Economy Part 1

2018 INTEGRATED LEARNING PROGRAMME, ILP-2018
IASBABA
[BASIC ECONOMY-SET 3]
Integrated Learning Programme 2018 is a step towards Enabling a person located at the most remote
destination a chance at cracking AIR 1 in UPSC/IAS
NATIONAL INCOME ACCOUNTING
Basic concepts of Macroeconomics

Final goods
Definition - an item that is meant for final use and will not pass through any more stages of
production or transformations is called a final good.
Example - Suppose a person sells rubber as raw material to MRF Company, which is a tyre
manufacturing company. The company manufactures tyre, sell it to MARUTI SUZUKI, which
uses the tyre, and manufacture a car.
Why do we call this car as a final good?
Here the car is a FINAL GOOD because
It is for final use.

It is no more in active economic flow, will not pass through any more stages of production
or transformations by producer. However, remember it can go for further transformation by
the purchaser or in other words, it may transform by the consumer.
A good, let us say a cardboard is not final good just because it is a cardboard. It assumes the
form of final good by its economic nature i.e. in the process of transformation it derives an
economic value or not. If it is used in home, then it is not a final good because it involves
transformation but no economic activity is there. While if same cardboard is used in a factory to
make cartoon boxes, which are sold to third parties or any person then they can be called as
Final goods.
Final goods are of two types Capital goods and Consumer goods.
Consumption goods or consumer goods
Definition Goods or services, which are consumed by the purchaser.

Example Food or services of plumber
Before going to capital goods, let us understand the meaning of capital. Capital is one of the
factors of production.
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Capital goods
Definition They help in production of other goods. They are crucial backbone of any
production process. While they make production of other commodities feasible, they
themselves are not transformed in the production process. In other words, they are final
goods for helping in production but not for consumption.
Examples Tools, implements and machines, which helps in manufacturing of any kind of
good such as car, bike, plane etc.
Capital goods gradually undergo wear and tear, and thus need to repair or gradually replaced
over time.
Consumer durables
Definition + example - Some goods or commodities such as Television, Laptops, washing

machine share two common things with Capital goods First, they are also durable i.e. have
a long life and second, they also needed to be repair or replacement of a part in case of
problem or fault.
Therefore, all the final goods and services produced in an economy in a given period of time
they are either in the form of consumption goods (both durable and non-durable) or capital
goods. As final goods, they do not undergo any further transformation in the economic process.
Intermediate goods
Definition These goods are used as raw material or inputs for production of other goods or
the raw materials that a firm buys from another firm, which are completely used up in the
process of production.
Example Paper used to make notebooks.
These goods are neither Final goods nor Capital goods.
Flows
Definition Flow is a variable, which is measured over a period of time i.e. daily, weekly or
annually.
Example - income makes sense only when it is defined with time period i.e. annual income
of X is rupees 10k.
Stock
Definition it is a variable, which is measured at a particular point of time.
Example if one has to tell, how much goods are there in store then it will be at a particular
point of time say, 2o clock not from 6am to 6pm. In other words, 100 cycles are there in
store at 2 pm.
Flow affects stocks. How?
In simple language, if flow of goods increases then stocks in store will also increase and
vice versa.
Change in stocks is flows.
Depreciation
Definition - An annual allowance for wear and tear of a capital good.

Example Suppose a newspaper-printing machine is there which can last up to 10 years.
However, each year we have to spend some amount of money to repair part of it (for
example conveyor belt) which gets wear in the process of printing. This is called as
depreciation.
How to calculate total flow of production in an economy?
For this, we need to have a quantitative measure, which can measure the aggregate level of
final goods produced in the economy.
This can be possible only if the quantitative measure uses a common value like monetary
value of goods and services to measure.
Nevertheless, we also need to take care that same good is not counted twice i.e. only
monetary value of all the final goods should be there and intermediary goods value should
be excluded to avoid double counting.
Total final output produced in an economy consists of consumer goods as well as capital
goods
Consumption goods are for population to sustain themselves. To consume goods people
must have purchasing power.
Capital goods produced are used by businesspersons for production or addition to capital
stock.
At a particular point of time final goods and services will be either consumption or
investment just like 6=3+3 or 6=2+4 or 6=4+2.
One increases at the cost of other. However, more production of capital goods will increase
the production of consumer goods.
What are the two factors, which enable the sale of goods and services?
One Demand for products

Second Purchasing power of people to buy the goods and services.
o Purchasing power means they must have income to pay for goods.
o People earn their income as owners of factors of production.
o For example A person X is owner of land and another person Y owns a company. X
gets his income from the rent paid to him for land while Y gets his income from
profits.
Circular flow of Income
Figure 1 Circular flow of income in a simple economy
Consider a simple economy in which there are only 2 players households and firms
and no savings, taxes, government and no external trade.
The two arrows on top represents goods and services market.
o Arrow A expenditure or income spent by households to purchase
consumption goods produced by firms.
o Arrow B goods and services provided by firms to households.
o The value of goods and services (arrow B) = expenditure spent by households on
goods and services (arrow A)
The two arrows below represent factors of production market
o Arrow C payment of wages (wage, rent, interest and profit) for factors of
production by households
o Arrow D services (labour, land, capital and entrepreneur) provided by
households to firms in form of factors of production.
o Factor payment (wage, rent, interest and profit) to households = factor services
(labour, land, capital and entrepreneur) by households to firms.
Wage, rent, interest and profit are expenditures for firms but income to households. So,
ones income is anothers expenditure and so both are equal.
Calculation of National Income
Figure 2 Methods of measuring national income
National income can be calculated by compiling of income of all or expenditure of all.
Production Method or Value Added Method
In this method, National income is calculated by aggregate annual value of goods and
services produced in a country in one year.
Now question arises do we calculate aggregate of all goods and services produced by all
the firms such as Reliance, Vodafone, Maruti, HP etc. in an economy?
Try to find answer in below example.
See this example Suppose Flying machine company buys some cotton from farmer and
give it to weaver who weaves the cotton into cloth and return it to company. Now
company gives this cloth to tailor to stitch a shirt. Tailor stitches it and return it to the
company. Company added some more things in it, packed it and sold in the market for
1500 rupees. This shirt produced by firm is not entirely of its own contribution, it also has
contribution of tailors, weavers, farmers etc. To calculate net contribution of firm we have
to subtract the contributions made by famers, weaver and tailors. If we do not do that
then it will lead to double counting.
The net contribution made by firm is called its value added.
Value added of a firm = value of production of the firm value of intermediate goods
used by firm.
Value added by firm is distributed among factors of production i.e. land, labor, capital and
entrepreneurship.
So, wages + interest + profits + rent must be equal to value added of firm.
In short -
Farmer Weaver Tailor Flying machine firm
Total
500 300 200 1500
production
Intermediate
0 0 0 500
goods used
Value added 500 300 200 1500 500 = 1000
Here intermediate goods used by firm is of 500 rupees for cotton while 1000 rupees is
value added, out of which 500 is paid to weaver and tailor as wages.
Value added is a flow variable i.e. measured over a period of time (weekly, monthly,
annually)
Gross Value Added and Net Value Added
We have read Depreciation above. It is also known as Consumption of fixed capital. But
why is it called so?
Capital goods gradually undergo wear and tear and so producer has to invest in repair or
replacing of weared parts to keep the value of capital constant.
This replacement investment is same as depreciation of capital. In other words, it is same
as using up of capital.
If we add depreciation into value added, then we get Gross value added. Gross value
added = value added + Depreciation.
If we deduct depreciation from Gross value added, then we get Net value added. Net
Value added = Gross value added Depreciation
Inventory
Definition - The stock of unsold finished goods, or semi-finished goods, or raw materials,
which firms carry from one year to the next, is called inventory.
Example Suppose BMW bought 500 airbags to use in manufacturing of cars. Each car uses
five airbags and company has planned to sell 100 cars in this year. However, because of low
demand they were able to sell only 50 cars. So, now they have 50 cars and 250 airbags
unsold stocks. These unsold stocks are called as Inventory.
Inventory is a stock variable i.e. measure at a particular point of time.
Inventory increased means inventorys value at the beginning of year was lower and higher
at the end of year.
While inventory decreased is lower value of inventory at end of year and higher at the
beginning of the year. It is just like water stored in tank.
Change of inventories of a firm during a year production of the firm during the year sale
of the firm during the year.
Change of inventories of a firm during a year value added + intermediate goods used by
the firm sale of the firm during a year.
Production of the firm value added + intermediate goods used by the firm.
For the above three statements consider Times of India newspaper inventory. The change in
its paper roll inventory will depend on how much newspaper it prints and how much
newspaper it sells or how much newspapers the customers read.
Change in the inventory takes over a period of time i.e. newspaper roll will accumulate
daily, weekly or monthly and so it is a flow variable.
Investment
Inventories are treated as capital. When inventories increase that means things are added
in stock. This addition is a kind of investment for future use just like stored water in a tank is
capital for summer season.
Investment have 3 major categories
o Investment expenditure
o Fixed business investment
o Residential investment
Investment expenditure
It is the expenditure incurred by either an individual or a firm or the government for the
creation of new capitals assets like machinery, building etc.
Fixed business investment
Remember it simply investment in fixed capital.

Investment in fixed capital or to the replacement of depreciated fixed capital. Thus, it is
investment in physical assets such as machinery, building, land etc.
Residential investment
Investment on buying homes.
Planned or unplanned changes in inventories
Planned accumulation of Inventories
We will try to understand it with the same BMW example. The firm wanted to sell 100 cars
in a year and want to keep the inventory of 10 cars. If they produce 110 cars and able to sell
100 cars then this is called as planned accumulation of inventories.
Unplanned accumulation of inventories
In the above example, if the no. of cars in inventory goes up to 50 due to low demand then
it is unplanned accumulation of inventories.
Planned decumulation of inventories
Suppose the firm have 50 cars in inventory and it want to reduce it to 10 cars. If the firm
succeeded in selling 40 cars with keeping 10 cars in inventory then it is called as planned
decumulation of inventories.
Unplanned decumulation of inventories
In the above example, if firm sells 45 cars instead of their planned selling of 40 cars due to
surge in demand, the inventory is reduced to 5 cars instead of 10 cars. It is called as
Unplanned decumulation of inventories.
Gross value added by firm (GVA) value of sales by the firm + value of change in inventories
value of intermediate goods used by firm. (Recall net contribution of firm does not include
intermediate goods value)
Firm sales in not only domestic country but it also sales to other countries.
Net value added of firm (NVA) GVA depreciation of the firm
GDP NVA + depreciation
GDP of the economy is the sum total of the net value added and depreciation of all the
firms of the economy.
NDP (Net Domestic Product) is summing up of net value added of all firms.
Income method
The calculation of National Income by compiling income of factors of production is called

as Income method.
National income = Total wages + Total rent + Total interest + Total profits
Diagrammatic representation of GDP by the three methods
In our country it is calculated by following formula (this formula sometimes appear in

economic survey)
GDP = Compensation of employees + Consumption of fixed capital + (Other taxes on Production
subsidies on production) + Gross operating surplus
Compensation of employees Salaries paid in cash and other benefits to employees. In simple
words wage.
Consumption of fixed capital Wear and tear of machinery. These are replaced with new parts
or machinery. It adds to income of the machinery and spare parts producers.
Net tax production = other taxes on Production subsidies on production
Other taxes on Production There is a difference between Tax on product and Tax on
production.
Tax on product It includes taxes like Sales tax and Excise duty. It is the tax imposed as
it was produced and sold.
Tax on production - Tax imposed irrespective of production like license fees and land
tax.
Gross operating surplus balance of value added after deducting the above 3 components. It
goes to pay rent of land and interest of capital. Roughly analogous to profit.
Expenditure method
The GDP under this method is calculated by summing up all of the expenditures made on
final goods and services.
There are four main aggregate expenditures that go into calculating GDP: consumption by
households, investment by businesses, government spending on goods and services, and
net exports, which are equal to exports minus imports of goods and services.
GDP = C + I + G + X M
C Consumption expenditure by consumers or by firms (in exception case) on consumption
goods.
I Investment expenditure by firms on capital goods.
G Expenditure by government on final goods and services produced by firms.
X - M Net exports i.e. exports imports.
Main components under Expenditure method
Consumer spending
Most dominant component in calculation of GDP under expenditure method.

It accounts for the majority of Indias GDP. It is about 59% and consumption expenditure
is the reason that our economy is less affected by up and downs in global world. The
economies, which export a lot, are affected by global winds.
It includes purchasing of durable goods, non-durable goods and services.
Government spending
It is the spending by central, state and local governments on basic services (like
education, health care etc.) and defense.
Dominant after consumer spending
Business investment
Most volatile component

It includes capital expenditure by firms on capital goods.
Net exports
It represents the effect of foreign trade of goods and services on the economy.
Why GDP includes expenditure on investment but not the expenditure on intermediate
goods?
Reason Investment goods remain with the firm, whereas intermediate goods are consumed in
the process of production.
Homework
Q.1 India uses which of the above three methods to calculate national income?
Hint - http://mospi.nic.in/Mospi_New/upload/nad_PR_31aug16.pdf
Also, check out the important terms like Private Final Consumption Expenditure, Government
Final Consumption Expenditure, Gross Fixed Capital Formation etc. in the document. Make their
notes and keep revising them. They keep popping up in economic survey.
Q.2 What changes were made by India in calculating the GDP? Why they have been made and
what are their implications?
Some macroeconomic identities
Measures of National Income
GDP GNP NNP NNPFC PI DP
GDP (Gross domestic product)
The word domestic here refers to geographical area.

Definition It is the total value of all final goods and services produced within the boundary
of the country during a given period, generally one year.
It considers production by both resident citizens as well as foreign nationals who reside
within country.
Formula GDP = Q*P
o Where, Q is total quantity of final goods and services produced in the country
o P is price of final goods and services.
Example
1. 125 crores Indian earns 100 crores in Indian Territory.
2. Five crore foreigners (USA) earn 10 crores in Indian Territory and send their
money to USA.
3. Five crore Indians earn 20 crores in Saudi Arabia and send their earnings to
India.
So, now GDP of India will be 100+10 = 110 crores only (why not 130 crores? Because we have to
include only those earnings or income that is earn in Indian Territory)
How GDP is calculated?
Click here
Important points about GDP
Central Statistics Office (CSO), Ministry of Statistics and Programme Implementation

releases the estimates of Gross Domestic Product(GDP) at constant (2011-12) and
current prices.
The components of expenditure on Gross Domestic Product, namely, consumption
expenditure and capital formation, are normally measured at market prices.
GDPFC
Formula - GDPFC = GDPMP - Indirect taxes + subsidy
GNP (Gross National Product)
The word national here refers to all the citizens of a country.

Definition It is the total value of the total output or production of nal goods and services
produced by the nationals of a country during a given period, generally one year.
It considers income of both resident and non-resident citizens of a country while the
income of foreigners who reside within the geographical boundary of the country is
excluded.
Formula GNP = GDP + (X M) or GNP = GDP + NFIA
o Where, GDP = Gross Domestic Product
o X (export) = remittances sent by non-resident citizens (working in other country) to
his country.
o M (import) = remittances sent by foreigners (working in foreign countrys
geography) to his country.
o X M = Net Factor Income from Abroad (NFIA).
Example If we take the same example of GDP, then the GNP would be 120 crores.
o How? According to formula the GNP would be 120 crores = 110 + (20 10) crores.
Net National Product (NNPMP)
Definition It is arrived after deducting depreciation from GNP. Why deduction in

depreciation? Because the part, which replaces the depreciated parts of the product,
already, produced, does not add value to current years total produce. It is just keeping the
already produced product intact.
Formula NNP = GNP Depreciation
The NNP with market prices includes indirect taxes and excludes subsidies, which are given
to produce goods and services.
Example - The cost of production of LPG gas is 600 rupees for 15 kg but after government
provides subsidy of 200 rupees then the price of product came to 400 rupees. This is called
as NNPMP i.e. NNP at market price.
NNP at factor cost (NNPFC) or National income
Definition - Adding of subsidies and deduction of indirect taxes from NNP MC is called as
NNPFC. This is done to find payments made to factors of production (land, labor, capital,
entrepreneurship)
Formula - NNPFC = NNPMC Net Indirect Taxes
Net Indirect Taxes = Indirect taxes Subsidies
National Income is term used for NNPFC.
Personal Income (PI)
Definition sum of income of all the people of a country in one year.

Sometime part of national income is not available to individuals and sometimes payments
made to some individuals are not included in national income.
So, while calculating national income parts of national income that are not available to
individuals of the country is deducted from the national income. The monetary payments
made to individuals but not included in national income are added to the national income.
Formula - Personal income (PI) National Income Undistributed profits Net interest
payments made by households Corporate tax + Transfer payments to the households
from the government and firms.
Undistributed profits - A portion of corporates profit which is for future expenditure and
expansion and it is not share with shareholders and factors of production.
Corporate Tax - It is imposed on the earnings made by the firms
Net interests paid by the households - The households do receive interest payments from
private firms or the government on past loans advanced by them. Households may have to
pay interests to the firms and the government as well, in case they had borrowed money
from either.
Transfer payments - The households receive transfer payments from government and firms
(pensions, scholarship, prizes, for example).
Personal Disposable Income
Definition Income available to individuals that can be spent at their will.

Example suppose your fathers income is 50000 rupees per month. After paying direct tax
payments and fines, the remaining income is there disposable personal income.
Formula - Personal Disposable Income (PDI) = PI Personal tax payments Non-tax
payments
Personal tax payments example income tax.
Non-tax payments like fines.
Goods and Prices
Q. Why do we need GDP at constant prices?
To compare the GDP figures of different countries.

To compare the GDP figures of the same country at different points of time.
Base year
The national income is calculated with reference to a particular year. That reference year is
called as base year.
Constant prices
The price of goods and services in base year is called price of base year or constant price.
Real GDP
Real GDP is national income at constant price.

National income at constant price = Q*P
Where, Q is quantity of goods and services in a particular year
o P is price of the base year (constant price)
Nominal GDP
Nominal GDP is national income at current price.

National income at current price = Q*P
Where, Q is quantity of goods and services in a particular year
o P is price of the goods and services in that particular year (current price)
Example
Base year 2011

Base year price 100
GDP at current price or nominal GDP for year 2011 100 (quantity) * 100 (current year
price) = 10,000
GDP at current price or nominal GDP for year 2015 120 (quantity) * 150 (current year
price) = 18,000
GDP at constant price or Real GDP for year 2015 120 (quantity) * 100 (constant year
price) = 12,000
Q. Why do we calculate national income at constant price?
To check whether the National Income has grown or not.
GDP and Welfare

Though GDP reflects the wealth of an economy but it cant be taken as an index of greater well-
being of the people of that country.
Why GDP cant be taken as an index of greater well-being of the people of a country?
Because many factors that contribute to people's happiness are not bought and sold, GDP is
a limited tool for measuring standard of living.
GDP does not account for leisure time. The US GDP per capita is larger than the GDP per
capita of Germany, but does this prove that the standard of living in the United States is
higher? Not necessarily since it is also true that the average US worker works several
hundred hours more per year more than the average German worker. The calculation of
GDP does not take German workers extra weeks of vacation into account.
GDP includes what is spent on environmental protection, healthcare, and education, but
it does not include actual levels of environmental cleanliness, health, and learning. GDP
includes the cost of buying pollution-control equipment, but it does not address whether
the air and water are actually cleaner or dirtier. GDP includes spending on medical care, but
it does not address whether life expectancy or infant mortality have risen or fallen.
Similarly, GDP counts spending on education, but it does not address directly how much of
the population can read, write, or do basic mathematics.
GDP includes production that is exchanged in the market, but it does not cover
production that is not exchanged in the market. For example, hiring someone to mow your
lawn or clean your house is part of GDP, but doing these tasks yourself is not part of GDP.
GDP has nothing to say about the level of inequality in society. GDP per capita is only an
average. When GDP per capita rises by 5%, it could mean that GDP for everyone in the
society has risen by 5% or that the GDP of some groups has risen by more while the GDP of
others has risen by lessor even declined. Relate it with income inequality. Rich getting
richer and poor getting poorer.
GDP also has nothing in particular to say about the amount of variety available. If a family
buys 100 loaves of bread in a year, GDP does not care whether they are all white bread or
whether the family can choose from wheat, rye, pumpernickel, and many othersGDP just
looks at whether the total amount spent on bread is the same.
Likewise, GDP has nothing much to say about which technology and products are
available. The standard of living in, for example, 1950 or 1900 was not affected only by how
much money people hadit was also affected by what they could buy. No matter how
much money you had in 1950, you could not buy an iPhone or a personal computer.
In certain cases, it is not clear that a rise in GDP is even a good thing. If a city is wrecked by
a hurricane and then experiences a surge of rebuilding construction activity, it would be
peculiar to claim that the hurricane was therefore economically beneficial. If people are led
by a rising fear of crime to pay for installation of bars and burglar alarms on all their
windows, it is hard to believe that this increase in GDP has made them better off. In that
same vein, some people would argue that sales of certain goods, like pornography or
extremely violent movies, do not represent a gain to societys standard of living.
MONEY AND BANKING
Money is a commonly accepted medium of exchange.
Money is not useful if there are no individuals to participate in market transactions.
Q. What is Barter exchange?
Exchange of goods without the mediation of money.

Example Suppose X has 2 kg rice and he wants 1 kg tomato so, he has to search for the
person who has tomato and needed rice in place of tomato.
Disadvantage of Barter system
1. Search cost may be high if number of people is more. (We have to search for the person
who needs the same thing which we possess and thing which we needed is possessed
by him)
2. The person may not get the quality, which he was looking for.
3. Perishable goods could not be saved as wealth for their future expenses.
4. The economy could not contribute anything towards capital formation of the country
too.
5. Barter system cannot exchange goods for services.
6. Cannot act as store for value. Means wealth cannot be stored for future in some form.
Functions of Money
1. Medium of exchange
Acceptable to everyone.
No double coincidence of wants i.e. even if Ram dont possess the thing which Shyam
needed but still Ram can purchase the thing which he needed by paying to Shyam.
2. It is a convenient unit of account.
Definition - The value of all goods and services can be expressed in monetary units.
OR
It is a basic function of money, providing a unit of measurement for defining, recording,
and comparing value. I.e., one rupee signifies a rupees worth of money in other forms
(deposits), of wealth in other forms than money, and of any good or service with a
market value.
3. It helps in calculating the relative price of commodities. In simple words, it means ratio of
prices. Example if Nokia mobile is of 1000 rupees and apple mobile is of 10000 rupees
then apple mobiles value is equal to 10 Nokia mobiles.
If prices of commodities increase in terms of money, then this means the value of
money had decreased in terms of its purchasing power. For example in childhood, we
were able to purchase 4 chocolates of one rupee but now we can purchase hardly one
chocolate from one rupee. This is called as deterioration in the purchasing power of
money.
4. Act as Store of value.
Meaning wealth can be stored in the form of money for future use.
Example gold can be stored in the form of money in bank.
5. Easily convertible to other commodities.
As it is acceptable to everyone i.e. universal acceptability, everyone is ready to exchange
any commodity for money.
Barter system Money
Perishable Yes No
Storage cost High Low
Double coincidence of want Yes No
Universal acceptability No Yes
Easy convertibility to other

No Yes
commodities
Demand for money
Q. Money is the most liquid of all assets. What does that mean?
As water takes shape of any container in which it is poured similarly money has universal
acceptability and so, can be exchanged for other commodities very easily.
Opportunity cost
Lets try to understand it with an example. Suppose you have 10000 rupees. If you put this
money into bank, then you can earn interest on it but you would not be able to purchase
anything. In addition, if you purchase a tab or any other thing then you lost the opportunity of
earning interest.
Liquidity preference
This means preference of asset in liquid i.e. cash.
People hold money for three reasons -
1. The Transaction motive

2. The Speculation motive
3. The Precautionary motive
Liquidity Trap
A liquidity trap means consumers' preference for liquid assets (cash) is greater than the rate at
which the quantity of money is growing. So any attempt by policymakers to get individuals to
spend more (and policymaker do this by increasing the money supply) to create demand will
not work.
Try to remember the following with the help of this diagram for better interlinking.
Suppose in an economy at one point of time (see the highest point of rate of interest in
graph) the rate of interest is so high that everyone expects it to fall in future and are
sure that they can made capital gains by holding bonds. Therefore, everyone starts
investing his or her deposit account money into bonds.
Now suppose, at another point (area where liquidity trap is written), the economy is in
liquidity trap. Everyone is sure of a future rise in interest rate and a fall in bond prices.
Therefore, everyone in the economy will hold their wealth in money balance and if
additional money is injected within the economy, it will be saved for future use without
increasing the demand for bonds and without further lowering the rate of interest.
This situation is called a liquidity trap.
Q. Why do Liquidity Traps Occur?
1. Expectations of deflation - If there is deflation or people expect deflation (fall in prices)

then real interest rates can be quite high even if nominal interest rates are zero. - If prices
are falling 2% a year, then keeping cash under your mattress means your money will
increase in value. The difficulty is in having negative nominal interest rates (banks would be
paying you to borrow money). There have been attempts to create negative interest rates
(e.g. destroy money in circulation but in practice, it is rarely implemented.
2. Preference for saving - Liquidity traps occur during periods of recessions and a gloomy
economic outlook. Consumers, firms and banks are pessimistic about the future, so they
look to increase their precautionary savings and it is difficult to get them to spend which is
necessary to create demand so that economy can revive once again. This rise in the savings
ratio means spending falls.
3. Credit Crunch - Banks lost significant sums of money in buying sub-prime debt, which
defaulted. Therefore, they are seeking to improve their balance sheets. They are reluctant
to lend so even if firms and consumers want to take advantage of low interest rates, banks
will not lend them the money.
4. Unwillingness to hold bonds. If interest rates are zero, investors will expect interest rates to
rise sometime. If interest rates rise, the price of bonds falls. Therefore, investors would
rather keep cash savings than hold bonds.
5. Banks Don't pass Base Rate cuts onto consumers
The supply of money

In our Indian economy RBI, monetary authority of India, issues the currency notes while
Government of India (GoI) issues the coins.
Q. The balance in savings or current account deposits is also considered money. Why?
As cheques, which are drawn on these accounts, are used to settle transaction.
All of us have used this note. Have you ever wondered that it is just a piece of paper but still
everyone accepts it? Why?
Because the note is guaranteed by RBI. In the image you can see the promise (highlighted in
box) from the Governor of RBI. The promise guarantees that if someone produces the note to
RBI, or any other commercial bank, RBI will be responsible for giving the person purchasing
power equal to the value printed on the note. It is same for coins as well. (The given currency is
only for example)
Fiat money
Currency notes and coins do not have any intrinsic value. They have value because of above
explained reasons. Therefore, they are called as Fiat money. They are legal tenders (they
cannot be refused by any citizen of the country for settlement of any kind of transaction)
Can cheques be refused to settle any kind of transaction? If yes, Why?
Cheques are drawn on savings or current accounts, however, can be refused by anyone as a
mode of payment as they are not legal tenders.
Legal definitions: Narrow and Broad Money or Monetary aggregates
Monetary aggregates is related only to monetary liabilities of the RBI and depository
corporations i.e. the banking system.
The new monetary aggregates are of four types. They are:
1. Reserve money or Base money (M0)

2. Narrow money (M1)
3. Intermediate money (M2) and
4. Broad money (M3)
1. Reserve Money or Base Money (M0)

The financial assets in M0 category is called as Reserve money because these are held by
public and banks (Currency in circulation) or by the RBI (Bankers deposits with RBI + Other
deposits with RBI).
These are not available for lending purposes.
M0 = Currency in Circulation + Bankers Deposits with the RBI + Other Deposits with the
RBI
Currency in circulation - Total amount of the Rupee notes issued by RBI and the Rupee
coins and small (paisa) coins issued by GoI. It is held by both public and banks.
Bankers deposit with RBI - Cash Reserve Ratio (CRR) and excess reserve. The banks keep
CRR with RBI as stipulated by the RBI. Some banks keep more cash reserve with RBI than
stipulated amount. It is called Excess Reserve.
Other deposits with RBI It includes
o Deposits of quasi-government and other nancial institutions including primary
dealers (nancial intermediaries operating in Government securities (G-Secs) and
other nancial instruments)
o Balances in the accounts of foreign central banks and governments
o Accounts of international agencies such as the IMF etc., and
o Provident, gratuity and guarantee funds of RBI staff
2. Narrow money (M1)

The financial assets it includes are fewer than the M2. This means it defines money in
narrower sense and hence called as Narrow money.
M1 = Currency with public + Demand deposits with the banking system + other deposits
with RBI
OR
In short CU + DD + Deposits with RBI
Currency with the public - currency in circulation (minus) cash on hand with the banking
system
Demand deposits are those deposits that can be withdrawn by depositor at any point of
time.
There are two major types of demand deposits viz., current deposits and saving deposits.
The saving deposits have two components namely demand liability and time liability. Most
part of the saving deposits is demand liabilities only. However, few saving deposits can be
withdrawn only on some performance or on some happenings, For example, a saving
deposit made in the name of a child may be deposited with a condition that it can be
withdrawn only after the child became a major.
In M1 only demand liability portion is included.
3. Intermediate Money (M2)

It is called intermediate money for the reason nancial assets included in this category are
more than those included in M1 but less than those included in M3.
In short M1 < M2 < M3
M2 = M1 + Time Liabilities portion of savings Deposits with the Banking system +
Certicates of Deposit issued by Banks + Term Deposits (excluding Foreign Currency Non-
Resident (Bank) (FCNR (B)) Deposits) up to one-year maturity with the Banking system.
4. Broad money (M3)

The financial assets it includes are more than the M2. This means it defines money in a
wider sense and so called as Broad money.
M3 = M2 + Term Deposits (excluding FCNR (B) Deposits) over one-year maturity with the
Banking system + Call borrowings from Non Depository Financial corporations by the
banking system.
RBI followed the following method since 1979 until implementation of above (current) method.
M1 (Narrow Money)
M1 = Currency with the Public + Demand Deposits of banks + Other demand deposits
with RBI
M2 (Intermediate money)
M2 = M1 + Post ofce Savings Deposits
M3 (Broad Money)
M1 = M1 + Time Deposits of the Public with Banks.
M4
M4 = M3 + Total Post ofce deposits.
Money creation by the Banking System
Factors which affects the money supply
RBI actions
Commercial banks actions
Cash holding by public in preference to deposits
Any change in CU, DD or Time deposits
Currency Deposit Ratio (cdr)
As name suggests it is the ratio of money held by the public in currency to that they hold in
bank deposits.
cdr = CU/DD
Mostly people prefer to keep cash instead of deposits and it also depends on seasonal
pattern of expenditure. For example - During the festivals people keep more cash holdings,
as the expenditures are more.
The Reserve Deposit Ratio (rdr)
It is the proportion of the total deposits, commercial banks keep as reserves.

The deposits by people in banks are used by banks to lend others but not whole of the
deposits are lended, part of it is kept as reserve money.
Reserve money is divided into 2 parts vault cash in banks and deposits of commercial
banks with RBI.
The first part i.e. vault cash in banks is used to meet the cash demands of depositors.
Keeping reserves is costly for banks as they can lend this part as well and can earn interest
but RBI ensures that they keep reserves so they can meet the cash demands of account
holders without any problem.
RBI uses various policy instruments to ensure that Commercial banks maintain healthy rdr.
These are CRR, SLR and Bank rate.
CRR (Cash Reserve Ratio)
if RBI sets CRR 4%, then this means whatever deposits commercial banks holds, its 4% must
be kept as reserve with RBI.
SLR (Statutory Liquidity Ratio)
It refers to the amount that the commercial banks require to maintain in the form of cash,
or gold or govt. approved securities before providing credit to the customers.
Q. Why is SLR changed from time to time?
The RBI can increase the SLR to contain inflation, suck liquidity in the market, to tighten the
measure to safeguard the customers money.
In order to control the expansion of bank credit.
SLR Example
If you deposit Rs. 1000/- in bank, CRR being 4.75% and SLR being 24%, then bank can use
1000-47.5-240= Rs. 712.5/- for giving loan or for investment purpose.
Difference between SLR and CRR (Cash Reserve Ratio)
SLR restricts the banks leverage in pumping more money into the economy.
CRR is the portion of deposits that the banks have to maintain with the RBI. Higher the
ratio, the lower is the amount that banks will be able to use for lending and investment.
To meet SLR, banks can use cash, gold or approved securities. While CRR has to be only
cash.
CRR is maintained in cash form with RBI, whereas SLR is maintained in liquid form with
banks themselves.
Bank rate
It is the interest rate at which a bank can borrow from the central bank.
An increase in the bank rate discourages banks from borrowing to meet reserve
requirements, causing them to build up reserves (and thus lend out less money). A
reduction in the bank rate has the opposite effect: It encourages banks to borrow to meet
reserve requirements, which makes more money available for lending.
Commercial Bank
They accept deposits from public and lend out to interest earning projects.
Borrowing rate rate of interest offered by bank to deposit holders.
Lending rate rate at which bank lend out their reserves to investors.
Spread = Lending rate Borrowing rate
Lending rate will always be higher and spread is the profit or margin earned by bank.
Deposits and its types have already been discussed under monetary aggregates.
Bans mainly lend cash credit, demand and short-term loans to private investors and to
government in form of investments in government securities and bonds.
Mostly loans are given against collateral (asset or property which remains security of
repayment of loan)
High powered money
Total liability of RBI is known as monetary base or high-powered money.

It consists of currency and deposits held by GoI and commercial banks.
The currency notes and demand deposits are liabilities on RBI.
Liabilities are claims by public, government and banks on RBI.
Example suppose RBI purchases 100 rupees gold from market. To purchase gold RBI paid
in 100 rupees note. So now 100 rupees note is liability on RBI and Gold is asset for RBI.
See similar examples in below table
RBI
Liability Assets
Rupees 5 Gold
Currency issued to government Debt bonds/securities issued by GoI
Loans to commercial banks Collaterals by commercial banks
High Powered Money in Relation to Total Money Supply
Money creation by RBI or commercial banks
To understand the process of money creation, let us create a hypothetical system of banks.
We will focus on two banks in this system: SBI Bank and Bank of Baroda. Assume that all
banks are required to hold reserves equal to 10% of their customer deposits.
Each bank has 10,000 rupees in deposits. So, each has 9,000 rupees in loans outstanding,
and 10,000 rupees in deposit balances held by customers.
Suppose a customer now deposits 1,000 rupees in SBI Bank. SBI will loan out the maximum
amount (90%) and hold the required 10% as reserves. There are now 11,000 rupees in
deposits like in SBI with 9,900 rupees in loans outstanding.
The debtor takes her 900 rupees loan and deposits it in Bank of Baroda. Bank of Baroda's
deposits now total 10,900 rupees. Thus, you can see that total deposits were 20,000 rupees
before the initial 1,000 rupees deposit, and are now 21,900 rupees after.
Even though only 1,000 rupees were added to the system, the amount of money in the
system increased by 1,900 rupees. The 900 rupees in checkable deposits is new money; SBI
created it when it issued the 900 rupees loan.
This multiplier process increases the value of currency holding among public, value of
increment in bank deposits and money supply in economy. The more rounds of multiplier
process decrease the increment in money creation.
Instruments of Monetary Policy and the RBI
Total amount of money in economy is much greater than the volume of high-powered money
i.e. liabilities on RBI.
Q. Who creates extra amount of money in economy and how?
Commercial banks create this extra amount of money by giving a part of their
customers deposits as loans.
Commercial banks have more amount of money as deposits and loans compared to reserves.
The multiplier process further increases this amount. If all the customers of a bank approaches
to bank and demanded their deposits at same time, then bank will unable to do so because
whatever deposits it was having it had landed it to investors or lenders. This is called as bank
failure.
To avoid such kind of problems RBI acts as guarantor of commercial banks and extends loans to
them in case of crisis. This ensures public that their money is safe and so they need not to panic
in case of crisis. This role by RBI is known as lender of last resort.
RBI act as a banker to (RBI- known as Bankers of Bank)
GoI
Commercial bank
State governments
When government had made more expenses than its revenues then it is called as budget
deficit. Now government still have to pay salaries to the government employees, providing
basic services, and other official works expenses. In this case it borrows money from RBI by
selling its treasury bills and government securities to RBI which acts as collateral by government
for RBI. Financing budget deficit in this manner is known as deficit financing through central
bank borrowing.
RBI functions
Most important function controller of money supply and credit creation in the
economy
Lender of last resort
Finance government in case of budget deficit.
Enforcing of Priority sector lending
PSL (Priority Sector Lending)

It is a lending programme to ensure that adequate institutional credit flows into some of the
vulnerable sectors of the economy, which may not be attractive for the banks from the point of
view of profitability. Eight-categories of PSL.
1. Agriculture
2. Micro, Small and Medium Enterprises
3. Export Credit
4. Education
5. Housing
6. Social Infrastructure
7. Renewable Energy
8. Others.
Instrument used by RBI to conduct monetary

policy
OMO Bank rate policy Varying reserve requirement Sterlisation by RBI
Open Market Operations (OMO)
Selling and purchasing of Government securities by RBI to increase or decrease the

money supply in economy.
Suppose today RBI bought government security of rupees 1000 from bond market and
paid a cheque of 1000 rupees to the seller.
Seller deposited this cheque into Bank X. Bank deposited 1000 rupees into the sellers
account and presented this cheque to RBI.
RBI will deposit 1000 rupees into Bank X account.
By this way, RBI had increased the money supply in market.
Varying Reserve Requirements
Increasing the SLR and CRR increase the reserve deposit ratio decreases the value of
money multiplier and money supply in economy.
Decreasing the SLR and CRR decrease the reserve deposit ratio increases the value
of money multiplier and money supply in economy.
Sterilisation by RBI
RBI has to be cautious about external shocks to economy and so uses some instruments
to stabilize the stock of money in economy.
Today, growth of our economy is very good. Foreign investors expect that it will keep
doing well and so they do investments in our economy expecting higher return in future.
They purchase bonds from the market from foreign currency.
The seller who has sold the bonds will convert this foreign currency into rupees, will use
part of it, and will deposit remaining into his account.
Bank has more money to lend + money multiplier effect. All these will create more
money supply in market.
Now this extra money supply can increase the prices of goods and commodities.
So now, RBI has to step in. To decrease the money supply it will take OMO or vary the
reserve requirements. This will decrease the extra money supply form economy.
In this way, economy can be saved from external shock. And, this is called as
Sterilization.
REVISE Below
Inflation - Introduction
Lets take an example first,
Lets say IASBaba has a small agricultural land in his village and grows apples there. All his
apples are sold in a city store. In 2014, you bought an IASBabas apple for Rs.20 per piece but in
2015, the same apple costs 2 rupees more.
Why was there a price increase at first place?
Lets study two cases to see the cause of this price rise:
Case 1: The rise in price could be because of the increased supply costs like
increased labour charges,

increased transportation costs or
increased seeds/fertilizers costs
In general rise in costs of goods and services.
Case 2: Suppose the customers get more salary. And now they will have more money to buy
apples and hence demand more apples. But baba cant increase production anymore and hence
can raise the prices. Here more money was chasing too few goods and hence there was a price
increase.
In both the cases, you can also say that the price of the apple hasnt increased; just
the rupee value got decreased or

Purchasing power of money was reduced.
With the same amount of money you could buy lesser apples in 2015 than in 2014. This is
Inflation.
Case 1 being a example of Cost push inflation (Price rise due to increase of production costs)
whereas Case 2 is an example of Demand pull Inflation (Price rise due to more money in
economy creating more demand)
In layman terms - Inflation can be defined as a sustained increase in the general level of
prices for goods and services
Major Types of Inflation:
Demand Pull Inflation:

This type of inflation occurs when demand exceeds supply primarily due to increased money
supply in the economy. As we have seen in case 2, Apples cost was increased just because the
customers started demanding more as the money in their pockets have increased. This is
Demand pull inflation.
Lets look at few causes for this type of inflation
Increase in money supply: When there is more money, people start to demand more
and prices rise up. This can happen by increased wages, increased savings, more
disposable income, etc.
Increased Government spending: More money spent on people -> increases money in
economy -> increase in prices of goods. Ex: Pension schemes, MGNREGA, etc.
Increase in Black Money: Black money is the excess of money any person possesses
over their actual and legit income. When people posses more black money, their
spending on commodities increases and hence demand increases pulling up the prices.
Also black money is the only cause which cannot be tackled by monetary measures
Increasing population: More the people, more the earnings, more the money, more the
demand for goods and thus, prices increase
Foreign prices and growth: If foreign population increases, they start demanding more
products from other countries and hence demand goes up. Again if foreign goods prices
go up, more of domestic goods will be demanded and hence demand will rise pulling up
the prices.
Expectation of Inflation: This is a major factor where people expect inflation in future
and hence start buying all goods at present increasing the current demand and pulling
up the prices.
Cost Push Inflation:

Simply it is the price rise due to increase in the production costs. As we have seen in case 1, the
apple prices were increased because of the cost of production and transportation. This is Cost-
push Inflation.
Some of the major causes of it are:
Increase in wages: With increase in wages of labours due to labour union or any other
circumstance, the production costs increase, increasing the prices of product
Business monopoly: When a company has monopoly over a particular product, it can
decide the quantity and price of product, which can lead to increase of prices
Government regulation and taxes: Indirect taxes directly increase the selling price of
any product. Also, government regulations like imposing a restriction on particular
resource or increasing MSP can lead to increase in the production costs of the product.
Exchange rates: If there is a fall in exchange rates, importing raw materials cost increase
hence increase in the prices of products
Rising production costs: Rise in any of the four factors of production increases the cost
of production.
Types of inflation with respect to rate
Inflation is divided based on the rate, but there are no clear lines of demarcation and hence you
can see them being used often interchangeably
Creeping When inflation is between 1 % and 5 %

Trotting When inflation is between 6 % and 10 %
Galloping When inflation is between 11 % and 20 %
Runaway When inflation is between 21 % and 50 %
Hyperinflation When inflation is very high and is above 50 %
Terms in Inflation:
1. Stagflation: Situation when inflation and unemployment is very high but has slow
economic growth.
2. Deflation: Simply negative inflation (below zero) is called Deflation. Where prices are
falling.
Low money or less demand Lowering of prices Lesser production at factories
Lesser investment
It goes in a spiral if not controlled which is also known as deflationary spiral. Similarly
when it happens in the positive direction with inflation, its known as Inflator-y spiral or
wage-price spiral.
3. Disinflation: Considerable slowdown of inflation rate with respect to previous period
but still is in positive. (Remember this is different from deflation as deflation is inflation
below zero)
4. Reflation: This term is used to refer the situation where measures are taken to curb
deflation. Steps can be like fiscal policy (reducing taxes) or monetary policy (increasing
money supply or reducing interest rates)
5. Slowdown Recession & Depression: These three terms are inter-linked. Generally first
slowdown occurs, then recession comes and finally depression occurs
a. Slowdown: A decline in economy of a country Link it with GDP, not inflation

b. Recession: If slowdown occurs for 2 successive quarters i.e. GDP falls for 2
successive quarters, it is known as recession. Common indicators are fall in GDP
and investments
c. Depression: Generally if recession lasts long, it is said that the economy is in
depression. Main indicators are huge fall in demand of goods and services with a
sharp decline in GDP and investments. Ex: Great Depression of 1930
Now that you have seen inflation and its forms, you can now see that inflation is not just about
raising prices, there is a need to study the causes of inflation which generally have some other
root causes and sometimes concerns. These vary a lot depending on situation and can be
critical at many circumstances.
Inflation Bad or Good?
Now the question occurs whether inflation is really bad? Lets try to answer it:
Deflation and very low inflation Is it harmful?
Deflation as we have seen is simply fall in prices of goods and services. Or in other words value
of money just gets increased during deflation.
Is that necessarily bad?
Not always!
If the prices suddenly decrease, there will be more consumption as prices have decreased and
hence the demand will again increase, increasing the prices of goods.
High Demand:
Increase in Price
More
Consumption
Decrease in Price
What happens if the deflation persists for few periods?
Will the consumption increase?
If you know that you can buy the same product for a lower price tomorrow, it will
discourage you from spending right now.
Also if you are in debt, it increases your debt burden, because the same amount which you
have borrowed earlier now has far more value, which makes it difficult to repay.
Hence, deflation can reduce the spending power of firms and consumers, more especially in
case they are in debts.
But now, you have certain doubts:
When we can buy more things with the same money?
What are we losing in deflation?
Well, when you have deflation, the following generally take place:
lowering of prices
lowering of wages and
High unemployment.
So, although you could get cheaper products, your disposable income got reduced because of
lower wages and unemployment effect. There might be some people who are better-off with
deflation but the problem is wider on a macroscopic view.
So, prolonged deflation is always bad?
No, there are few cases where it can be good but it can rarely be observed in this 21 st century.
Suppose if there occur continuous technological improvements: Most of the goods could be
produced at a lower cost every year and hence prices can fall.
This is definitely a good sign even though there would be a deflation. Also like how it happened
with Japan, if most of the neighboring countries are having inflation, then the country with
deflation has better competitive advantage as their goods obviously seem cheaper than other
countries with inflation.
Think about Chinas Yuan Devaluation
So can we just sit at 0 inflation?
Inflation often (but not always - think?) relates to growth.
When there is 0 or very minute inflation, then:
money in the economy remains almost constant

Productions will be at constant and
Demand will also be at constant.
So, its not good for growing economy. Growth be doomed!
Now we understood that having some inflation is good. So, cant we keep it high so that it
will never come near 0?
Okay, here we are talking about high Inflation. As you know, inflation makes your money less
valuable.
Lets just look at few of the major consequences of having high inflation:
It erodes the purchasing power of money: As we have seen many times before,
inflation makes your monetary assets fall in value. Ex: The same 1000 rupees with which
could serve you 10 meals before can now serve you only 9 because of inflation.
Redistribution of Income among groups: People who know how to save their assets
from inflation gets protected but all others will lose the value of their monetary assets
creating inequality.
Ex: Borrowers are benefitted with inflation as they now need to pay a lower value of
money but lenders suffer. How? Suppose I have Rs.20. You wanted to buy an apple now
which costs Rs.20 but dont have money. So, you lend it from me with 10 % interest. So,
you will have to give me Rs.22 next year. So, I am happy to give it to you as I can buy an
apple and save 2 rupees next year. But unfortunately this year saw a high inflation of 20
% and hence apple cost is now Rs.24. So, as a lender I lose 2 rupees in buying an apple
instead of gaining 2 rupees but you as a borrower gained because the apple is worth
more than 22 which you paid to me.
Loss of Business Confidence and fall in Investments: When the inflation is high, the
aggregate demand reduces (remember that demand increases inflation but not the vice
versa). Also companies anticipate an increase in interest rates to combat with inflation
and hence will discourage them from investments. Also higher fluctuation leads to low
confidence in investments. This is particularly important to Indias Make in India
initiative.
High /unpredictable inflation
Low /unpredicatable 'real' return for companies leading to unpredictable profits/losses
No confidence in investing in India - Companies do not Invest
Dream of 'Make in India" lives forever likes a dream!!
Bad for Balance of Payments: Higher inflation will cause our exports to price more and
imports to cost less. Hence, there will be lesser exports and more imports worsening
the Balance of Payment.
By looking at all the above, it is evident that both a high inflation and low inflation are harmful
to economy.
So how much should it be?
Many countries have different desirable limits of inflation but all countries hope for a low and
predictable rate of inflation. Even in India there are varied opinions on how much it should be,
but some currently say that 2 to 6 % of inflation is good to have. All these make inflation the
single most important macro-economic objective for most of the countries.
India and past Inflation
Were there spikes and dips in inflation of India in the past?
Were those spikes and dips really bad or were sometimes good?
Lets look at various situations in the past and analyze the inflation history in India.
1930s & 1940s:

Perhaps the most fluctuating decade in Indian history, where the rate of inflation varied from
-11 % (deflation) to a sharp rise of inflation which even touched 150 %
Dancing Numbers:
Remember 1930? Yes, it was the Great Depression of 1930s where India was affected as well
with cotton Industries being the worst hit. It is during this stage, the prices started dropping
with a peak deflation of nearly 11 %. Although the RBI was set up in 1935, it could control the
deflation only to some extent.
Okay, if the prices were going down, why did it shoot up so much suddenly?
It was obviously the World War II effect. Even before the war started, the expectation of
shortage itself spiked the inflation to nearly 40 % but once the war started it went to an
uncontrollable inflationary spiral and by the end of war it was as high as 150 %. Indians suffered
a lot during this period. This was the only period in Indian history where the prices rose up very
sharply for 3 consecutive years. One of the major causes of this is the unrestricted deficit
financing which lead to such an inflationary spiral.
So, how did we get out of it and how long it lasted?
With the introduction of partial rationing and stable budget deficits, we could get back the
inflation to a near single digit. But India had another challenge in front of her The partition
and Independence!! - With many unrests, social uprisings, massacres, printing of excess money
and losing fertile lands to Pakistan, the inflation again peaked to 22 % and there was heavy
fluctuations during this period. It was then in 1949, RBI was nationalized but it did not see any
success in controlling inflation.
World War
Effect
(Speculation of
Shortage)
Partition and
Independence INFLATION
Unrestricted
Deficit
Financing
1950s & 1960s:

Lots of fiscal measures were taken in 1949 to bring down the inflation along with rupee
devaluation. All these steps got the inflation to around 2 % by 1950. But these 2 decades saw
some peaks of 15 %. These can be mainly accounted to
Wars with China & Pakistan,

Famine in 1965 &
Adaption of Nehru-Mahalonobis strategy which saw Huge Investments + Deficit
Financing
But on a whole these two decades saw inflation in an acceptable rate. RBI was a key performer
during this period which took various monetary policy measures. The end of 1969 saw
nationalization of banks in India which was indeed a major step taken by the government since
Independence.
1970s & 1980s:
With last two decades going pleasantly, India could not sustain it in the upcoming decades. It
was in 1972-75, where first time after Independence, three consecutive years saw high inflation
with averages touching around 20%. The major factors for this are
the oil shock in 1973 and

Failure of Kharif crops.
Government and RBI used all their tools but when they realized that its not enough to bring it
down, it started their attacks on hoarders, black markets and smugglers. Finally from a high of
25%, it came down to -1% within a year.
Just when things were cooling down, another oil shock in 1980 pulled up the inflation back to
9%. This stayed around 7 to 9% throughout the 1980s but one good thing about this period
since the second oil shock is that the fluctuations were very low during this period. But this
decade closed with another hike of inflation from 7 to 10 % with Gulf wars.
1990s & 2000s:

This decade can be started with the Balance of Payment crisis, which resulted in the economic
reforms of 1991. After the reforms were taken, for almost 5 years the inflation contained at
around 10 % due to increased demand and adjustments of exchange rate in 1991. After 5 years
of high inflation rates, in 1996, it was brought down to almost half with average around 5 %.
The main factors which contributed to such a decrease were
RBI containing money supply,

Food prices inflation were reduced by half,
Cooling of global inflation,
Huge buffer stocks of grains &
High foreign exchange reserves.
Since 1996, for almost 12 years the inflation was contained at an acceptable rate and
fluctuations were also minimal. There is only one major fluctuation in 2000-01 which can be
accounted to the increase of petroleum prices, but was brought back to control immediately.
The 2008 oil spike was a major event which took Indias inflation to a double digit and was since
then remained at 8 % till now.
So, in the past 80 years ranging from 1930s to 2010, India although have seen many ups and
downs in inflation, we can still say its been a good economy without any major disasters like
hyper-inflation. Even if we compare with Asian countries, India is better off with many
countries In terms of inflation. For around half of the last 80 years, India could contain Inflation
below 6 % which is generally considered good.
Measuring Inflation:
In India, we generally use two indices to measure Inflation Consumer Price Index (CPI) and
Wholesale Price Index (WPI)
Wholesale Price Index (WPI):
It measures the change in price of goods in wholesale market Currently 697 items
(Producer-centric mainly)
Its released by Office of Economic Advisor, Department of Industrial Policy and
Promotion
Base year of WPI currently is 2011-12.
Pan India approach- Does not fluctuate often; better at targeting supply side constraints
But gets affected by international prices (Manufacturing- higher weightage)
It doesnt take services sector and unorganized manufacturing sector into account
Consumer Price Index (CPI):
It measures the change in price of goods and services of consumers

Its released by Central Statistics Office, Ministry of Statistics and Program
Implementation
Base year of CPI- 2012
As the consumption diversity is high, India currently has 7 CPI indicators
Imported Goods- Not included
Issues: Lack of
Competitive Integrated Market
Proper Infrastructure
Think-
Which method is used by USA to measure inflation?
Are monetary policies based on the CPI are the best policies?
Consumer Price Index Consumer Price Indices (CPI) released at national level are:
CPI for Industrial Workers (IW)- Released and compiled by Labour Bureau (Ministry of
Labour and Employment
CPI for Agricultural Labourers (AL)/ Rural Labourers (RL)- Released and compiled by
Labour Bureau (Ministry of Labour and Employment
CPI (Rural/Urban/Combined)- Released and compiled by Central Statistics Office (CSO)
in the Ministry of Statistics and Programme Implementation
Differences
WPI- to have inflationary trend in the economy as a whole.
CPI- used for adjusting income and expenditure streams for changes in the cost of living.
WPI -Wholesale prices for primary articles, administered prices for fuel items and ex-factory
prices for manufactured products.
CPI -Retail prices, which include all distribution costs and taxes.
WPI-Prices for WPI are collected on voluntary basis
CPI- Price data for CPI are collected by investigators by visiting markets.
WPI- Covers all goods including intermediate goods transacted in the economy.
CPI- Covers only consumer goods and consumer services
WPI- Weights primarily based on national accounts and enterprise survey data
CPI- Weights are derived from consumer expenditure survey data.
Does RBI use WPI or CPI Inflation to manage monetary policy?
While earlier the Reserve Bank of India used WPI inflation to manage monetary policy
expectations, it is now the CPI inflation which is largely taken into account. The RBI highlights its
inflation expectations based on the CPI inflation data that comes in. For example, it sets targets
on CPI Inflation and monitors it accordingly. Many analysts for long had suggested that the RBI
should move to the CPI data vs the WPI data, which had now happened in the last couple of
years.
WPI Inflation Vs CPI Inflation: Which should you keep in mind?
For the common man it is always better to keep retail inflation which is the CPI or the
Consumer Price Inflation number in mind. It is a better measurement of what is largely
happening with consumer prices. WPI inflation on the other hand is better known to individuals
who track the wholesale prices and is of better significance to them. In any case both are a
measure of inflation.
Core Industries: Coal, Fertilizer, Electricity, Crude oil, Natural Gas, Refinery products, Steel &
Cement
Measures to control Inflation:

Inflation is generally controlled by using monetary measures, fiscal measures or few other
measures.
Lets look at each of them in detail:
Credit Control: Central bank (RBI in India) can control the money flow into economy
through various methods. Ex: Changing CRR, SLR, etc.
Demonetization of currency: It means to withdraw currency notes (generally higher

denomination) from the economy. This brings out black money and helps control
Inflation.
Issue of new currency: This is helpful to curb hyperinflation by exchanging old notes
with a new note. But this burdens the small depositors.
Increase in taxes: Increasing tax leads to less disposable income, which cuts
consumption and hence controls inflation. But increasing it to a very high level leads to
low savings and investment which slowdowns economy. Instead, tax benefits for
investments and savings should be encouraged while using this measure.
Reduction of unnecessary Government expenditure and surplus budgets: Cutting

down unnecessary spending and also giving up deficit financing helps in reduction of
money and controls inflation. Also public debt repayment should be stopped
temporarily and more debt should be taken.
Increasing production: The main factor for inflation is not having enough supply for the
increasing demand. There are various methods to increase production from expansion
to increasing productivity.
Rational Wage Policy: To prevent inflation spiral from happening, the wages can be
freeze-d or can be linked with productivity Helps control inflation.
Price Control and Rationing: By either controlling prices of essential goods or
distributing essential commodities, demand can be reduced and prices can be in check.
GDP Deflator
It is ratio of Nominal GDP to real GDP and a well know index of prices.
GDP deflator =
GDP deflator in % terms = *100
GDP deflator in above example - = 1.5 (in % terms 150)
This 1.5 means price of goods in 2015 is 1.5 times of the price in 2011
Similar to GDP deflator there is also GNP deflator.
Difference between CPI and GDP deflator
CPI GDP Deflator
Goods produced in country Does not represent all the Represents all such goods
goods
Imported goods Included Not included
Weightage to goods Constant for all goods Differ according to production

level of each good
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Economy Part 1

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2018 INTEGRATED LEARNING PROGRAMME, ILP-2018

Basic concepts of Macroeconomics

Why do we call this car as a final good?

Here the car is a FINAL GOOD because

It is for final use.

Consumption goods or consumer goods

Definition Goods or services, which are consumed by the purchaser.

Definition + example - Some goods or commodities such as Television, Laptops, washing

Definition it is a variable, which is measured at a particular point of time.

Flow affects stocks. How?

Definition - An annual allowance for wear and tear of a capital good.

How to calculate total flow of production in an economy?

One Demand for products

Circular flow of Income

Figure 1 Circular flow of income in a simple economy

Figure 2 Methods of measuring national income

National income can be calculated by compiling of income of all or expenditure of all.

Production Method or Value Added Method

Farmer Weaver Tailor Flying machine firm

Value added 500 300 200 1500 500 = 1000

Gross Value Added and Net Value Added

Fixed business investment

Remember it simply investment in fixed capital.

Investment on buying homes.

Planned accumulation of Inventories

Unplanned accumulation of inventories

Planned decumulation of inventories

Unplanned decumulation of inventories

The calculation of National Income by compiling income of factors of production is called

In our country it is calculated by following formula (this formula sometimes appear in

Net tax production = other taxes on Production subsidies on production

Main components under Expenditure method

Most dominant component in calculation of GDP under expenditure method.

Most volatile component

Some macroeconomic identities

Measures of National Income

GDP GNP NNP NNPFC PI DP

GDP (Gross domestic product)

The word domestic here refers to geographical area.

How GDP is calculated?

Important points about GDP

Central Statistics Office (CSO), Ministry of Statistics and Programme Implementation

Formula - GDPFC = GDPMP - Indirect taxes + subsidy

GNP (Gross National Product)

The word national here refers to all the citizens of a country.

Net National Product (NNPMP)

Definition It is arrived after deducting depreciation from GNP. Why deduction in

NNP at factor cost (NNPFC) or National income

Personal Income (PI)

Definition sum of income of all the people of a country in one year.

Personal Disposable Income

Definition Income available to individuals that can be spent at their will.

To compare the GDP figures of different countries.

Real GDP is national income at constant price.

Nominal GDP is national income at current price.

Base year 2011

To check whether the National Income has grown or not.

GDP and Welfare

Q. What is Barter exchange?

Exchange of goods without the mediation of money.

Disadvantage of Barter system

Barter system Money

Storage cost High Low

Double coincidence of want Yes No