UPSC Prelims GS Revision Notes Indian Economy

KEY REVISION POINTS INDIAN ECONOMY

What is Economics?

  • Economics is the study of scarcity.
  • Microeconomics and Macroeconomics are the two types of Economics.
  • Microeconomics studies economic systems on a small scale or at individual level. It seeks to understand how individuals, households, and companies make decisions.
  • Macroeconomics studies economics on the larger scale which covers interactions of GDP, Unemployment, Inflation, International Markets and Organisations, Imports and Exports etc.

What is Economy?

  • An economy is a system within which goods and services are produced and exchanged. All economic activities like production, consumption etc are carried out in an economy.

Three Types of Economies:

  • Free market economy: Prices of goods and services are decided by market forces of demand & supply and government has no interference in it. Also called Capitalist Economy.
  • Command economy: National government allocates resources and decides prices for goods and services. Also called Socialist economy or Centrally Planned Economy.
  • Mixed economy: It contains elements of both capitalist and socialist economies. Both Public and Private enterprises operates here. Government involves in production to meet its social objectives. Eg: Providing subsidies to Agriculture and MSMEs.

Factors of Production:

  • Four factors of production are Land, Labour, Capital, and Entrepreneurship.
  • These are the resources people use to produce goods and services.

Factor income: It is the income or returns received on factors of production. They are as follows

  1. Land – Rent
  2. Labour – Wage
  3. Capital – Interest
  4. Entrepreneur – Profit

Sectors of Economy:

  • Primary Sector: It extracts raw materials by exploiting natural resources like land, forests, mines etc. It includes agriculture and allied activities, fishing, forestry, mining, quarrying.
  • Secondary Sector: It converts raw materials obtained from primary sector into finished goods. Eg: Manufacturing of sugar from sugarcane. It includes manufacturing, construction, utilities like electricity supply, water supply, gas supply.
  • Tertiary Sector: It provides services to consumers and businesses. It includes banking, financial services, retail shops, real estate, tourism, transport and communication. Also called Service sector.
  • Quaternary Sector: It is a knowledge economy sector which includes education, research & development activities.

Measures of National Income

  1. Gross Domestic Product (GDP)
  2. Gross National Product (GNP)
  3. Net National Product (NNP) 
  4. Personal income (PI) 
  5. Disposable income (DI)

Formulae related to Measures of National Income:

  • GNP = GDP + Net factor income from abroad
  • GNP = GDP + (X-M) ; X is exports, M is imports
  • NDP = GDP – Depreciation
  • NNP = GNP – Depreciation
  • Net Indirect Taxes = Indirect Taxes – Subsidies
  • NNP at factor cost = NNP at market price – Net Indirect Taxes
  • NNP at factor cost = NNP at market price – Indirect Taxes + Subsidies
  • NNP at factor cost = National Income
  • GDP at factor cost = GDP at market price – Indirect Taxes + Subsidies
  • PI = NNP at factor cost – Undistributed corporate profits – Corporate taxes – Contribution of employers to Social Security – Net Interest Payments made by Households + Transfer payments to the households from Government & Firms
  • PI = NNP at factor cost + Income received – Income earned but not received
  • PI = National Income + Income received – Income earned but not received
  • DI = Personal Income – Personal Taxes
  • DI = Personal Income – Personal Income Taxes – Non Tax Payments/Fines
  • Per capita income = National Income / Total Population
  • GDP deflator = (Nominal GDP / Real GDP) x 100

Current prices and Constant prices

  • Current prices are the market prices prevailed at a given moment in time. Current prices are influenced by the effect of inflation.
  • Constant prices are used to measure the real or true growth. Constant prices are adjusted for the effects of price inflation. Constant price can also be termed as Base year price.

Nominal GDP:

  • It measures a country’s production of final goods and services at current market prices.

Real GDP:

  • It measures a country’s production of final goods and services at constant price or base year price.
  • Real GDP is a nation’s output adjusted for inflation or deflation.

Base Year (2011-2012)

  • In 2015, the Central Statistics Office (CSO) under the Ministry of Statistics had changed the base year for tabulating the Gross Domestic Product or the size of economy to 2011-12 from 2004-05.

What is ICOR?

  • Any additional investment required to increase output is termed as incremental capital output ratio (ICOR).
  • It is the additional capital required to increase one unit of output.
  • This ratio is used to measure the efficiency of an industrial unit.
  • The lesser the ICOR, more efficient the organization.
  • ICOR reflects how efficiently capital is being used to generate additional output.
  • So a country with ICOR of 3 is better than a country with ICOR of 4.

Three Methods to calculate National Income:

  • Product/Output Method: It is a Value Added Method. In this method we calculate money value of all final goods and services produced by different sectors in the economy during a year. To avoid double counting we will consider the value of only final goods and services.
  • Income Method: In this method, we will add the incomes of the four factors of production used in the production process.
  • Expenditure Method: It measures national income as sum total of final expenditures made by consumers, business firms, governments and foreigners during a year. Formulae for this method is as follows –

GDP = C + I + G + (X – M)

Consumption expenditure (C)

Government expenditure (G)

Investment expenditure (I)

Net exports (X-M)

Economic Growth:

  • Economic growth is an increase in the capacity of an economy to produce goods and services, compared from one period of time to another.
  • Economic growth is usually measured by the percentage of change in a country’s Gross Domestic Product (GDP).
  • It can be measured in nominal or real terms.

Economic Development:

  • Economic growth is a straightforward measurement of actual economic output. But economic development is much broader in scope and it reflects social and political, as well as economic progress.
  • Economic development is a process of targeted activities and programs that work to improve the economic wellbeing and quality of life of a community.

What is Human Development?

  • Human development is an approach focusing on the people themselves and the opportunities they have.
  • Human development is about providing more freedom and opportunity to the people for living their lives as they wish. For this, people should be able to improve and use their capabilities.
  • Human Development focuses on improving the lives people lead rather than assuming that economic growth will lead, automatically, to greater wellbeing for all.

Human Development Index (HDI)

  • It is published by UNDP (United Nations Development Programme).

HDI considers the below three components:

  • Long and Healthy Life: It is measured by average life expectancy.
  • Education: It is measured by expected years of schooling of children at school-entry age and mean years of schooling of the adult population.
  • Decent Standard of Living: This measurement is done with the per capita income. GNI measures the income generated by the residents of a country, whether earned in the domestic territory or abroad. So GNI per capita gives better picture of well-being and it is better than GDP per capita.

UNDP also publishes the following:

Inequality-adjusted Human Development Index (IHDI):

  • The Inequality-adjusted Human Development Index (IHDI) adjusts the Human Development Index (HDI) for inequality.
  • The difference between the IHDI and HDI is the human development cost of inequality i.e, the overall loss to human development due to inequality.
  • Under perfect equality the IHDI is equal to the HDI, but falls below the HDI when inequality rises.

Global Multidimensional poverty Index (MPI):

  • It is an international measure of multidimensional poverty covering more than hundred developing countries.
  • It was first developed in 2010 by Oxford Poverty and Human Development Initiative (OPHI) and United Nations Development Programme (UNDP) for UNDP’s Human Development Reports.
  • Global MPI is computed by scoring each surveyed household on 10 parameters based on -nutrition, child mortality, years of schooling, school attendance, cooking fuel, sanitation, drinking water, electricity, housing and household assets.
  • It reflects both the incidence of multidimensional deprivation (a headcount of those in multidimensional poverty) and its intensity (the average deprivation score experienced by poor people).

Gender Inequality Index (GII):

  • It is a composite measure, reflecting inequality in achievements between women and men in three dimensions: reproductive health, empowerment and the labour market.
  • The GII varies between 0 (when women and men fare equally) and 1 (when men or women fare poorly compared to the other in all dimensions).
  • The health dimension is measured by the maternal mortality ratio and the adolescent fertility rate.
  • The empowerment dimension is measured by the share of parliamentary seats held by each gender, and by secondary and higher education attainment levels.
  • The labour dimension is measured by women’s participation in the workforce.

Gross National Happiness

  • It is a term coined by the King of Bhutan, Jigme Singye Wangchuck in the 1970s.
  • The concept implies that sustainable development should take a holistic approach towards notions of progress and give equal importance to non-economic aspects of wellbeing.
  • GNH Index is constructed based upon a robust multidimensional methodology known as the Alkire-Foster method.

1991 Economic Reforms:

  • India had launched Economic reforms in July 1991. It is done under following two categories.
  • Stabilisation measures: These are short term measures aimed at solving the immediate cause i.e, 1991 economic crisis. It involves correcting the balance of payments crisis and steps to bring the inflation under control.
  • Structural measures: These are long term measures aimed at improving the efficiency of the economy and increasing its international competitiveness by removing regulations. It is done through Liberalisation, Privatisation and Globalisation (LPG).

Liberalisation:

  • It means relaxing the government restrictions over economic activities. It is done through the following ways.
  • Deregulation of industrial sectors
  • Financial sector reforms
  • Tax reforms
  • Foreign exchange reforms (Devaluation of Indian Rupee)
  • Trade and investment policy reforms

Privatisation:

  • It means the transfer of assets from public sector to private sector.
  • Disinvestment – Privatisation of public sector enterprises

Globalisation:

  • It is the process of increasing international integration of world’s economies, cultures, and populations.

What is Inflation?

  • Inflation is the rate of increase in prices over a given period of time.

Types of Inflation:

Creeping Inflation:

  • It is also known as mild inflation.
  • It occurs when prices rise 3% a year or less.

Walking or Trotting Inflation:

  • It occurs when prices rise moderately and the annual inflation rate is a single digit varies between 3% – 10%.

Running Inflation:

  • When prices rise rapidly at a rate of 10%-20% per annum, it is called running inflation.
  • Its control requires strong monetary and fiscal measures, otherwise it leads to hyperinflation.

Galloping Inflation:

  • When prices rises between 20% to 100% per annum or even more, it is called galloping inflation.
  • The economy becomes unstable, and government lose credibility. So it must be prevented at all costs.

Hyper Inflation:

  • It occurs when the rate of increase in prices is extremely high or out of control.
  • It occurs when the increase in prices is more than three-digit rate annually.

Demand-Pull Inflation:

  • Demand-pull inflation takes place when aggregate demand is rising while the available supply of goods is less.

Cost-Push Inflation:

  • Sudden shortfall of supply leads to a increase in the cost of production, which increases the rate of Inflation.
  • For example, soap and shampoo prices may rise if the chemicals used in making these become costlier.

Wage Inflation:

  • It occurs when workers’ pay rises faster than the cost of living.

Core Inflation:

  • It measures rising prices in everything except food and energy.

Causes of Inflation

  • Increase in Money Supply
  • Increase in Public Spending
  • Deficit Financing of Government Spending
  • Increase in Population
  • Hoarding
  • Increase in Foreign demand and Exports
  • Tax Reduction gives more money and excess cash in hand leads to inflation.
  • Price-rise in the International Markets

Four phases of the Business cycle:

Depression: An economic depression is an extremely severe, long-term contraction in economic activity. Eg: The  Great Depression.

Recovery: It means an economy is healing from a recession and starting to expand again.

Boom: It means economic growth at the peak phases of the business cycle. It is a time of economic prosperity.

Recession: A recession is a significant decline in economic activity. It begins just after the economy reaches a peak of activity and ends as the economy reaches its trough.

Important Terms:

Deflation: It is opposite of inflation. Deflation means fall in prices of goods and services. It occur when the rate of inflation falls below 0%.

Disinflation: It is the falling rate of inflation. This is when the average price level is still rising, but to a slower extent. This means goods and services are relatively cheaper now than a year ago, and the purchasing power of money has increased.

Reflation: It is a period in which central banks and governments provide monetary and fiscal stimulus in order to spur economic activity and inflation.

Stagflation: It is an economic situation in which there is a high rate of inflation and high unemployment.

Skewflation: It  refers to an economic situation in which some commodities are facing inflation and some are facing deflation.

Phillips Curve:

  • It shows inverse relationship between the level of unemployment and the rate of inflation.
  • According to Phillips Curve, level of unemployment decreases with increased rate of inflation.
  • It was developed by A. W. Phillips.

What is Public Finance?

  • Public finance is a field of economics concerned with how a government raises money (revenue), how that money is spent (expenditure) and the effects of these activities on the economy and society. Simply, Public Finance is the way of managing the public funds in the economy of the country.

What is Fiscal policy?

  • Fiscal policy is the use of government spending and taxation to influence the economy.

Accounts of Government are kept in three parts

The Constitution of India provides for the manner in which the accounts of the Government have to be kept. The Annual Financial Statement (Article 112) shows the receipts and payments of government under the three parts in which government accounts are kept:

  • Consolidated Fund of India – Article 266 (1)
  • Public Account of India – Article 266 (2)
  • Contingency Fund of India – Article 267 (1)

Consolidated Fund of India: All revenues received, loans raised and all moneys received by the Government in repayment of loans are credited to the Consolidated Fund of India. All expenditures of the Government are incurred from this fund. Money can be spent through this fund only if appropriated by the Parliament. The consolidated Fund has further been divided into ‘Revenue’ and ‘Capital’ divisions.

Public Account of India: All other moneys received by or on behalf of Government are credited to the Public Account.

Contingency Fund of India: Contingency Fund enables the Government to meet unforeseen expenditure, which cannot wait approval of the Parliament. It is placed at the disposal of the President.

Budget Contains Receipts and Expenditure

  • Two types of Receipts:
    • Revenue Receipts
    • Capital Receipts
  • Two types of Expenditure:
    • Revenue Expenditure
    • Capital Expenditure
  • Revenue receipts are those receipts which neither create any liability nor cause any reduction in the assets of the government.
  • Capital receipts are those receipts which either create liability or reduce the assets of the government.
  • Revenue Expenditure is that part of government expenditure that does not result in the creation of assets.
  • A capital expenditure is an amount spent to acquire or significantly improve the capacity or capabilities of a long-term asset such as machinary equipment or buildings. It includes the expenditure incurred on acquiring fixed assets.

Revenue Receipts

  1. Tax Revenue
  2. Non Tax Revenue

Tax Revenue

  • Corporation Tax
  • Income Tax
  • Wealth Tax
  • Union Excise Duties
  • Customs Duties
  • Service Tax
  • Goods and Services Tax (GST)
  • Other Taxes and Duties on Commodities and Services

Non Tax Revenue

  • Interest Receipts
  • Dividends and Profits
  • Fiscal Services
  • General Services
  • Social Services
  • Economic Services
  • Grants-in-aid and Contribution

Capital Receipts

  1. Non Debt Receipts
  2. Debt Receipts

1. Non Debt Receipts

  • Recoveries of Loans & Advances
  • Disinvestment Receipts

2. Debt Receipts             

  • Borrowings
    • Market Loans
    • Borrowing for providing back to back loans to States and UTs for GST compensation cess shortfall
    • Issuance of Special Securities to Public Sector Banks
    • Issuance of Special Securities to EXIM Bank 
    • Issuance of Special Securities to IDBI Bank Ltd.
    • Issuance of Special Securities to IIFCL
    • Post Office Life Insurance Fund (POLIF)
    • Treasury Bills
    • Ways & Means Advances
    • Securities against Small Savings     
  • State Provident Funds     
  • Other Receipts (Internal Debts and Public Account)
  • External Debt     
    • Multilateral Loans
    • Bilateral Loans

Revenue Expenditure

  • Interest Payments
  • Defence Expenditure
  • Police Expenditure
  • Subsidies
  • Expenditures on Social services
  • Expenditures on General services
  • Grants to States & Union Territories

Capital Expenditure

  • Expenditure on creation of assets like schools, colleges, hospitals, roads etc
  • Expenditure on Defence
  • Expenditures on General services
  • Plan Expenditure
  • Other Liabilities

Tax Revenue:

  • Tax revenue is the income that is earned by governments through taxation.
  • Income Tax: It is levied on individuals on the income earned with different tax slabs for income levels.
  • Corporate Tax: It is the direct tax imposed on the net income or profit that enterprises make from their businesses.
  • Gift Tax: It is a tax on gifts of property by an individual in his lifetime to future successors.
  • Wealth Tax: It is levied on the specified assets of certain persons including individuals and companies. This Tax has been abolished since 2016-17.
  • Excise Duty: It is levied on the goods produced domestically. It is paid by the manufacturers.
  • Customs Duty: It is levied on import and export of goods. It is levied by the Central Government.
  • Export Duty: It is levied on export of few specific items such as ores and concentrates of Iron, Chromium etc
  • Service Tax: Government levies the tax on service providers.
  • GST: Goods and Services Tax is an indirect tax levied in India on the supply of goods and services. It has come into force w.e.f. 1st July, 2017.

Non-Tax Revenue:

  • The revenue earned by the government from sources other than the tax sources is called Non-Tax Revenue.
  • Interest Receipts: It comprises of interest of loans given to states and union territories.
  • Dividends and Profits: This Section comprises of dividends and profits from Public Sector Enterprises. It also includes surplus of the Reserve Bank of India that is transferred to Government.
  • Fiscal Services (Currency, Coinage, and Mint): The Government also derives income from running the Currency Note Printing Presses. The profits are made from the circulation of coins — this profit is the difference between the face value of the coins and their manu­facturing cost.
  • Other Fiscal Services: The receipts mainly relate to contributions by Reserve Bank of India towards Extended Fund Facility (EFF) charges payable to the International Monetary Fund, remunerations, etc. received from IMF and penalties, etc. realized against Economic Offences.
  • Other Non-Tax Sources of Revenue: Fees, Fines or Penalties, etc. forms other Non-Tax Sources of Revenue.

Three types Budgets (Depending on the estimates)

  1. Balanced Budget = Estimated Govt. Receipts = Estimated Govt. Expenditure
  2. Surplus Budget = Estimated Govt. Receipts > Estimated Govt. Expenditure
  3. Deficit Budget = Estimated Govt. Expenditure > Estimated Govt. Receipts

What is a Deficit?

  • Deficit means shortage. If you spend more money than you make, then deficit occurs.

Budget Deficit:

  • A budget deficit occurs when expenses exceed income.
  • Budget Deficit = Total Government Spending – Total Government Income

Revenue Deficit:

  • It refers to the excess of government’s revenue expenditure over revenue receipts.
  • Revenue Deficit = Revenue expenditure – Revenue receipts.

Fiscal Deficit:

  • It is the gap between the government’s expenditure requirements and its receipts.
  • The government meets fiscal deficit by borrowing money.
  • Fiscal Deficit = Total Expenditure – Total Receipts (Excludong Borrowing and Other liabilities)

Primary Deficit:

  • Primary deficit equals fiscal deficit minus interest payments on previous year borrowings.
  • Primary deficit = Fiscal deficit – Interest payments

Monetised Deficit:

  • It is the monetary support extended by the RBI to the central government in its borrowing programme.
  • It is also known as debt monetisation.

Effective Revenue Deficit:

  • It is defined as the difference between revenue deficit and grants for creation of capital assets.

Taxation in India

  • Tax system of India mainly consists of two types of taxes — Direct Tax and Indirect Tax.

What is Direct Tax?

  • Direct Tax is levied directly on individuals and corporate entities.
  • This tax cannot be transferred or borne by anybody else.

Following are the Direct Taxes:

  • Income Tax: It is levied on individuals on the income earned with different tax slabs for income levels.
  • Corporate Tax: It is the direct tax imposed on the net income or profit that enterprises make from their businesses.
  • Wealth Tax: It is levied on the specified assets of certain persons including individuals and companies.
  • Capital Gain Tax: Any profit or gain that arises from the sale of a ‘capital asset’ is a capital gain. This gain or profit is comes under the category ‘income’, and hence you will need to pay tax for that amount in the year in which the transfer of the capital asset takes place. This is called capital gains tax, which can be short-term or long-term.

What is Indirect Tax?

  • Indirect taxes are taxes which are indirectly levied on the public through goods and services.
  • The sellers of the goods and services collect the tax which is then collected by the government bodies.

Following are the Indirect Taxes:

  • Value Added Tax (VAT): A sales tax levied on goods sold in the state.
  • Octroi Tax: It is levied on goods which move from one state to another. This tax is levied by the respective state governments.
  • Excise Duty: It is levied on the goods produced domestically. It is paid by the manufacturers.
  • Customs Duty: It is levied on import and export of goods. It is levied by the Central Government.
  • Export Duty: It is levied on export of few specific items such as ores and concentrates of Iron, Chromium etc
  • Service Tax: It is a tax levied on service providers.
  • GST: Goods and Services Tax is an indirect tax levied in India on the supply of goods and services. It has come into force w.e.f. 1st July, 2017.

Impact and Incidence of Tax

Impact of Tax:

  • Impact refers to the initial burden of the tax.
  • Impact is at the point of imposition.

Incidence of Tax:

  • Incidence refers to the ultimate burden of the tax.
  • Incidence occurs at the point of settlement.

The impact of a tax falls upon the person from whom the tax is collected and the incidence rests on the person who pays it eventually. Impact may be shifted but incidence cannot.

For example, suppose a excise duty is imposed on soap. Its impact is on the producers, in the first instance, as they are liable to pay it to the government. But, the producers may succeed in collecting it from the consumers by raising the price of soap by the amount of tax. In that case, consumers eventually pay the tax and so the incidence falls upon them.

Goods and Services Tax

  • GST is commonly described as indirect, comprehensive, broad based consumption Tax.
  • The Constitution (101st Amendment) Act, 2016 provided for the provisions for the implementation of GST Regime.
  • Article 246A was newly inserted to give power to the Parliament and the respective State/Union Legislatures to make laws on GST respectively imposed by each of them.
  • The objective is to remove the multiplicity of tax levies thereby reducing the complexity and remove the effect of Tax Cascading.
  • The objective is to subsume all those taxes that are currently levied on the sale of goods or provision of services by either Central or State Government.

Taxes  subsumed under GST:

  • Central Excise Duty (CENVAT)
  • Additional Excise Duties
  • Additional Customs Duty, commonly known as Countervailing Duty
  • Special Additional Duty of Customs
  • Service Tax
  • VAT / Sales tax
  • Entertainment tax (unless it is levied by the local bodies)
  • Luxury tax
  • Taxes on lottery, betting and gambling
  • Octroi and Entry Tax
  • Purchase Tax

Following products are out of the ambit of GST:

  1. Petroleum Crude
  2. High-Speed Diesel
  3. Motor Spirit
  4. Natural Gas
  5. Aviation Turbine Fuel
  6. Alcohol

Progressive, Regressive and Proportional Taxation

  • Progressive Taxation: Here tax rate increases with the increase in income.
  • Regressive Taxation: Here tax rate decreases with the increase in income.
  • Proportional Taxation: Here tax rate remains same for every taxpayer, irrespective of income.

Important Terms:

Ad valorem

  • It is levied on the basis of value of the goods.
  • Here revenue increases if the price value of the good increases.
  • It is progressive in nature.

Specific duty

  • It is levied on the basis of number of unit of the goods.
  • Here revenue increases if the quantity of good produced increases.
  • It is proportional in nature.

Cess

  • A cess is a form of tax levied by the government on tax with specific purposes.
  • It is used to raise revenue for a temporary need.
  • The money collected is used for that purpose only.
  • Eg: Education cess, Health cess

Surcharge

  • Surcharge is a tax on tax.
  • It is a additional tax payable over & above the normal tax.
  • The money collected through surcharge can be used by the government at its own discretion.

Countervailing duty (CVD)

  • It is imposed by the government to protect domestic producers from the negative impact of import subsidies.
  • So it is an import tax by the importing country on imported products.

Anti-dumping duty

  • Dumping is said to occur when the goods are exported by a country to another country at a price lower than its normal value.
  • This is an unfair trade practice which can have a distortive effect on international trade.
  • Anti-dumping duty is a tariff imposed on imports manufactured in foreign countries that are priced below the fair market value of similar goods in the domestic market.
  • The imposition of anti-dumping duty is permitted by the WTO.

Laffer curve

  • Developed by Arthur Laffer.
  • It explains the relationship between tax rates and the tax revenue collected by the government.
  • It says there will be low tax revenue collection at both higher and lower tax rates.

What is Monetary Policy?

Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control to achieve the goals. The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.

The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.

In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.

The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years.

Monetary Policy Committee (MPC) constituted by the Central Government determines the policy interest rate required to achieve the inflation target.

Monetary Policy Committee – 6 members

  • Monetary Policy Committee shall determine the Policy Rate required to achieve the inflation target.
  • The decision of Monetary Policy Committee shall be binding on the Bank.

Composition of Monetary Policy Committee

Monetary Policy Committee shall consist of the following Members

  • Governor of the Reserve Bank of India — Chairperson, ex officio
  • Deputy Governor of the Bank in charge of monetary policy — Member, ex officio
  • One officer of the Bank to be nominated by the Central Board — Member, ex officio
  • Three persons to be appointed by the Central Government as Members.

Instruments of the Monetary Policy

Bank Rate:

  • It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers.
  • This rate has been aligned to the MSF rate.

Cash Reserve Ratio (CRR):

  • Every bank is required to keep a certain percentage of its Net demand and time liabilities (NDTL) with RBI. It is CRR.

Statutory Liquidity Ratio (SLR):

  • It is the share of NDTL that a bank is required to maintain in its vaults in any form – government securities, cash and gold.

Open Market Operations (OMOs):

  • It includes purchase and sale of government securities.

Market Stabilisation Scheme (MSS):

  • With this surplus liquidity is absorbed through sale of short-dated government securities and treasury bills.
  • The cash so mobilised is held in a separate government account with the Reserve Bank.
  • It was introduced in 2004.

Repo Rate:

  • It is the (fixed) interest rate at which Reserve Bank lends to banks.

Reverse Repo Rate:

  • It is the (fixed) interest rate at which Reserve Bank borrows from banks.

Liquidity Adjustment Facility (LAF):

  • It is a tool that enables banks to borrow money through repo and reverse repo auctions.

Marginal Standing Facility (MSF):

  • Under this facility, banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.

Two types of Financial Markets: Money Market & Capital Market

Money Market:

  • It is a short term financial market.
  • It deals with financial assets and securities which have a maturity period of upto one year.

Capital Market:

  • It is a long term financial market.
  • It deals with financial assets and securities which have a maturity period more than one year.

Indian Money Market classified into

  1. Organised sector
  2. Unorganised sector

Organised Sector:

  • Banking Sector
  • Call and Notice Money Market
  • Treasury Bills
  • Commercial Bills
  • Cash Management Bills (CMBs)
  • Certificates of Deposits (CDs)
  • Commercial Papers (CPs)

Unorganised sector:

  • Indigenous Bankers
  • Money Lenders
  • Chit Funds
  • Nidhi company

Organised Sector:

Call and Notice Money Market:

  • Under call money market, funds are transacted on overnight basis.
  • Under notice money market funds are transacted for the period between 2 days and 14 days.

Treasury Bills:

  • These are short-term securities issued by RBI on behalf of Government.
  • Treasury bills are zero coupon securities and pay no interest.
  • They are issued at a discount and redeemed at the face value at maturity.
  • There are three types of treasury bills – 91 days, 182-day and 364-day treasury bills.

Commercial Bills:

  • Commercial bill is a short-term, negotiable instruments drawn by a seller on the buyer for the value of goods delivered by him. Such bills are called trade bills.
  • When trade bills are accepted by commercial banks, they are called commercial bills.

Cash Management Bills (CMBs)

  • These are short-term securities issued to meet the temporary mismatches in the cash flow of the Government.
  • CMBs are issued for maturities less than 91 days.

Certificates of Deposits (CDs):

  • These are negotiable promissory notes issued at a discount to the face value.
  • They are issued by Commercial banks and Development financial institutions.
  • CDs can be high-risk liabilities for any scheduled commercial bank

Commercial Papers (CPs):

  • It is an unsecured money market instrument issued in the form of a promissory note with fixed maturity.
  • CPs are generally issued by corporate entities.
  • Companies, including Non-Banking Finance Companies (NBFCs) and All India Financial Institutions (AIFIs), are eligible to issue CPs.

Unorganised Sector

Indigenous Bankers:

These are financial intermediaries or individuals who operate as banks. They receive deposits and given loans.

Money Lenders:

They are mainly engaged in money lending operations.

Chit Funds:

  • They are saving institutions.
  • The members make regular contribution to the fund.
  • The collected funds is given to some member based on previously agreed criterion.
  • Chit fund companies come under the Chit Fund Act, 1982 and hence are legal, registered, and safe. They are different from unregulated deposits and Ponzi schemes.
  • Unregistered chit funds are not legally bound to pay the amount deposited to its members.

Nidhi Company: It is a type of NBFC.

  • Its core business is borrowing and lending money between their members.

Indian Capital Market classified into

  1. Securities Market
  2. Development Financial Institutions
  3. Financial Intermediaries

Securities Market classified into two types

  1. Gilt-Edged Market
  2. Industrial Securities Market

Industrial Securities Market divided into two categories

  1. Primary Market
  2. Secondary Market

Development Financial Institutions are

  • IFCI
  • ICIC
  • SFC
  • IDBI
  • IIBI
  • UTI

Financial Intermediaries

  • Merchant Banks
  • Mutual Funds
  • Leasing Companies
  • Venture Capital Companies

What are Securities?

  • Securities are financial instruments issued to raise funds.
  • Stocks, Bonds, ETFs, Mutual funds, Hedge funds, Private equity, Derivatives are types of securities.

What is Securities Market

  • It is the market where trading in securities such as stocks and bonds take place.
  • The primary function of the securities markets is to enable to flow of capital from those that have it to those that need it.
  • Securities Market is regulated by SEBI.

What is Gilt- Edged Market?

  • Gilt-edged market is also known as Government securities market.
  • It is a market where Government securities are traded.
  • As the securities are risk free, they are known as gilt-edged i.e. the best quality securities.
  • RBI plays an important role in this market through its open market operations.

Primary Market

  • It is also called the new issue market.
  • It is the market where issuers raise capital by issuing securities to investors.
  • This market facilitates capital formation.

Secondary Market

  • It is also called the stock exchange.
  • It is also called the old issue market as it facilitates trade in already-issued securities, thereby enabling investors to exit from an investment.
  • The risk in a security investment is transferred from one investor (seller) to another (buyer) in the secondary markets.
  • The primary market creates financial assets, and the secondary market makes them marketable.

Note:

  • Both Primary and Secondary markets are regulated by SEBI.
  • Capital markets include stock and bond markets.
  • Derivatives markets include futures and options markets.

Stocks or Shares:

  • Stocks are also known as shares. Sometimes they also referred to as an equity.
  • Stocks/Shares represent ownership interest in companies.
  • So buying shares means buying part of a company.
  • The Owner of the Share is referred as Shareholder.

What are Bonds?

  • Bonds are a type of Debt securities.
  • If investors are purchasing bonds means, they are lending money to a company in exchange for regular interest payments.
  • The company or an issuer of the bond will make annual interest payments and will also repay the initial investment amount on maturity at a specified date in the future.

What are Derivatives?

  • Derivatives derive their properties from underlying assets, such as commodities, stocks, bonds and currencies.
  • Futures, Options and Swaps are all types of Derivative.

What are Debentures?

  • A debenture is a bond issued without a collateral (security for a loan).
  • The company will repay the principal amount with a fixed interest rate after a particular tenure.

Issuer of securities

The following are the participants who are permitted to issue debt securities in India:

  • Central Government
  • State Governments
  • Government Agencies/ Statutory Bodies
  • Public Sector Units
  • Corporate
  • Banks
  • Financial Institutions
  • NBFCs

Merchant Banks

  • They help an issuer to access the security market with an issuance of securities.
  • They act as intermediaries between the company and the investors.
  • They engage other intermediaries such as registrars, brokers, bankers, underwriters and credit rating agencies in managing the issue process.
  • Merchant bankers also called as issue managers or investment bankers.

Underwriters

  • Underwriters are primary market specialists who promise to pick up that portion of an offer of securities which may not be bought by investors. 
  • The specialist underwriters in the government bond market are called primary dealers.

Mutual fund

  • Mutual fund is an investment vehicle to mobilize money from a large number of individuals and invests in different markets and securities.

Venture Capital Companies

  • These companies provide the necessary risk capital to the entrepreneurs or startups.

What is External Sector?

The external sector of a country’s economy refers to all international economic transactions between residents of the country (private and public sector) and the rest of the world.

Balance of payments (BOP)

It is a systematic record of all international economic transactions.

BOP accounts consists of two accounts – Current account and Capital account.

Current Account:

  • It mainly records the inflow and outflow of goods and services in the economy.
  • It deals with the exports and imports of goods, services, income and current transfers.

Capital Account:

It deals with capital investments and expenditures and it also includes investments made by public and private companies.

It includes assets and liabilities covering direct investment, portfolio investment, loans, banking capital and other capital;

Main components of the Current account are:

  • Merchandise trade
  • Services
  • Income receipts
  • Transfers

Income receipts and Transfers are part of Invisibles.

Main components of the Capital account are:

  • Foreign direct investment (FDI)
  • Foreign portfolio investment (FPI)
  • External Assistance
  • Short-Term Loans to India
  • Commercial Borrowings
  • Banking Capital
  • NRI deposits

Difference between Current Account and Capital Account:

  • Current account shows the inflow and outflow of ‘goods & services’ in the economy.
  • Capital account shows the inflow and outflow of ‘capital’ in the economy.

What are Non Resident Deposits?

Non resident Indians (NRIs) are allowed to open and maintain bank account in India under special deposit schemes – both rupee denominated and foreign currency denominated. Such deposits are termed NRI deposits. NRIs can park their funds in both term deposits as well savings accounts.

NRI deposits include deposits under:

  1. Foreign Currency Non-resident (Banks) (FCNR)(B)
  2. Non Resident External-Rupee (NRE) Accounts
  3. Non-Resident Ordinary (NRO) Account

Foreign Currency Non-resident (Banks) (FCNR)(B): It allows NRIs to invest foreign currency in term deposits in India and earn tax-free interest.

Non Resident External-Rupee (NRE) Accounts: It is an Indian rupee-denominated account.

Non-Resident Ordinary (NRO) Accounts: These accounts may be opened / maintained in the form of savings, recurring or fixed deposit accounts. These are Rupee accounts opened for the purpose of depositing income earned in India.

What is Foreign Exchange?

  • Foreign exchange (Forex) is the conversion of one currency into another at a specific rate known as the foreign exchange rate.

What is Foreign Exchange Market?

  • It is a decentralized global market in which currencies are traded.

Foreign Exchange Reserves consist of the following components:

  1. Foreign Currency Assets (FCA)
  2. Gold
  3. Special Drawing Rights (SDR)
  4. Reserve Tranche Position in IMF (RTP)

Devaluation and Revaluation

  • Under a fixed exchange rate system, devaluation and revaluation are the changes brought by government or monetary authority in the value of a country’s currency relative to other currencies.
  • When the price of the currency is officially decreased then it is Devaluation
  • When the price of the currency is officially increased then it Revaluation

Depreciation or Appreciation

  • Under a floating exchange rate system, market forces (demand and supply) brings changes in the value of the currency, known as currency depreciation or appreciation.
  • When the value of currency falls (decreases) as compared to other currency it is known as Depreciation.
  • When the value of the currency goes up (increases) as compared to other currency it is known as Appreciation.

Facts:

  • Currency convertibility means the freedom to convert domestic currency (rupee) into other international currencies (like Dollars etc.)
  • Current account convertibility means freedom to convert domestic currency into a foreign currency and vice versa for export and import of goods and services.
  • In India, there is full current account convertibility since August 20, 1993.
  • Capital account convertibility means there is no restriction on conversion of the domestic currency into a foreign currency to enable a resident to acquire any foreign asset (i.e, equity, debt etc) or on conversion of a foreign currency to the domestic currency to enable a non-resident to acquire a domestic asset ((i.e, equity, debt etc) ).
  • There is partial capital account convertibility in India. It means there are certain restrictions on the movement of capital. India adopted a cautious approach towards full convertibility.

Nominal and Real Effective Exchange Rate (NEER and REER)

NEER: NEER is the weighted geometric average of the bilateral nominal exchange rates of the home currency in terms of foreign currencies.

REER: REER is the weighted average of NEER adjusted by ratio of domestic inflation rate to foreign inflation rates.

Six currencies chosen are US Dollar, Euro, Pound sterling, Japanese yen, Chinese renminbi and Hong Kong Dollar.

Sources: Internet, RBI website