Sources of Revenue Receipts (a) Tax Revenue (b) Non-Tax Revenue Tax Revenue Tax revenue refers to sum total of receipts from taxes and other duties imposed by the government. Tax is a compulsory payment made by people and companies to the government. Tax receipts are spend by the government for common benefit of people in the country. A tax payer cannot expect that the tax amount will be used for his direct benefits. Tax Revenue can be further classified as: Direct:TaxesNEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir Direct Tax and Indirect Tax. Direct Tax Indirect Tax Direct taxes are levied on individuals and | Indirect taxes are levied on goods and services. companies. The burden of a direct tax cannot be | The burden of an indirect tax can be shifted, Le. impact and ineidence shifted, ie. impact and incidence is on the | is on different persons. same person. They are generally progressive innature. _| They are generally proportional in nature. Income tax, corporate tax etc. Goods and Services tax ete. Non-Tax Revenue: refers to receipts of the government from all sources other than those of tax receipts. The main sources of non-tax revenue are: 1. Interest: Government receives interest on loans given by it to state governments, union territories, private enterprises and general public. Interest receipts from these loans are an important source of non-tax revenue. 2. Profits and Dividends: Government earns profit through public sector undertakings like Indian Railways, LIC, BHEL, etc. It earns profit from the sale proceeds of the products of such public enterprises. Government also gets dividend from its investments in other companies. 3. Fees: Fees refer to charges imposed by the government to cover the cost of recurring services provided by it. Such services are generally in public interest and fee is paid by those, who receive such services. It is also compulsory contribution like tax. Court fees, registration fees. Import fees, etc. are some examples of fees. 4. License Fee: It is a payment charged by the government to grant permission for something. For example, license fee paid for permission of keeping a gun. 5. Fines and Penalties: They refer to those payments which imposed on law breakers. For Example, Fine for jumping red light or penalty for non-payment. of tax. Fines are different from taxes as the former is levied to maintain law and order, whereas, the latter is imposed to generate revenue. 6. Escheats: It refers to claim of the government on the property of a person who dies without leaving behind any legal heir or awill. Capital Receipts refers to those receipts which either create a liability or cause a reduction in the assets of the government. Sources of Capital Receipts 1. Borrowings: Borrowings are the funds raised by government to meet excess expenditure. Govt. borrow funds from: (a) Open Market (b) Reserve Bank of India (RBI) anNEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir (c) Foreign governments (like loans from USA, England etc.) (d) International institutions (like World Bank, International Monetary Fund) Borrowings are capital receipts as they create a liability for the government. 2. Recovery of Loans: Government grants various loans to state governments or Union territories. Recovery of Loans is a capital loans is a capital receipt as it reduces the assets of the government. 3. Other Receipts: These include: (a) Disinvestment: refers to act of selling a part or the whole of shares of selected public sector undertakings (PSU) held by the government. They are termed as capital receipts as they reduce the assets of the government. (b) Small Savings: Small savings refer to funds raised from the public in the form of post office deposits, National Saving Certificates, Kisan Vikas Patras etc. They are treated as capital receipts as they lead to an increase in liability. Difference between Revenue Receipts and Capital Receipts Revenue Receipts Capital Receipts They neither create any liability nor | They either create any liability or reduce any asset reduce any asset of the government of the government, They are regular and recurring in mature. | They are irregular and non-recurring in nature. There is no future obligation to return the | in case of certain capital receipts (like borrowings), amount. there is future obligation to return the amount along with interest. Examples: Tax Revenue (Income tax and| Examples: Borrowings, Disinvestment etc. GST etc.) and Non-tax |_fevenue (like interest, fees etc.) Budget Expenditure The Budget expenditure can be broadly categorised as: (i) Revenue Expenditure (ii) Capital Expenditure Revenue Expenditure: refers to the expenditure which neither creates any asset nor causes reduction in any liability of the government. Examples: Payment of Salaries, pensions, interests, expenditure on administrative services, defence services, health services, grant to states, etc. 42NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 bby Vibhas Jha Sir eal __ (Satisfies both the Conditions) Capital Expenditure: refers to the expenditure which either creates an asset or causes a reduction in the liabilities of the government. It adds to capital stock of the economy and increases its productivity through expenditure on long period development programs like Metro or Flyover. Examples: Expenditure on building roads, flyovers, factories, purchase of machinery, repayment of borrowings etc. erect iol aliability (Satisfies any one condition) Revenue Expenditure and Capital Expenditure. Revenue Expenditure Capital Expenditure Revenue expenditure neither creates any | Capital expenditure either creates an asset or asset nor reduces any liability of the | reduces a liability of the government government. Ttis incurred for normal running of running | It is incurred mainly for acquisition of assets and of government departments and provision | granting of loans and advances. of various services. It is recurring in nature. It is non-recurring in nature. Salary, Pension, interest, etc. Repayment of borrowings etc. Types of Budget 1. Balanced Budget, where estimated government receipts = estimated government expenditure. . Surplus Budget, where estimated government receipts > estimated government expenditure. 4aNEXT IAS | GS Pre Cum Main Foundation Course for CSE-2022 ty Vibhas Jha Sir 3. Deficit Budget, where estimated government receipts < estimated government expenditure. Government Deficit 1. Revenue Deficit 2. Fiscal Deficit 3. Primary Deficit 1, Revenue Deficit: It refers to excess of revenue expenditure over revenue receipts during the given fiscal year. Revenue Deficit= Revenue Expenditure - Revenue Receipts Revenue deficit signifies that government’s own revenue is insufficient to meet the expenditure on normal functioning of government departments and provisions for various services. Implications 1. It indicates the inability of the government to meet its regular and recurring expenditure in the proposed budget. 2. It implies that government is dissaving 3. It also implies that the government has to make up this deficit from capital receipts, i.e. through borrowings or disinvestments. Measure to reduce Revenue Deficit (i) Reduce Expenditure: Government should take serious steps to reduce its expenditure and avoid unproductive or unnecessary expenditure. (ii) Increase Revenue: Government should increase its receipts from various sources of tax and non-tax revenue. 2. Fiscal deficit refers to the excess of total expenditure over total receipts (excluding borrowings) during the given fiscal year. Fiscal deficit = Total Expenditure - Total Receipts (excluding borrowings) The extent of fiscal deficit is an indication of how far the government is spending beyond its means. Implications of fiscal deficit The implications of fiscal deficit are as follows: (a)Debt Trap «Fiscal deficit indicates that the total borrowing requirements of the government. * Borrowings not only involve repayment of principal amount, but also require payment of interest. «Interest payments increase the revenue expenditure, which leads to revenue deficit. “4NEXT IAS | Gs Pre Cum Main Foundation Course for CSE-2022 by Vibhas Jha Sir «It creates a vicious circle of fiscal deficit and revenue deficit, wherein government takes more loans to repay the earlier loans. * Asaresult, country is caught in a debt trap. (b) Inflation: Government mainly borrows from RBI to meet its fiscal deficit. RBI prints new currency to meet the deficit requirements. It increases the money supply in the economy and creates inflationary pressure. 3. Primary Deficit refers to difference between fiscal deficit of the current year and interest payments on the previous borrowings. Primary deficit = Fiscal Deficit - Interest Payments The difference between fiscal deficit and primary deficit shows the amount of interest payments on the borrowings made in past. Low or Zero Primary Deficit: indicates that interest commitments (on earlier loans) have forced the government to borrow. 45