MACROECONOMICS ESSENTIALS FOR CIVIL SERVICE EXAMINATIONS

2018 WWW.OBJECTIVEIAS.IN MACROECONOMICS ESSENTIALS FOR CIVIL SERVICE EXAMINATIONS Special Features: 1. Detailed Explanation of Each Concept 2. Important Key Words at the end of Each Unit 3. Check your progress objective questions at the end of Unit with Answers 4. Concept Explainer Glossary 5. Infographics explainer 6. Based on NCERT Introductory Macroeconomics 7. Supplemented by Indian Economy by Ramesh Singh

Title : Macroeconomics Essentials Publisher : OBJECTIVE IAS 2 Address : Jhadaposhi, Keonjhar-31, Odisha Mail : objectiveias.in@gmail.com Website : Contact : +917008074714 Disclaimer: Due care has been taken to ensure that the information provided in this book is correct. However, the publishers bear no responsibility for any damage resulting from any inadvertent omission or inaccuracy in the book. Notes: Edition: 2018 Price: Rs 99 All right reserved. No part of this book may be reproduced or transmitted in any form or by any means without the prior written permission of the publishers. Join Our Test Series OPSC OAS Prelims 2018-19 Test Series OPSC OAS Mains 2017-18 Test Series: General Studies, History and Geography For More Details visit:

4 Contents 1. Introduction to Economics Page-6 2. National Income Accounting Page-14 3. Goods, Prices and Inflation Page-28 4. Money and Banking Page-36 5. Government Budget and Economy Page-50 6. External Sector Page-61 7. Glossary Page-75

Unit Structure Unit-1: Introduction to Economics 6 1. Introduction 2. Microeconomics and Macroeconomics 3. Types of Economy 4. Sectors of an Economy 5. Economic Agents 6. Factors of Production 7. Four Major Sector in an Economy Unit Objectives After reading this unit you will be able to understand: 1. What is economics? 2. What is Microeconomics and Macroeconomics? 3. The difference between Macroeconomics and Microeconomics 4. Different Types of Economies 5. Different sectors of economy 6. About Economic Agents 7. About Factors of Production and their financial returns 8. What are the four major sectors in an economy? What is 'Economics'? Economics is a social science concerned with the production, distribution and consumption of goods and services. It studies how individuals, businesses, governments and nations make choices on allocating resources to satisfy their wants and needs, and tries to determine how these groups should organize and coordinate efforts to achieve maximum output. Economic analysis often progresses through deductive processes, much like mathematical logic, where the implications of specific human activities are considered in a "means-ends" framework. Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the aggregate economy, and microeconomics, which focuses on individual consumers. Microeconomics: Microeconomics (from Greek prefix mikro- meaning "small") is a branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

Definition: Microeconomics is the study of individuals, households and firms' behavior in decision making and allocation of resources. It generally applies to markets of goods and services and deals with individual and economic issues. 7 Description: Microeconomic study deals with what choices people make, what factors influence their choices and how their decisions affect the goods markets by affecting the price, the supply and demand. Macroeconomics: Macroeconomics (from the Greek prefix makro- meaning "large" and economics) is a branch of economics dealing with the performance, structure, behavior, and decisionmaking of an economy as a whole. This includes national, regional, and global economies. Definition: Macroeconomics is the branch of economics that studies the behavior and performance of an economy as a whole. It focuses on the aggregate changes in the economy such as unemployment, growth rate, gross domestic product and inflation. Description: Macroeconomics analyzes all aggregate indicators and the microeconomic factors that influence the economy. Government and corporations use macroeconomic models to help in formulating of economic policies and strategies. Macroeconomics and microeconomics, a pair of terms coined by Ragnar Frisch, are the two most general fields in economics. In contrast to macroeconomics, microeconomics is the branch of economics that studies the behavior of individuals and firms in making decisions and the interactions among these individuals and firms in narrowly-defined markets. Difference between Macroeconomics and Microeconomics Microeconomics focuses on how individual consumers and producers make their decisions. This includes a single person, a household, a business or a governmental organization. Microeconomics ranges from how these individuals trade with one another to how prices are affected by the supply and demand of goods. Also studied are the efficiency and costs associated with producing goods and services, how labor is divided and allocated, uncertainty, risk, and strategic game theory. Macroeconomics studies the overall economy. This can include a distinct geographical region, a country, a continent or even the whole world. Topics studied include government fiscal and monetary policy, unemployment rates, growth as reflected by changes in the Gross Domestic Product (GDP) and business cycles that result in expansion, booms, recessions and depressions.

3. Labour (wage/salaries): the remuneration for labour, given in return for their physical and mental efforts given during the production process. 4. Entrepreneurship (Profit): received when entrepreneurs take responsibilities and takes risks during the production process 11 Factors of Production Land Capital Labour Entrepreneur Rent Interest Wage/salaries Profit Income or Revenue Four Major Sectors in an economy according to the macroeconomic point of View 1. Private Capitalist Sector: production activities are mainly carried out by capitalist enterprises 2. Government Sector: role of state includes framing laws, enforcing them and delivering justice. The state in many instances undertakes production- apart from imposing taxes and spending money on building public infrastructure, running schools, providing health services etc. 3. Household sector: by a household we mean a single individual who takes decisions relating to her own consumption, or a group of individuals for who decisions relating to consumption are jointly determined. 4. External sector: all the countries of the world are engaged in external trade. Trade with the external sector can be of two types exports and imports. Key Words Economics, Macroeconomics, Microeconomics, traditional economy, Free Market Economy, Command Economy, Mixed Economy, Open Economy, Closed Economy, Capitalist Economy, Socialist Economy Check Your Progress Q1. Which branches of economics examines the behavior of Individual actors such as consumers, businessman, households in the face of scarcity and what effects they have? a) Macro economics

c) Tertiary Sector d) Service Sector 13 Q8. Financial Planning Activities comes under, particularly which sector of economy? a) Primary Sector b) Secondary Sector c) Service Sector d) Quaternary Sector Q9. A country s degree of development evaluated on the basis of: a) Per Capita GDP b) Level of Industrialization c) The amount of widespread infrastructure d) all of these Q10. Which branch of economics studies foreign exchange, balance of Payments, Balance of Trade particularly? a) Macroeconomics b) Development economics c) International economics d) Open economics Answers to Check Your Progress 1. b 2. a 3. a 4. d 5. c 6. a 7. b 8. d 9. d 10. c *************

Unit Structure Unit-2: National Income Accounting 14 1. Some Basic Concepts of Macroeconomics 2. Circular flow of Income 3. Methods of Calculating National Income 4. Calculation of GDP 5. Calculation of National Income 6. Calculation of Personal Income 7. Problems in Calculating National Income 8. National Income Estimation in India Unit Objectives After going through this unit you will be able to understand: 1. Types of Goods, Flows and Stocks, Investment and Depreciation 2. The circular flow of Income 3. Different methods used to calculate national income 4. How the GDP of a country is calculated? 5. What are inventories and investment? 6. Calculation of GNP and NNP 7. What is Personal Income and how it is calculated? 8. What are the Problems in calculating National Income? 9. The National Income Estimation in India. Some Basic Concepts of Macroeconomics Final good: Item that is meant for final use and will not pass through any more stages of production or transformations is called a final good. We call this a final good because once it has been sold it passes out of the active economic flow. It will not undergo any further transformation at the hands of any producer. It may, however, undergo transformation by the action of the ultimate purchaser. In fact many such final goods are transformed during their consumption. Thus the tea leaves purchased by the consumer are not consumed in that form they are used to make drinkable tea, which is consumed. It is not in the nature of the good but in the economic nature of its use that a good becomes a final good. For example- cooking at home is not an economic activity, even though the product involved undergoes transformation. Home cooked food is not sold to the market. However, if the same cooking or tea brewing was done in a restaurant where the cooked product would be sold to customers, then the same items, such as tea leaves, would cease to be final goods and would be counted as inputs to which economic value addition can take place. Thus it is not in the nature of the good but in the economic nature of its use that a good becomes a final good.

GNP = GDP + Net Factor Income from Abroad Net National Product: If we deduct depreciation from the GNP then we get Net National Product (NNP) 22 NNP = GNP + Depreciation Factor Cost (FC): It refers to costs of factors of production viz. rent of land, interest of capital, wages of employees and profit for entrepreneurship. Market Price (MP): It is the price the customer actually pays. It includes the components of indirect taxes and of subsidies. We may formulize- FC = MP- Indirect Taxes + Subsidies MP = FC +Indirect taxes subsidies OR MP = FC + Net Indirect Tax Now Back to National Income- It is to be noted that GDP, GNP, NNP, etc are evaluated at market prices. Through the expression given above, we get the value of NNP evaluated at market prices. But market price includes indirect taxes. When indirect taxes are imposed on goods and services, their prices go up. Indirect taxes accrue to the government. We have to deduct them from NNP evaluated at market prices in order to calculate that part of NNP which actually accrues to the factors of production. Similarly, there may be subsidies granted by the government on the prices of some commodities (in India petrol is heavily taxed by the government, whereas cooking gas is subsidized). So we need to add subsidies to the NNP evaluated at market prices. The measure that we obtain by doing so is called Net National Product at factor cost or National Income. National Income = Net National Product at Factor Cost National Income= NNP at market prices- (Indirect taxes- subsidies) National Income= NNP at market prices- net indirect taxes Net Indirect Taxes= Indirect taxes subsidies Note- Net factor income from abroad is zero then GDP=GNP Calculating Personal Income The part of NI which is received by households is called Personal Income (PI). To calculate- First, let us note that out of NI, which is earned by the firms and government enterprises, a part of profit is not distributed among the factors of production. This is called Undistributed Profits (UP). We have to deduct UP from NI to arrive at PI, since UP

Unit Structure 1. Real GDP and Nominal GDP 2. GDP Deflator 3. CPI and WPI 4. Why CPI Differ from GDP Deflator 5. Inflation Unit- 3: Goods, Prices and Inflation 28 Unit Objectives After reading this unit you will be able to know: What are real GDP and Nominal GDP? What are GDP deflator and various other indexes to measure Price rise such as CPI and WPI? What is inflation, its causes, effects and various measures to check it? Let s Start If we measure the GDP of a country in two consecutive years and see that the figure for GDP of the latter year is twice that of the previous year, we may conclude that the volume of production of the country has doubled. But it is possible that only prices of all goods and services have doubled between the two years whereas the production has remained constant. Therefore, in order to compare the GDP figures (and other macroeconomic variables) of different countries or to compare the GDP figures of the same country at different points of time, we cannot rely on GDPs evaluated at current market prices. For comparison we take the help of real GDP. Real GDP is calculated in a way such that the goods and services are evaluated at some constant set of prices (or constant prices). Since these prices remain fixed, if the Real GDP changes we can be sure that it is the volume of production which is undergoing changes. Real GDP = GDP at Constant Prices On the other hand the GDP at current prevailing Prices is called Nominal GDP. Nominal GDP = GDP at Current Prices Example: Suppose a country only produces bread. In the year 2016 it had produced 100 units of bread, price was Rs 10 per bread. Then

Unit Structure 1. What is Money? 2. Barter System 3. Functions of Money 4. Demand for Money 5. Liquidity Trap 6. The Supply of Money 7. RBI Policy Instruments 8. Commercial Banks 9. High Powered Money 10. Mechanism of Money creation by RBI 11. Bank Failure 12. Role of Reserve Bank of India 13. Instruments of Monetary Policy Unit Objectives Unit- 4: Money and Banking 36 After Reading this unit you will be able to understand: 1. What is Money and Its functions and How does money over come the shortcomings of Barter System? 2. The transaction and speculative demands of money 3. What is Liquidity Trap? 4. What are Narrow and Broad Money? 5. What are the factors, which affect money supply? 6. What is High Powered Money? 7. Mechanism of Money Creation by RBI 8. What are the instruments of Monetary Policy? What is Money Money is an officially-issued legal tender generally consisting of notes and coin, and is the circulating medium of exchange as defined by a government. Money is often synonymous with cash and includes various negotiable instruments such as checks. Each country has its own money that is used as a medium of exchange within that country. Barter System Money is the commonly accepted medium of exchange. Economic exchanges without the mediation of money are referred to as barter exchanges. A system of exchange of goods and services without the help of medium of exchange such as money is called Barter System. The barter system works in principle of double

Legal Tenders: Notes and coins are also called Legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transactions. 41 Note: Cheques drawn on Savings or current accounts, however can be referred anyone as a mode of payment. Hence, demand deposits are not legal tenders. Narrow Money & Broad Money Money supply, like money demand, is a stock variable. Money Supply: The total stock of money in circulation among the public at a particular point of time is called money supply. RBI published figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows: M1 = CU + DD, where CU is currency (Notes and coins) held by public and DD is net demand deposits held by commercial banks. M2 = M1 + Savings deposits with Post Offices Savings Banks M3 = M1 + Net time deposits of commercial banks ( the word net implies that only deposits of the public held by the banks are to be included in money supply, the interbank deposits are not to be regarded as part of money supply) M4 = M3 + total deposits with Post Office Savings Organization excluding National Savings certificates M1 and M2: Narrow Money M3 and M4: Broad Money These gradations are in de3creasing order of liquidity. M1 is the most liquid and easiest for transactions, where as M4 is least liquid of all. M1> M2> M3> M4 M3 is most commonly used measure of money supply. It is also known as aggregate Monetary Resources. Factors Affecting Money Supply Money supply will change if the value of any of its components such as CU, DD or Time Deposits changes. For simplicity, we use the most liquid definition of money viz. M1= CU + DD, as the measures of money supply in the economy. Various actions of monetary authority (RBI) and commercial banks are responsible for changes in the value of issue items. The preference of the public for holding cash balance vis-à-vis deposits in banks also affects the money supply. The influences on money supply can be summarized by the key ratios such as: the Currency Deposit Ratio (CDR), the Reserved Deposit Ratio (RDR) and High Powered Money (H).

Assume also that the values of CDR and RDR of this economy are 1 and 0.2 respectively. The seller encashes the cheque issued by RBI at his account in Bank A, keeping Rs H/2 in his account and taking Rs H/2 away as cash. 45 Now, the currency held by public thus goes up by Rs H/2 because of this increment in in deposits. But its assets also go up by the same amount through the possession of this cheque, which is nothing but a claim of the same amount on RBI. The liability of RBI goes up by Rs H, which is the sum total of the claims of Bank A (Rs H/2) and its client, the seller (Rs H/2) High Powered Money Currency Reserves Bank Failure Currency Deposits Total Money Supply (High Powered Money in relation to Total Money Supply) As we know that the amount of money stock in the economy is much greater than the volume of High Powered Money (Refer above Figure). Commercial Banks create this extra amount of money by giving out a part of their deposits as loans or investment credits. It is also true that the total amount of deposits held by all commercial banks in the country is much larger than the total size of their reserves. If all the account-holder of all commercial banks in the country wants their deposits back at the same time, the banks will not have enough means to satisfy the needs of every account holder and there will be a Bank Failure. Role of Reserve Bank of India Followings are important roles played by the Reserve Bank of India- 1. Lender of Last Resort 2. Banker s to the Bank 3. Banker s to the Government (Both Union and States) 4. Deficit financing and controller of the money supply and credit creation (Most Important)

Unit Structure Unit-5: Government Budget and Economy 50 1. Functions of Government Budget 2. Budget 3. Few More things about Budget in India 4. Measures of Government Deficit 5. Government deficit and Government Debt 6. Issue of Fiscal Deficit Reduction 7. Few more terms related to Taxation Unit Objectives After reading this unit you will be able to understand: 1. What are the three functions of Government Budget? 2. Details about the Budget of India 3. Different types of Deficits such as: Revenue Deficit, Fiscal Deficit, and Primary Deficit 4. Relation between government deficit and government debt 5. How fiscal deficit will be reduced? 6. What are Regressive tax and Progressive tax? Functions of Government Budget Primarily, there are three functions or requirement of Government budget such as: Allocation, Distribution and Stabilization of resources of government. Let s discuss them one by one: Allocation Function: Certain goods, referred to as Public goods, such as roads, national defense, government administration, are cannot be provided through the market mechanisms. These must be provided by the government. This is the allocation function. Distributive Function: Through its tax and expenditure policy, the government attempts to bring about a distribution of income that is considered fair by society. The government affects the personal disposable income of households by making transfer payments and collecting taxes and, therefore, can alter the income distribution. Stabilization Function: The economy tends to be subject to substantial fluctuations and may suffer from prolonged periods or unemployment or inflation. In such situation, there need to frame proper policy to reduce the same. This function of budget is called stabilization function.

Difference between Public Goods and Private Goods 1. The benefits of public goods are not limited to a particular consumer, as in case of Private Goods but become available to all. 2. In case of Private Goods anyone who does not pay for the Goods can be excluded from enjoying its benefits. However, in case of public goods, there is no feasible way of excluding anyone from enjoying the benefits of the goods. 51 Public Provisions: Public provisions means that they are financed through the budget and made available free of any direct payment. These goods may be produced directly under government management or by the Private sector Budget Under Article-112 of the Indian Constitution, there is a constitutional requirement to present before Parliament a statement of estimated receipts and expenditures of the government in respect of every financial year which runs from 1 st April to 31 st March. This Annual Financial Statements constitutes the main budget document. Further the budget must distinguish expenditure on the Revenue Account from other Expenditures. Therefore, the Budget comprises of the: a) Revenue Budget; and b) Capital Budget. Government Budget Revenue Budget Capital Budget Revenue Receipts Revunue Expenditure Capital Receipts Capital Expenditure Tax Revenue Non-tax Revenue Plan Revenue Expenditure Non-Plan Revenue Expenditure Plan Capital Expenditure Non-Plan Capital Expenditure Direct Taxes Indirect Taxes (Components of Government Budget) Now let s discuss the different components of Government Budget in brief:

When a government incurs a revenue deficit, it implies that the government is dissavings and is using up the savings of the other sectors of the economy to finance a part of its consumption expenditure. 56 This situation means that the government will have to borrow not only to finance its investment but also its consumption requirements. This will lead to a buildup of stock of debt and interest liabilities and force the government, eventually to cut expenditure. Since a major part of the revenue expenditure is committed expenditure, it cannot be reduced often the government reduces productive capital expenditure or welfare expenditure. This would mean lower growth and advance welfare implications. Fiscal Deficit Fiscal deficit is the difference between the government s total expenditure and its total receipts (excluding borrowing). Gross Fiscal Deficit = Total Expenditure (Revenue receipts + Non-debt creating Capital receipts) Non-debt Creating Capital Receipts are those receipts which are not borrowings and therefore do not give rise to debt. Examples: Recovering of loans and the proceeds from the sale of PSUs, etc. The Fiscal Deficit will have to be financed through borrowing. Thus, it indicates the total borrowing requirements of the government from all sources. From the finance side- Gross Fiscal Deficit = Net borrowing at Home + Borrowing from RBI + Borrowing from abroad Net Borrowings at Home includes- 1. That directly borrowed from the public through debt instruments (e.g. the various small savings scheme) and 2. Indirectly from commercial banks through (Statutory Liquidity Ratio) SLR The gross fiscal deficit is a key variable in judging the financial health of the Public sector and the stability of the economy. From the above it is clear that revenue deficit is a part of fiscal deficit. Fiscal Deficit = Revenue deficit + (Capital expenditure non-debt creating capital receipts) A large share of revenue deficit is fiscal deficit indicated that a large part of borrowing is being used to meet its consumption expenditure needs rather than investment.

Unit Structure 1. Open Economy 2. Balance of Payments (BoP) 3. BoP Surplus and Deficit 4. Foreign Exchange Market 5. Determination of Exchange Rate 6. History of Exchange Rate Management 7. History of Exchange Rate Management in India Unit Objectives After reading this Unit you will be able to understand: Unit-6: External Sector 61 1. What is Open Economy? 2. What is Balance of Payment (BoP) and its different Components? 3. What is Foreign Exchange Market and different types of Exchange Rates? 4. How Exchange Rates are Determined? 5. Brief history of exchange rate management? 6. Brief History of Exchange rate management in India? Open Economy Before proceeding to study the external sector it is very important to understand what Open Economy is. An open economy is one that trades with other nations in goods and services and, most often, also in financial assets. Total foreign trade (exports + imports) as a proportion of GDP is a common measures of the degree of openness of an economy. Note: When goods move across national border, money must move in the opposite direction. The Balance of Payments (BoP) The Balance of Payments (BoP) records the transactions in goods, services and assets between resident of a country with the rest of the world for a specific period of time, typically a year. There are two main accounts in BoP 1. The Current Account; and 2. The Capital Account

2. Net Investment Income: it includes the interests, profits, and dividends on our assets abroad minus the income foreigners earn on assets they won in India. 3. Net non-factor Income: net income from shipping, banking, insurance, tourism and software services 63 Current Account Balance: By adding trade-in-services, net transfers and trade balance, we get Current Account Balance. 1. Current Account Deficit: If the Current Account Balance is a negative number, it is Current Account Deficit. 2. Current Account Surplus: If the Current Account Balance is a positive number, it is current Account Surplus. Curent Account Balance Trade-in- Services Net Transfers (Transfer Payments) Trade Balance Factor Income Imports Net Investment Income Exports Net nonfactor Income Capital Account The Capital Account records all international purchases and sales as assets such as money, stocks, bonds etc. 1. Credit: Any transactions resulting in a payment to foreigners is entered as debit and is given a negative sign. 2. Debit: Any transactions resulting in a receipt from foreigners is entered as a credit and is given a positive sign. Balance of Payment Surplus & Deficit Like an individual who spends more than her income must finance the difference by selling assets or by borrowing A country that has a deficit in its Current Account

Glossary Adam Smith (1723 1790) Regarded as the father of modern Economics. Author of Wealth of Nations. 75 Aggregate monetary resources: Broad money without time deposits of post office savings organisation (M3). Automatic stabilizers: Under certain spending and tax rules, expenditures that automatically increase or taxes that automatically decrease when economic conditions worsen, therefore, stabilizing the economy automatically. Autonomous change: A change in the values of variables in a macroeconomic model caused by a factor exogenous to the model. Autonomous expenditure multiplier: The ratio of increase (or decrease) in aggregate output or income to an increase (or decrease) in autonomous spending. Balance of payments: A set of accounts that summarise a country s transactions with the rest of the world. Balanced budget: A budget in which taxes are equal to government spending. Balanced budget multiplier: The change in equilibrium output that results from a unit increase or decrease in both taxes and government spending. Bank rate: The rate of interest payable by commercial banks to RBI if they borrow money from the latter in case of a shortage of reserves. Barter exchange: Exchange of commodities without the mediation of money. Base year: The year whose prices are used to calculate the real GDP. Bonds: A paper bearing the promise of a stream of future monetary returns over a specified period of time. Issued by firms or governments for borrowing money from the public. Broad money: Narrow money + time deposits held by commercial banks and post office savings organisation. Capital: Factor of production which has itself been produced and which is not generally entirely consumed in the production process. Capital gain/loss: Increase or decrease in the value of wealth of a bondholder due to an appreciation or reduction in the price of her bonds in the bond market. Capital goods Goods which are bought not for meeting immediate need of the consumer but for producing other goods. Capitalist country or economy: A country in which most of the production is carried out by capitalist firms.

Transfer payments to households from the government and firms: Transfer payments are payments which are made without any counterpart of services received by the payer. For examples, gifts, scholarships, pensions. 82 Undistributed profits: That part of profits earned by the private and government owned firms which are not distributed among the factors of production. Unemployment rate: This may be defined as the number of people who were unable to find a job (though they were looking for jobs), as a ratio of total number of people who were looking for jobs. Unit of account: The role of money as a yardstick for measuring and comparing values of different commodities. Unplanned change in inventories: Change in the stock of inventories which has occurred in an unexpected way. Value added: Net contribution made by a firm in the process of production. It is defined as, Value of production Value of intermediate goods used. Wage Payment for the services which are rendered by labour. Wholesale Price Index (WPI): Percentage change in the weighted average price level. We take the prices of a given basket of goods which is traded in bulk. ******** OBJECTIVE IAS